Earnings Call Transcript - FIBK Q2 2020

Operator, Operator

Good day, and welcome to the First Interstate BancSystem, Inc. Second 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.

Lisa Slyter-Bray, Senior Vice President

Thanks, Rocco. Good morning. Thank you for joining us for our second 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 of the 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 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 executive team. At this time, I'll turn the call over to Kevin Riley. Kevin?

Kevin Riley, CEO

Thanks, Lisa. Good morning, and thanks again to all of you for joining us on our call today. Along with our earnings release, we have published an updated investor presentation that has some additional disclosures that we believe will be helpful to you. We have updated a few slides, and that update will be published this morning. The presentation can be accessed on our Investor Relations website. If you haven't downloaded a copy yet, I would encourage you to do so. I'm going to start today by providing an overview of the major highlights of the quarter, and then I'll turn the call over to Marcy, so she can provide more detail on our financials. I want to begin by saying how proud I am of the whole organization. The COVID-19 pandemic has presented an unprecedented set of challenges, and with each turn, our team has figured out a way to keep our operations running smoothly, maintain a superior level of client service, and capitalize on our new business development opportunities that are available to us. I would like to thank all of our colleagues for the hard work and commitment that resulted in a strong financial performance in a very challenging environment. For the quarter, we generated net income of $36.7 million or $0.58 per share, and a pretax provision income of $66.6 million. In my mind, the real highlights of the quarter have to be the resiliency of our markets. We continue to be fortunate that many of our markets that we operate in have been among the areas of the country least impacted by COVID-19. Unemployment rates in our footprints, with the exception of Oregon, are slightly outperforming the national level. Montana, Wyoming, and South Dakota remain in the top 14 states in terms of the lowest unemployment, while Idaho ranks third in the nation with an unemployment rate of 5.6%. Additionally, consumer spending trends, while mostly negative since the start of the year, have seen marked improvement and are well above levels witnessed in early April. This matches up to the anecdotal information that we hear from our bankers and clients across our footprint. Simply put, people have money in their pockets, and they are spending. With our diverse business mix, we have been able to capitalize on pockets of strength that we are seeing in the economy. While our commercial borrowers remain cautious about making new investments, we are seeing strong demand in our residential mortgage and indirect consumer lending businesses. Our mortgage banking revenue was up 58% in the second quarter compared to the second quarter of last year. In the loan portfolio, residential real estate loans were up 18.5% and indirect consumer loans were up 14.1% on an annualized basis. In the mortgage business, we are not only benefiting from the increased demand for refinancing but also from the steady influx of people relocating to Montana and Idaho, which is driving up more purchase volume. The resilience of our markets is also reflected in the strength of our asset quality. We saw declines in nonperforming assets and criticized loans during the quarter. As of July 22, 64% of the loans that received a modification or deferral had either continued or resumed making their scheduled payments. These positive trends also reflected strong underwriting in our portfolio and the limited exposure we have to industries most impacted by the pandemic. Today, we've had limited requests for second deferrals or modifications, and the majority of those are coming from clients in our hospitality industry. Another highlight of the quarter was the productivity and efficiencies of our efforts around the Paycheck Protection Program. The investments we have made to adapt our lending to be scalable and the processes standardized over the past several years served us well in getting our PPP application process up and running very quickly. We were getting loan applications completed and submitted in a matter of hours. As a result, we were able to process more than 11,000 applications that were approved for $1.2 billion in funding. Through our efforts, we earned $43.2 million in fees and gained $90 million in deposits from over 2,200 new customers. Time after time, we heard stories from companies being frustrated with the lack of response from their current bank, both large and small institutions, and being impressed by the level of service and the speed with which we could get their PPP loans processed and approved. The PPP program turned into an incredible business development opportunity that enabled us to really demonstrate the value proposition that we offer: a bank that leverages technology and efficiencies combined with an unmatched level of personal service. Since bringing on these new clients, we have made significant progress in expanding our relationships. We are receiving numerous messages from our bankers about clients moving over their deposit accounts, both business and personal, to First Interstate, and expanding their lending relationship to include other types of loans, such as commercial lines of credit as well as equipment and residential real estate loans. We expect further progress with these new clients will positively impact our loan and deposit pipeline in the coming quarters. The experience of the pandemic has also underscored the strength of our deposit franchise. Our total deposits increased by $1.8 billion from the end of the first quarter, with almost all of that coming in our lowest-cost deposit categories. In general, the increasing balances are coming from the operating accounts of our commercial clients as their businesses continue to perform relatively well. Before I pass the call on to Marcy, I wanted to mention that we are excited that Michael Lugli joined our team as our new Chief Credit Officer. Michael comes to us from KeyBank, where he served in various roles for nearly 30 years. His extensive credit background, including asset recovery, health care, real estate, commercial banking, private banking, and mergers and acquisitions, combined with his leadership experience, makes Michael the perfect person to oversee our credit team, and we are fortunate to have him with us. With that, I'd like to turn the call over to Marcy, so she can provide some additional details around our second quarter results. Go ahead, Marcy.

Marcy Mutch, CFO

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 first quarter of 2020, and I'll begin with our income statement. Our net interest income decreased $600,000 from the prior quarter due to an $800,000 decrease in accretion and interest recovery income, along with the impact from the Fed Fund rate cut we had in March. On a reported basis, our net interest margin decreased 38 basis points to 3.52% in the second quarter. Breaking down the major components of the change in our net interest margin, 26 basis points were attributed to the change in yields, with the decline in asset yields being partially offset by the decline in deposit costs; 8 basis points of the decline were attributable to the impact of the lower-yielding PPP loans; 2 basis points were attributable to a decline in interest recoveries and accretion income; and 2 basis points were attributable to the subordinated debt we took on in March. Excluding the impact of interest recoveries and loan accretion, our operating net interest margin declined 33 basis points to 3.44%. Our cost of funds for the month of June was 12 basis points, down from 20 basis points in March, so we will continue to see a bit of relief on that front entering the third quarter. During the second half of 2020, we have $556 million in CDs, or 54% of the current CD portfolio that will mature, and these deposits carry a weighted average rate of 1.14%. Other than the maturation and renewal of these CDs at lower rates, we don't think we'll have much more room to bring down deposit costs. While the repricing in our loan portfolio from the last fed rate cut has largely occurred, new loan production is coming on the books at 15 to 20 basis points below our average yield in the loan portfolio, excluding PPP loans. We are witnessing declining yields in the securities portfolio as payoffs from investments are being reinvested at much lower yields. Given this pressure on the earning asset side, we expect to see some continued compression in our margin, although it should be manageable. Moving to noninterest income, as we stated in the earnings release, I want to point out that we have reclassified mortgage servicing revenues and direct costs related to loans sold to mortgage banking revenue. This is to be more consistent with how others in the industry are reporting. Our noninterest income increased $1.3 million quarter-over-quarter to $39.7 million. The increase was almost entirely due to a $3.3 million increase in net mortgage banking revenue, which includes a $5.5 million mortgage servicing impairment adjustment this quarter. Our mortgage banking revenue is benefiting from the strong demand for refinancing, which accounted for 71% of our total mortgage production in the second quarter. In May, our digital mortgage application portal began accepting applications for refinancing, which helped drive additional volume to this channel. In the second quarter, we closed approximately $162 million of loans through the digital channel. Our pipeline for both refinance and purchase residential mortgage loans remained very strong as we started the third quarter. It's not quite at the record levels we saw in the second quarter, so it's likely we'll have revenues that are somewhat lower than this quarter, but still higher than historical norms. The increase in mortgage banking revenue in the second quarter was partially offset by lower revenue in several line items that have been impacted by COVID-19. Payment services revenue is lower due to the decline in the volume of transactions during the pandemic, mainly related to travel expenses, as well as a higher percentage of the transactions coming through retailers that have negotiated lower interchange rates. Service charges on deposit accounts are lower for a couple of reasons. First, we saw a shift in behavior as clients had fewer opportunities for spending as a result of COVID restrictions, and we also made the decision to waive certain overdraft fees as part of our client support efforts. Lastly, wealth management revenues declined due to a drop in assets under management as a result of volatility in the market. Moving to noninterest expense, we had an increase of $600,000 from the prior quarter. This was primarily due to higher salaries and wages, resulting from higher levels of incentive accruals. Our base compensation is steady on a linked-quarter basis. However, in the first quarter, based on our initial expectations from the fed rate cut, we had accrued lower levels of incentive pay. As we began to see the impact from government stimulus and the PPP loans, we've readjusted our expectations and were able to catch up on our incentive compensation accrual this quarter. This increase in salaries and wages was partially offset by lower employee benefits expenses resulting from lower health insurance costs and lower payroll taxes. Most of our other expense items were relatively consistent with the prior quarter as we continue to keep a tight lid on discretionary spending while the pandemic is ongoing. One notable exception is occupancy expense. We needed an adjustment to correct the depreciation on assets that were added at the beginning of the year, which increased our occupancy expense this quarter. We expect this expense to level back out to the low $10 million range per quarter, although longer term, there will be some opportunities for cost savings in this area. We have decided to permanently close two in-store branches that have already been closed due to the pandemic. This will result in modest cost savings. However, the decline in branch traffic and the increasing preference for digital banking channels will provide us with an opportunity to continue evaluating our real estate needs going forward, including continuing to transition certain larger branches to smaller, more efficient footprints. Moving to the balance sheet, our total loans increased $1.1 billion from the end of the prior quarter, with all of the growth being attributable to PPP loans. Excluding PPP loans, our total loans would have been slightly down, as the decline in commercial loans offset the growth we saw in the residential mortgage and indirect consumer portfolios. At this point, excluding PPP loan activity, we expect our loan portfolio to remain relatively flat to slightly up for the rest of the year, as any new growth will most likely be offset by normal paydowns and payoffs. Our total deposits increased $1.8 billion from the end of the prior quarter, with most of the growth coming in noninterest-bearing deposits. We also saw significant growth in our repo balances, which were up 23% quarter-over-quarter. Moving to asset quality, we saw decreases in most problem asset categories. Our nonperforming assets declined $7.2 million, while our criticized loans declined by approximately $34 million. We recorded a provision for credit losses of $19.5 million, which covered our $2.3 million of net charge-offs in the quarter while adding to our general reserves to reflect the downgrade in our economic forecast. This brought our allowance for credit losses to 1.46% of total loans when PPP loans are included or 1.64% when PPP loans are excluded. And with that, I'll turn the call back over to Kevin.

Kevin Riley, CEO

Thanks, Marcy. Nice job. I'm going to wrap up with a few comments about our ability to manage through this crisis. We entered this crisis with a fortress balance sheet, a concertedly underwritten, well-diversified loan portfolio, a high level of reserves, excess capital, and ample liquidity. Throughout this crisis, our balance sheet has even gotten stronger. We've increased our allowance. We've further increased our liquidity while maintaining a significant amount of excess capital. Operations will remain relatively constant over the second half of the period, and we will continue to generate solid earnings and pretax pre-provision income. Although the crisis has demanded significant amounts of time and attention, we continue to operate with a long-term perspective and execute well on technology initiatives that are strengthening our infrastructure, improving our scalability, and enabling us to offer new digital banking features to our clients. Over the past year, we launched digital portals for mortgage lending and business in consumer credit cards. Further, we're actively engaged in efforts to roll out a new digital process for small business lending to really automate that process and reduce our time from application to approval and funding. We continue to see more retail and small business clients utilizing our digital banking tools, and the number of digital interactions we have with our commercial clients has increased nearly 50% from the beginning of the year. Online account openings for both demand deposits and savings accounts are up over 30% since the beginning of the year. We are not allowing the crises to impede our progress in modernizing our bank. While others are retrenching, we are moving forward and investing in our franchise. At some point, and I don't know when that will be, we will get back to a normalized environment. When we do, we believe the progress we have made to enhance our technology platform will have us well positioned to capitalize on organic and acquisition growth opportunities that will be available and enable us to further increase the value of our franchise. So with that, I'd like to open the call up to questions.

Operator, Operator

Today's first question comes from Jared Shaw at Wells Fargo.

Jared Shaw, Analyst

Could you give an update on tourism trends and how that's impacting the hospitality portfolio and your expectations for trends there in hospitality? I guess, if you know what the occupancy levels and activity levels are, that would be great too.

Kevin Riley, CEO

I'll start off a little bit, and Marcy can follow up with some of it. But we've talked to some of our hospitality clients. And they're saying that people are starting to travel more. The occupancy rate right now runs from 32% all the way up to 98% in the properties. This is from people who operate a number of hotels. So it's coming back and moving in the right direction, but in some pockets, it's stronger than other markets. Marcy has some numbers regarding visitations up at Yellowstone. So Marcy, why don't you go over those?

Marcy Mutch, CFO

Yes. So Jared, for just the Yellowstone visitations, year-to-date, we're down about 49%, and that's starting to come back since June. The park didn't even open until June 1. They're only down 32% for June of 2019 versus June of 2020. In general, in Montana and South Dakota, we are seeing that tourism isn't completely cut off. To that point, they are expected to have a surge this year, so we think we'll continue to see some increases as well.

Jared Shaw, Analyst

Great. Shifting gears a bit, can you provide insights on the digital trends? How is the digital uptake for mortgage origination? Did you observe any increases in digital closing and application closing?

Kevin Riley, CEO

Yes. We continue to see that grow more and more each quarter. So yes, we believe that will continue to grow.

Operator, Operator

Our next question today comes from Gordon McGuire with Stephens.

Gordon McGuire, Analyst

Marcy, a few questions on the salaries line and overall expenses. I was hoping you could quantify the incentive accrual catch-up this quarter. Also, do you have any offsetting deferred compensation related to the PPP program? Broadly, what do you think a good overall expense run rate is for us to think about going forward?

Marcy Mutch, CFO

I think the incentive catch-up was around $2 million to $2.5 million this quarter. That will come down a little bit. Health insurance costs will probably level back out a bit. So those two could offset each other. In terms of capitalized PPP costs, it was less than $1 million, Gordon. We believe that the normalized run rate will be right around the $95 million rate going forward.

Gordon McGuire, Analyst

Great. I appreciate the color on production coming down from record levels. Is it fair to say with the digital channel fully open to refi, you've kind of reset what you're capable of here? Or do you anticipate a more meaningful reversion to historical production levels over time?

Kevin Riley, CEO

I would say that we'll probably get back to more of historical production levels. I think we might be a little above what we normally used to do because of the digital channel. I don't think it's going to be all of a sudden a whirlwind of activity. I think we're going to get more activity, but just a little more than we've seen in the past. So it's going to help us, but it's not going to be huge.

Marcy Mutch, CFO

One of the challenges, Gordon, is our inventory levels. We just don't have the inventory that would allow for a huge uptick, even if there was demand for purchase activity over and above what we're seeing. We just don't have the inventory in any of our markets across the footprint.

Gordon McGuire, Analyst

Understood. Does the digital channel pipeline come over with different pricing in terms of gain on sale margins? I noticed the growth in fees wasn't quite commensurate with the production level increase versus the first quarter.

Kevin Riley, CEO

No, it has pretty much the same sale gains as all production. The good thing is, at some point, it might have fewer costs associated with the speed at which we can get these loans done. So the cost of origination could go down.

Gordon McGuire, Analyst

Just a follow-up on your comments about the $47 million that moved into the second round of deferrals. I'm curious how many of those modifications have reached the expiration of their first period. Is there another group of modifications that still hasn't come to term yet that we should think about rolling back to scheduled payments?

Kevin Riley, CEO

This is a moving target. All I can give you is the information that I provided earlier. To date, we only have $47 million that we've moved into a second round of deferral modifications, which is just over maybe 4% of the portfolio. We believe this will come down substantially. Everyone is guessing what it might be, and we're somewhere around 15% to 20% that might represent our current balances that might look for a second round, but most of it is returning to normal payments.

Operator, Operator

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

Matthew Clark, Analyst

On the favorable migration in criticized loans, can you give us a sense for what drove that? How much of that was just upgrading credits and so forth?

Marcy Mutch, CFO

It was just upgrading some credits. There was nothing in particular that stood out; we just kind of went through our normal processes. We had some downgrades, some upgrades, and the upgrades just offset the downgrades. But there were no particular loans that stood out in that process.

Matthew Clark, Analyst

Okay. Did you guys repurchase any stock this quarter? I didn't think so, but I wasn't sure.

Kevin Riley, CEO

No.

Matthew Clark, Analyst

On the PPP loans, I assume you're using a 24-month accrual, or a shorter period. How do you plan to use a lot of those proceeds in the next couple of quarters?

Kevin Riley, CEO

The plan is to integrate it into the income bottom line. We are amortizing fees over 24 months; we're not taking a shorter amortization period. As Marcy said, we deferred very few costs against those fees, so as those loans are forgiven, we will record that as income.

Operator, Operator

Our next question today comes from Jackie Bohlen with KBW.

Jackie Bohlen, Analyst

On that same line of questioning, did you have any loans that were forgiven during the quarter?

Kevin Riley, CEO

No.

Marcy Mutch, CFO

We did not.

Jackie Bohlen, Analyst

Do you happen to have the average balance of loans in the quarter, not the average amount of each loan, but the total average PPP loan?

Marcy Mutch, CFO

$943 million.

Jackie Bohlen, Analyst

Lastly, how are you thinking about balance sheet size, excess liquidity, and deposit flows? How might you deploy some of that excess cash going forward?

Kevin Riley, CEO

We are picking our places to deploy it, but the investor portfolio isn't giving us a lot of great opportunities. We're surprised by the amount of liquidity that we have here. I mean, we funded PPP loans, and we believe that some of the clients could utilize those balances. Our deposits were up $1.8 billion, and our repo dropped almost $200 million. We just had an immense amount of liquidity come in. We don't know where that's going to settle out. But we'll continue to take in additional deposits and try to deploy them the best way we can. However, we don't know where it will settle out, but it is some amazing growth.

Jackie Bohlen, Analyst

Yes, I definitely agree with that. As you think about the deployment of liquidity, are you looking primarily at deploying into assets? Or might there be some liability reductions?

Kevin Riley, CEO

We don't have many liability reductions. Most of it will probably be in asset deployment.

Operator, Operator

Our next question today comes from Levi Posen with D.A. Davidson.

Levi Posen, Analyst

How are you thinking about the pace of your continued digital investment compared to your thoughts at the beginning of this year?

Kevin Riley, CEO

I would say that the speed at which we deliver some of the digital capabilities is faster than we thought at the beginning of the year. With the PPP process, we learned a lot about utilizing technology to enhance the delivery of small business lending. So I would say that we're probably ahead of what we thought we could deliver this year based on what we learned through the pandemic.

Levi Posen, Analyst

I was curious if those downgrades were loans that had modifications. What was your approach with the $47 million of credits that did receive second modifications?

Kevin Riley, CEO

No, the downgrade is just part of our normal operating way we look at the businesses out there. There wasn't anything specifically related to those deferrals.

Operator, Operator

Today's next question comes from Garrett Holland with Baird.

Garrett Holland, Analyst

On the PPP program, it's clearly helpful for revenue and capital benefit as you recognize the fees. How confident are you that you can backfill that contribution as we move into next year when the vast majority of those loans are forgiven?

Kevin Riley, CEO

I can say I'm very confident that I'll put on over $1 billion of loans in the next period. So it will be hard to backfill. I see that as kind of a windfall, and we will continue to grow off our normal levels of performance we've seen in the past. I believe that we will benefit from the overall environment. However, to say we will grow loans by $1 billion, I can't say that for sure. We'll do our best; let's see what happens.

Marcy Mutch, CFO

We expect to see some of our other noninterest income areas, like service charges and payment services, return to a more normal environment. Hopefully, we’ll see those pick up.

Garrett Holland, Analyst

How quickly do you expect those deposit service charges to bounce back?

Kevin Riley, CEO

We are already starting to see some bounce back. We waived some fees, and those are back on again. We're also starting to see higher overdraft fees. But travel is a significant factor; people still aren’t traveling.

Garrett Holland, Analyst

I guess just on credit, it was a strong quarter overall, across charge-offs, NPAs, and credit size. How do you see this credit cycle playing out for First Interstate?

Kevin Riley, CEO

We are looking for issues, but we haven't found anything that concerns me at this juncture. The quote from Jamie Dimon is relevant: losses will likely come in 2021. I don’t see large losses. This is a different type of credit cycle. I will let you know if I encounter any concerns, but so far, I haven't found anything.

Operator, Operator

Our next question is a follow-up from Gordon McGuire with Stephens.

Gordon McGuire, Analyst

Marcy, I was hoping you could reconcile the $8.6 million of PPP interest income with the 8 basis points of NIM dilution from PPP this quarter. Based on the average balance you provided, I calculate an effective yield of 3.7%, which would be accretive to NIM unless there are offsets?

Marcy Mutch, CFO

Yes. That rolls into some of the cash that came in, which impacts that adjustment as well. I have those worksheets, Gordon, let me follow back up with you, and I can provide you with the exact calculation once I look into it.

Operator, Operator

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

Kevin Riley, CEO

I appreciate your time, and thank you for all your questions. As always, we welcome calls from our investors and analysts. Please reach out to us if you have any follow-up questions, and thank you for tuning in today. Goodbye.

Operator, Operator

Thank you, sir. 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.