Financial Institutions Inc Q3 FY2020 Earnings Call

Good day, and welcome to Financial Institutions, Inc. Third Quarter Earnings Conference Call. Please note, this event is being recorded. I would now like to turn the conference call over to Shelly Doran, Director of Investor Relations. Please go ahead.

Thank you for joining us for today's call. Providing prepared comments will be President and CEO, Marty Birmingham; and CFO, Justin Bigham. Director of Financial Planning and Analysis, Mike Grover will join us for Q&A. Today's prepared comments and Q&A will include forward-looking statements. Actual results may differ materially from forward-looking statements due to a variety of risks, uncertainties and other factors. We refer you to yesterday's earnings release and our historical SEC filings available on our website for our Safe Harbor description and a detailed discussion of the risk factors relating to forward-looking statements. We will also discuss certain non-GAAP financial measures used to supplement and not substitute for comparable GAAP measures. Reconciliations of these measures to GAAP financial measures were provided in the earnings release, which was filed as an exhibit to a Form 8-K. Please note that this call includes information that is accurate only as of today's date, October 30, 2020. I'll now turn the call over to Marty.

Thank you, Shelly. Good morning, everyone, and welcome to our third quarter earnings call. As I stated in yesterday's release, the past 7 months have tested us. We have weathered many challenges, yet we've continuously delivered essential products and services to our customers, helped preserve thousands of jobs through the PPP program, provided community support, learned new ways to work together while being apart, and continued to execute on our strategic initiatives, including the launch of a new digital banking platform to improve the customer experience. We continue to lend prudently and are working closely with our customers to help them through these turbulent times. Despite all the challenges, we've generated net income of $12.3 million for the quarter or $0.74 per diluted share, as compared to $11.1 million or $0.67 per share in the second quarter of 2020 and $12.8 million or $0.78 per share in the third quarter of 2019. The pre-tax pre-provision income for the third quarter was the highest in company history at $19.2 million, a $1.9 million increase from the second quarter of 2020, and a $283,000 increase from the third quarter of 2019. These strong results were made possible by the dedication and adaptability of our associates. Approximately $1.6 million of restructuring charges were included in the third quarter results in connection with 6 branch closures and staffing reductions announced in July as part of our enterprise standardization program. Excluding these non-recurring expenses, our efficiency ratio was just below 57% for the quarter. As I've shared previously, the enterprise standardization program is focused on improving operational efficiency and future profitability, while enhancing associate and customer experiences. Opportunities identified by the program have resulted in the implementation of robotic automation and the streamlining of processes and operations throughout the organization as well as the branch transformation announced in July, and an additional branch closure announced in October. The program is not yet complete, and we continue to identify operational improvements. Back in January, when we announced the launch of this initiative, we indicated that we expected to generate annualized expense savings once implemented within the range of $5 million to $7 million. While COVID did delay the implementation of certain components of the program, we continue to expect annualized savings in this range. We anticipate that some of these savings will be reinvested in our 2 new branch openings scheduled in the City of Buffalo in the first half of next year. After quarter end, we completed an initiative to raise capital in the form of subordinated debt, seizing upon opportunities created by historically low interest rates and ready access to the capital markets. While we were confident that we already had appropriate capital levels to effectively run our business, we determined that it would be prudent to access the debt markets at favorable rates to add capital for use in serving our customers, taking advantage of organic and strategic growth opportunities, and strengthening the bank's capital ratios. We also deemed it wise to add capital as we continue to operate in a COVID-19 environment where the long-term impacts of the pandemic on the economy remain uncertain. In October, we sold $35 million of 10-year fixed-to-floating rate subordinated notes to institutional investors. The interest rate is fixed at 4.375% for the first 5 years and thereafter, it becomes floating rate debt redeemable at our discretion. This structure provides important flexibility if interest rates are significantly higher in 5 years or we determine that this is no longer an attractive source of capital. Our subordinated debt offering was very well received, demonstrating the financial strength and viability of our company. Investor demand exceeded the amount of notes offered, and the interest rate obtained was lower than we anticipated. The execution of the facility resulted in a fixed rate well below similar offerings conducted by Upstate New York peers in the past several months. Our enterprise standardization program, digital platform upgrade and conversion, and the successful completion of our notes offering are the most recent examples of the many ways we are working to strengthen our institution and support its long-term sustainability and performance. We continue to deliver tangible results of the hard work that is transforming our company. Now my pleasure to turn the call over to Justin for a discussion of results for the quarter. Justin?

Thanks, Marty. Good morning, everyone. I'll be providing comments on several items with comparisons to the second quarter of 2020. Net interest income for the quarter was $35.5 million, an increase of $1.3 million from the linked quarter. The increase was driven by a higher level of interest-earning assets, primarily loan growth, which benefited from the PPP loan program. Net interest margin was 3.22%, down 1 basis point from the linked quarter. The average yield on interest-earning assets was 3.6%, a decrease of 16 basis points from the linked quarter. Cost of funds was 38 basis points, a decrease of 15 basis points. The margin compression we've experienced as compared to the linked quarter and prior year quarter is largely attributable to excess liquidity and elevated cash levels. The low interest rate environment and overall challenging economic environment have made it difficult to deploy cash in investment alternatives with attractive duration adjusted yields. The decline in interest-earning asset yield was driven by elevated cash levels, coupled with the impact of a lower rate environment on commercial loans and mortgage-backed securities and the impact of a full quarter of lower-yielding PPP loans. The impact on interest-earning asset yield of heightened federal reserve interest-earning cash and PPP loans was approximately 2 basis points and 1 basis point, respectively, when compared to the second quarter of 2020 and approximately 6 basis points and 5 basis points, respectively, when compared to the third quarter of 2019. The decline in the cost of funds was driven by lower deposit costs and wholesale borrowing costs, driven by lower market interest rates and a favorable funding mix. Provision for credit losses for the quarter was $4 million, comprised of $3.6 million of provision for loans and $461,000 of provision for unfunded commitments. Credit losses were minimal for the second quarter in a row, with net charge-offs totaling $488,000. However, as we stated last quarter, although we remain cautiously optimistic, the long-term impact of the pandemic remains to be seen. Our allowance for credit losses on loans increased to $49.4 million at September 30 from $46.3 million at June 30. The higher allowance for credit losses considers the impact of COVID-19 and the economic environment on our primary loss driver, which is national unemployment. We used the Bloomberg economist weighted average unemployment forecast, which now forecasts fourth quarter national unemployment at 8%, which is down from the 13% peak level of unemployment reached during the second quarter, which was at the height of the pandemic. We forecast unemployment out 6 quarters, and overall, the forecast is now lower than it was last quarter. In addition, our CECL quantitative model estimates expected credit losses using a reversion to the mean of the company's historic loss rates on a straight-line basis over 2 years. Our CECL model also includes qualitative adjustment, and given the uncertainty associated with the long-term impact of the pandemic on unemployment, and ultimately credit losses, we increased our qualitative factors to more than offset the decrease in the unemployment forecast in establishing the higher allowance. The allowance for credit losses on loans to total loans was 1.38% at quarter end as compared to 1.33% at June 30. If you exclude PPP loans, the ratio increases to 1.49%, an expansion of 5 basis points from the linked quarter. Noninterest income was $2.6 million higher than the second quarter of 2020. The key drivers were: First, net gains on the sale of mortgage loans were $850,000 higher due to an increase in transaction volume and margin. Second, service charges on deposits were $774,000 higher because of our COVID relief measures of waiving or eliminating fees for the entire second quarter, most of which ended on July 9. Third, insurance income was $538,000 higher due to the timing of commercial renewals typically received in the third quarter each year. And fourth, investment advisory fees were $192,000 higher as a result of the impact of market gains, new customer accounts and increases in existing accounts on assets under management. While our relief programs related to waiving or elimination of fees have ended, we are still seeing lower than historic levels in service charges on deposits. This is likely the result of the positive impact of stimulus programs on consumer account balances combined with changes in consumer behavior. We continue to see strong performance from our interest rate swap program for commercial banking customers with revenue of $1.9 million in the quarter, consistent with the second quarter. We sold securities in the second quarter that we believe have a higher propensity to prepay, resulting in $554,000 of gains, down $120,000 from the linked quarter. We remain focused on managing premium risk in the portfolio and monitoring securities with increased prepayment characteristics. Noninterest expense was $28.7 million, an increase of $2 million from the linked quarter. The largest contributors to the increase were; nonrecurring severance and real estate-related restructuring charges of $1.6 million were incurred in connection with the July announcement of branch closures and staffing reductions. $224,000 is included in salaries and benefits expense and $1.4 million is included in restructuring charges. Computer and data processing expense was $551,000 higher, primarily due to costs related to the second quarter launch of Five Star Digital Banking. And advertising and promotion expense was $410,000 higher, also related to the launch of our new digital banking platform. Partially offsetting these higher expenses was a $338,000 decrease in professional services expense. The decrease was the result of the timing of fees for consulting and advisory projects, including our improvement initiatives. Income tax expense was $2.9 million in the quarter, representing an effective tax rate of 19.3%. Moving to the balance sheet. Growth in total loans was $83 million or 2.4% from the end of the second quarter of 2020. Commercial mortgages grew 5.4%; residential loans increased 2%; and consumer indirect was up 1.5%. Commercial business was relatively flat compared to the linked quarter. Originations in C&I continue to be soft, largely due to PPP loans and the resultant cash that borrowers have on hand. Third quarter commercial loan closings included select new financings for existing developers and draws on existing construction lines of credit. Residential lending demonstrated continued strong performance during the quarter, largely due to increased refinance volume driven by the low rate environment. The saleable portion continues to grow, increasing $422,000 in the quarter. And as I noted before, gains on the sale of loans increased $850,000 over the linked quarter. Total deposits at quarter end were $371 million higher than the end of the second quarter of 2020 and $779 million higher than September 30 of last year. The increase from June 30 was primarily the result of seasonality in our public deposit portfolio, combined with growth in both our reciprocal and brokered deposit portfolios. We are flushed with deposits and remain cautious of chasing yield in investment purchases. Purchases during the quarter were focused on cash flowing, agency wrapped mortgage-backed securities with yields and dollar prices reflective of market demand for this paper. The increase from the year earlier period, primarily in demand, savings, and money market accounts was largely the result of the impact of government stimulus programs, pandemic-related changes in customer habits and growth in our reciprocal and brokered deposit portfolios. Our brokered deposit portfolio was $128 million higher than the end of the second quarter and $280 million higher than September 30, 2019. In February of 2020, we entered into a long-term brokered sweep arrangement as a stable, collateral-free alternative funding source to reduce reliance on FHLB secured borrowings and improve our available committed liquidity. The stable funding raised through the brokered deposit relationship was utilized to pay off $100 million of higher cost FHLB term advance during the third quarter. Decreases in the common equity to assets ratio and TCE ratio were the result of heightened federal reserve, interest-earning cash and the impact of lower-yielding payroll protection program loans. At quarter end, both ratios would have been higher than the previous period if not for these factors. During the third quarter of 2020, the company paid a common stock dividend of $0.26 per share, returning 35% of third quarter net income to common shareholders. Management and the Board of Directors will continue to closely monitor the economic environment and business trends, and we will prudently manage capital levels going forward. There are no current intentions to reduce the dividend.

At this time, I'll turn the call back to Marty for closing remarks. Thank you, Justin. We benefit from a very stable Western New York and Finger Lakes market within Upstate New York, and our commercial customers are generally conservative in nature. Many of them learned valuable lessons in the Great Recession and were better prepared coming into the current COVID-19 environment. We continue to see significant improvement in loan deferrals. At June 30, $525 million of loans or 16% of total loans outstanding were on deferral. As disclosed in the third quarter investor presentation posted on our Investor Relation website yesterday. As of October 23, deferrals were down 86% to approximately $76 million or 2% of total loans. We continue to stay in close touch with our borrowers to monitor their operating environments as well as overall market trends. While we generated strong results in the third quarter and are seeing positive economic trends, we remain cautiously optimistic about the coming months and quarters. The economy will hinge on the impact of COVID on businesses and communities as the country manages through an increase in cases and a possible second wave. We continue taking great care of our customers and supporting our communities through these challenging times. Many of our support initiatives are described in the Five Star Bank 2020 Community Report, which is now posted to the Five Star Bank website and our Investor Relations website. I encourage you to read this report to better understand the many ways our company and our associates are giving back. Our outlook is positive, and we remain focused on driving strong outcomes, supporting our customers' financial wellbeing, the quality of life for the communities we serve, and building long-term shareholder value. Operator, this concludes our prepared comments, and we are ready to open the call for questions.

We will now begin the question-and-answer session. Our first question comes from Alex Twerdahl of Piper Sandler.

First off, I wanted to discuss NII and the margin. I think you have done a very good job keeping the margin relatively stable. Looking at the balance sheet with excess cash, it seems you have created some room to lower deposit costs. Can we expect margin stability from here and perhaps even a bit of expansion in the fourth quarter and into 2021?

So Alex, yes, I think the way I would think about that is, I'm pretty comfortable that our margin has become relatively stable. But saying that beyond the fourth quarter is kind of tough. At some point, deposit costs are going to bottom out, and then we might be subject to potentially some additional compression depending upon what happens with spreads in the market on commercial loans, et cetera, et cetera. And depending upon what happens to the shape of the yield curve, which I always like to talk about as well. So I'm only really willing to talk about at this point fourth quarter. And I do think that, again, barring anything unusual, I think we do have the opportunity to continue to maintain a relatively stable margin into the fourth quarter.

And then maybe I was hoping you could comment a little bit on the loan pipelines, and you guys grew a little bit of the consumer indirect this quarter. I know that's been a little bit less of a focus recently. But just sort of given what's going on in that market, does it make sense to turn those engines back on in more force?

So, Alex, our loan pipelines remain strong due to solid customer relationships, reliable sponsors in commercial real estate, and effective operators in commercial and industrial as well as small business sectors. We are actively engaging with our customers. In Upstate New York, the economy has remained relatively stable, largely because the impact of COVID-19 in this area was not as severe, leading to less disruption. We continue to see positive activity from our clients. We were among the first regions to reopen under Governor Cuomo's guidance during the pandemic. We will keep nurturing these relationships and pursue additional business opportunities as they arise. Regarding indirect lending, it currently accounts for about 23% of our overall loan portfolio, which aligns with our long-term management strategy for the balance sheet. As you've noted, this has been a strong segment for us. Our approach has consistently focused on maintaining sound credit in the areas we serve and similar regions that reflect our economic and business environment. During the Great Recession, we capitalized on the volatility in this area, as large competitors exited the market. We are observing similar activity now, and our spreads remain favorable at this time, providing us with an opportunity to enhance our performance.

And then just final question for me. You guys raised a little bit of sub debt earlier this month, added about almost 100 basis points to total capital. Just wondering if you could kind of go through sort of the priorities or the uses for that capital. And at 70-ish percent of tangible book value, do buybacks play a role in those capital priorities as well?

We have dedicated significant time as a management team to assess our capital outlook and long-term performance in light of the pandemic, while also collaborating with our Board. After analyzing the decline in deferrals, we are increasingly confident in the company’s capital structure and will explore how to utilize it effectively. As mentioned in our prepared remarks, our focus is on supporting the company's ongoing growth and exploring opportunities, both strategic and organic. We are aware of and have been assessing the potential impact of a share buyback program, and once we conclude our evaluation, the decision will ultimately be made in conjunction with our Board.

Our next question comes from Marla Backer of Sidoti.

So I'm trying to get my arms around like how things might be changing now in your specific markets, if they're changing at all? We're seeing spikes in cases in the New York City region. We're moving into colder weather, which might impact some of the businesses that reopened during the earlier portion of the pandemic, but reopened primarily outdoors. What are you seeing in your specific markets in response to some of these changes?

Well, like the rest of the country, we are starting to observe some developing hotspots in the markets we serve. However, the communities have been very proactive, implementing measures such as social distancing and shutting down school systems as needed. Overall, the economy, the market, and the communities continue to operate as normally as possible. Our infection rates remain relatively low, currently around 4%. Direct action is taken when there are indications of hotspots or increasing outbreaks.

In terms of deferrals, you mentioned them in your prepared remarks, and there is a slide in the slide deck indicating they have decreased significantly since the start of the pandemic. What is your approach to individual requests for customized relief, if you are receiving those? How are you managing that? Do you expect that to increase potentially?

Yes, we are encouraged by the improvement in the deferral rate and the decline in all of our portfolios as highlighted in our investor materials. However, this continues to be a significant issue for our company, the banking industry, our communities, and our country, particularly regarding the impact of COVID on sectors heavily affected by the pandemic. We are in discussions with our regulators and are committed to supporting our customers in alignment with the CARES Act, ensuring we do so in a safe and sound manner.

And then my last question is about the nonbank revenue. And it was a little bit higher than I expected, which I thought was very positive. Can you talk to where you're seeing activity perhaps increase beyond what you had expected? Or if that's not the case, is this just normal business as usual? Can you talk to how those other businesses seem to be operating right now?

Yes, Marla. One important point to note is that we experience some seasonality in our fee income as a broad category. For instance, our wealth management income, specifically in investment advisory, showed strong growth this quarter, largely due to increased assets under management. This growth is not solely attributable to market gains; we are also seeing significant cash inflows into our customers' advisory accounts where they are adding new funds. Additionally, there's a seasonal uptick in our insurance income. Historically, the third quarter is one of our strongest periods for the insurance business, driven by commercial renewals. We are indeed experiencing robust growth in that area. Moreover, our mortgage banking revenue from gains on sales has also been quite strong, supported by the current low interest rates and increased refinancing activity. We have also raised the proportion of our mortgage business that we sell to the secondary market while retaining the servicing rights, which has further enhanced our fee income.

Hey, Marla, it's Marty again. I just want to jump back in. I reviewed my notes. And relative to infections, the hotspots that we have in our geographic footprint the infection rate is around 4%. But, generally, in our entire footprint, it still remains low below 1% as far as the COVID infection.

Our next question comes from Damon DelMonte with KBW.

So my first question regarding expenses and kind of the outlook there. Justin, any insight on the trending level on data processing or any other categories as we kind of look forward?

Thank you, Damon, for your question. The increase we observed this quarter was approximately $600,000 in the computer, data, and processing category. I tend to avoid going into too much detail about specific categories since, as you know, there are various factors affecting expenses, including seasonal variances and marketing spend that can fluctuate. However, I want to clarify that the $600,000 increase is not indicative of a sustainable rise. A portion of it relates to one-time expenses from the digital banking launch, with about half of that increase being more of a recurring nature. It's important to note that most software today, including ours, operates on a subscription basis linked to usage, so we can expect some variability in this area due to changes in volume. That said, our platform is enhancing customer engagement and significantly expanding our capabilities, which leads us to anticipate continued revenue growth from it. We've conducted an in-depth business case on this digital banking platform. With that in mind, I can provide some guidance for fourth-quarter expenses. Based on my assessment, we expect expenses to be around $26 million, give or take a couple of hundred thousand.

My next question is about the trends in credit quality, which remain very strong. You increased the reserve by about 5 basis points excluding the PPP loans. What are your thoughts on future provisions and reserve levels? Do you believe you have built an adequate reserve? I understand there are factors to consider in your CECL modeling, but based on the underlying trends, should we expect provision levels similar to those in the second and third quarters, or do you think it might return to levels seen in 2019, which were about half of that?

It's a complex situation. We've been cautiously optimistic about our book's performance in relation to deferrals, but we're aware that the full impact of this pandemic has yet to unfold. This quarter, with the decrease in the unemployment rate, which is our primary loss driver, it influenced our quantitative model to suggest reducing reserves. However, we didn't feel comfortable proceeding with that reduction since we are still unsure of future developments. We have our qualitative factors in place, and with the lowered unemployment forecast, we adjusted them to account for other factors influencing reserve needs beyond just unemployment. This adjustment helped us recognize that our reserves should indeed increase, and they grew by about 4 to 5 basis points this quarter. Looking ahead to the next quarter, it's challenging to predict. If unemployment rates decrease significantly, it may compel banks to lower their models substantially, making it hard to maintain or increase reserves qualitatively. It's tough to forecast given the uncertainty in unemployment rates. However, if such decreases occur, we would hope they are accompanied by positive developments in the market that benefit our portfolios. I appreciate your question, but that's all I can provide at this stage.

And wasn't CECL supposed to make this process a little better for everybody? Apparently not so. Okay, and then just one more quick question, if I can. So when you talk about the margin outlook and the optimism of keeping it kind of steady or flat here in the fourth quarter, does that take into account the impact from the sub debt raise that you guys did earlier in this month?

Yes, it does.

Thank you, Damon.

Our next question comes from Kevin Swanson of Hovde Group.

I just wanted to maybe a follow-up on the credit discussion. I appreciate the color. But thinking about the stimulus and maybe a potential for a second round, do you think that it's simply delayed losses? Or do you think it's actually gone a long way in saving some of the businesses and kind of helping out?

I do think it's had a very positive impact on the business. And I would say that the coordination between the legislative, executive and Federal Reserve System has really been superb in terms of helping provide relief efforts. As Justin talked about in his comments, our balance sheet has been impacted with cash balances that are sitting there, so that I recognize that the proceeds of the PPP and cash is fungible, but I think our customers that have participated in that program are sitting on some liquidity and some dry powder, if you will, to navigate future challenges with the pandemic in whichever way it goes. We are looking at our credits, those that have been impacted, and it's going to come down to hospitality, really probably for the most part, as well as some forms of retail. And we will look at these credits on an individual basis and determine ultimately the sustainability of those credits to bridge the pandemic and to kind of pick up where they were all acceptable credits pre-pandemic when it's over. And that's the process that we're going through. It is a work in process, and it's part of the uncertainty that Justin was talking about.

I have one more question. Considering the loan-to-value ratios at the time of origination, have you received any clarity on pricing through the market, sales, or transactions that would allow you to provide an updated loan-to-value number or valuation for the business, or is it still too unclear?

It's probably still too early to determine. However, we've consistently discussed that even in this COVID environment, we are not experiencing the typical highs and lows of economic performance. Our underlying real estate values, whether it’s consumer properties, individual homes, residential mortgages, or commercial properties, are trading within a narrow range and are relatively stable. As we navigate this process, we expect to gain valuable insights through new appraisals and observations of market developments. Our aim will be to manage well, and if we provide structures to help our customers navigate the pandemic, we will focus on maintaining the integrity of the loan-to-value ratios as outlined in our credit policies.

This concludes the question-and-answer session. I would like to turn the call back over to Mr. Birmingham for any closing remarks.

I want to thank everyone for their participation on the call this morning. I also want to acknowledge our associates once again for their hard work and commitment to helping us produce these results, and we'll look forward to continuing this conversation at the end of the fourth quarter. Thank you.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.