Financial Institutions Inc Q1 FY2023 Earnings Call

Hello, everyone, and welcome to the Financial Institutions, Inc. First Quarter 2023 Results Call. My name is Nadia, and I'll be coordinating the call today. I will now hand over to your host, Kate Croft, Director of Investor Relations and External Relations to begin.

Thank you for joining us for today's call. Providing prepared comments will be President and CEO, Marty Birmingham; and CFO, Jack Plants. Chief Community Banking Officer, Justin Bigham; and 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 investor presentation as well as historical SEC filings which are available on our Investor Relations website for our Safe Harbor description and a detailed discussion of the risk factors relating to forward-looking statements. We'll also discuss certain non-GAAP financial measures intended to supplement and not substitute for comparable GAAP measures. Reconciliations of these measures to GAAP financial measures were provided in the earnings release filed with an exhibit to Form 8-K. Please note that this call includes information that may only be accurate as of today's date April 27, 2023. I'll now turn the call over to President and CEO, Marty Birmingham.

Thank you, Kate. Good morning, everyone, and thank you for joining us today. First quarter net income available to common shareholders was $11.7 million or $0.76 per diluted share, consistent with the linked quarter and down from the prior year period when the company reported $14.6 million or $0.93 per diluted share. The year-over-year decline was primarily the result of higher provision for credit losses and an increase in expenses compared to the year ago period, driven in part by investments in talent. Before turning the call over to Jack for more detail on our financial performance and our expectations for the remainder of the year, I would like to provide some insights in context on the health of our balance sheet. Given the recent bank failures, increased volatility, and broad brush commentary by the financial media, it's appropriate to provide a company-specific update. On the funding side, deposits totaled $5.1 billion at March 31, up 4.3% from December 31. As a reminder, we have a substantial public deposit portfolio associated with local municipalities. Balances are typically higher in the first quarter as a result of seasonality associated with inflows from tax payments and state funding. Reciprocal deposits were also up during the quarter as this has become an attractive option affording our larger customers the benefit of FDIC insurance on accounts greater than $250,000. Given the interest rate environment, we continue to see disintermediation from core transaction-type accounts to time deposits in both our non-public and public deposit portfolios, which has impacted margin as non-public time deposit balances increased $89 million on a linked quarter basis through both new talent acquisition and quarter time deposit disintermediation. Despite this expected remix of deposits, the granularity of our community banking franchise benefits our deposit portfolio. We operate through 49 banking locations across our Upstate New York footprint, which had average deposit balances per branch of approximately $79 million, excluding reciprocal and brokered deposits. Further, uninsured retail deposits make up approximately 14% of total deposits when considering the secured nature of our public and reciprocal portfolios, which typically have larger balances. Independent of the balance sheet, our available committed liquidity remained strong at approximately $1.2 billion. Organic loan growth was once again a highlight of our quarterly performance with a 4.8% increase in total loans from December 31, 2022, which was supported by a strong pipeline at year-end 2022 and several large commitments that carried over to the first quarter of 2023. In our investor presentation published yesterday, you'll find more granularity on our commercial portfolio, and in particular, commercial real estate and office space exposure. Commercial growth has been achieved while maintaining our disciplined credit culture. Our experienced in-market lenders have excellent relationships with high-quality sponsors within our footprint that have demonstrated consistency in execution and credit performance. Our CRE portfolio consists of assets with outstanding balances of $1.6 billion and committed credit exposure of $2.1 billion at March 31. There are more than 700 loan facilities associated with this portfolio among approximately 300 separate lending relationships, resulting in an average loan size of approximately $2.8 million. Considering the rollover risk of the portfolio, 15.5% of exposure is scheduled to mature within the next 12 months and another 14% will mature within 24 months. We've been careful to scale our underwritten loan amounts to the global financial profile and track record of sponsors. Our analysis indicates that proxy maturities are manageable. More than 90% of CRE loans have full or limited personal or corporate recourse, helping mitigate loan rollover risk and reinforcing the alignment of interest between borrowers and Five Star Bank. The average loan-to-value ratio of the portfolio is 55%. Realizing that at a national level, there is a heightened focus on office CRE, I would like to comment on the stability of our office book, which we believe is of high quality and differentiated from what lenders operating primarily in large urban markets might be experiencing. Office space represents 18% of our CRE exposure and less than 8% of total loan balances at March 31. About three-quarters of the portfolio is for Class B or medical space, which consists of medical properties located in close proximity to hospitals in densely populated areas. We have very limited exposure to central business districts with just four loans for properties representing total exposure of $27 million, and we have strong confidence in the quality of the sponsors we're working with on these projects. In fact, two of these loans are with a publicly traded developer who will be leasing the space to a publicly traded tenant with an A+ credit rating for over 20 years, which is longer than the term of our loan. Consistent with our approach for all CRE lending, we have reasonable loan-to-leverage ratios for our office portfolio, including average loan-to-value at origination of 57%. In our annual stress testing of the portfolio, including increasing rates by 250 basis points above current rates and decreasing net operating income by 20%, we achieved debt service coverage ratios of 1:1. As supported by strong sponsors and personal recourse on loans, we remain comfortable with the overall quality and mix of the office book given geographic dispersion, strong credit metrics and exposure diversification outside of central business districts. Multifamily is our largest concentration, representing 39% of CRE exposures and 15% of loans. Within our multifamily portfolio, about 53% relates to stabilized properties and the remainder are in the construction phase. We are considered a premier construction lender in our market and have been providing construction funds for projects that have identified permanent mortgage take-out options by obtaining long-term non-recourse financing structures. Supporting the diversification of commercial loans is our expanded geographic footprint. Our Mid-Atlantic team, which joined us a little over a year ago, grew commercial loans outstanding by approximately $49 million in the first quarter of 2023 to $197 million at March 31. In the first quarter of this year, we also announced our expansion into the Syracuse, New York market with a new commercial loan production office. We have three C&I lenders based at this office and believe this expansion will support the growth of our commercial business portfolio, which was up 4.6% during the first quarter driven by line draws. The team has been doing an excellent job of engaging with prospective clients so far, and we look forward to their future contributions. Our residential loan portfolio was relatively flat with the end of the linked fourth quarter as expected. Among ongoing pressures of inflation, higher interest rates and tight housing inventory, the consumer indirect loan portfolio was $1 million at quarter-end, also flat with the linked quarter. As we noted on our call in January, we are proactively moderating consumer and direct production through pricing and continue to focus on credit quality and stringent underwriting standards, which has been and continues to be the foundation for this business activity. Ours is a prime lending operation with an average portfolio FICO score of 714. In the first quarter, 60% of consumer indirect fundings were Tier 1, 700 and above; and another 22% were Tier 2, 670 and above. The weighted average coupon on new production was 8.45%. Net charge-offs were 73 basis points in the current quarter, in line with historical trends. Our disciplined approach to credit and risk management continues to support strong asset quality metrics. For the first quarter, we reported 21 basis points of both non-performing loans and annualized net charge-offs to average loans. While we did see a $17.7 million increase during the quarter in criticized and classified loans to $77.7 million, this increase related to two relationships that were downgraded to special mention. One in the C&I portfolio, which is expected to be temporary, as well as one CRE relationship where we are a participant. Provision for credit losses on loans was $4.2 million in the quarter, supporting an allowance for credit losses to total loans ratio of 112 basis points and 540% of non-performing loans at March 31. Overall, credit remains benign and we continue to believe our loan portfolio performance will be consistent with historic outcomes. This concludes my introductory comments. It's now my pleasure to turn the call over to Jack for additional details on results and updates to our guidance for 2023.

Thank you, Marty. Good morning, everyone. Net interest income of $41.8 million was down $1.3 million from the fourth quarter of 2022, reflective of fewer days than the most recent quarter, as well as the higher cost of funds in the current rate environment. Our overall cost of funds in the quarter was 162 basis points, up 53 basis points in the linked fourth quarter. Net interest margin on a fully taxable equivalent basis was 309 basis points for the first quarter of 2023 compared to 323 basis points in the linked fourth quarter. Margin was pressured by a shift in funding mix as our customers shifted balances from lower-cost transaction deposit accounts to higher-cost time deposits when we brought on additional wholesale borrowings to fund loan growth that was higher than planned. With that said, we expect the pace of loan growth to moderate through the remainder of the year with planned commercial growth being front-loaded in the first and second quarters. We continue to expect to deploy cash flow from our loan and securities portfolio, which represents a combined $1 billion over the course of the year into new loan originations at market rates to partially offset the impact of higher funding costs and stabilize our margin moving forward. Relative to the magnitude of FOMC rate increases that occurred in 2022 and so far in 2023, our total deposit portfolio has experienced a cycle-to-date beta of 27%, including the cost of time deposits. Excluding the cost of time deposits, the non-maturity deposit portfolio had a beta of 13%. Non-interest income, which includes revenue from our insurance and wealth management businesses, was $10.9 million in the first quarter, consistent with the linked quarter as anticipated. Non-interest expense of $33.7 million was also flat to the linked quarter. In the current quarter, we recorded a higher level of FDIC insurance expense due in part to the final rule that went into effect in 2023, increasing the initial base deposit insurance assessment rate schedules uniformly by 2 basis points, coupled with balance sheet growth driven by commercial mortgage loans. In comparison to the linked quarter, the increase in FDIC insurance offset non-recurring restructuring charges incurred in the fourth quarter of 2022 related to the closure of five branches. Income tax expense was $2.8 million in the quarter, representing an effective tax rate of 18.7% compared to $2.4 million at an effective tax rate of 16.4% in the fourth quarter of 2022. We saw improvement in our cumulative other comprehensive loss to $127.4 million given the current position of the recourse and roll-off of the investment securities. As you'll see in our investor presentation, relative to year end 2021, just before the FOMC began raising interest rates, the unrealized loss position negatively impacted quarter end TCE by 193 basis points and tangible common book value per share by $7.42. Excluding the AOCI impact, our TCE ratio and tangible common book value per share would have been 6.96% and $29.04 respectively. We continue to expect these metrics to return to more normalized levels over time given the high quality of our investment portfolio. I would now like to provide an update on our outlook for 2023 in key areas. We continue to expect mid-to-high single-digit growth in our total loan portfolio for full year 2023, although front-loaded given the strong first quarter results. We continue to expect that growth will be driven by commercial loan categories, inclusive of any contributions from our Mid-Atlantic and Central New York LPOs. We continue to plan for mid-single-digit growth in non-public deposits with a heavier weighting in time deposits based on our first quarter actual experience. We are focused on attracting new consumer and commercial deposit accounts and expect the positive impact of these new accounts to be partially offset by a lower average balance per account as an outcome of the economic environment. Banking-as-a-Service or BaaS initiatives are expected to generate approximately $150 million of deposits in the last three quarters of 2023, a significant contributor to our non-public deposit growth goals. Given competitive pressures, we experienced a reduction in public deposits, some of which were shifted to the reciprocal deposit portfolio. We expect balances to be relatively flat throughout the remainder of 2023 with the exception of typical seasonal fluctuations on a quarterly basis. We now expect full year NIM of 305 to 315 basis points, approximately 25 basis points lower than previous guidance given the funding cost pressure experienced in the first quarter. Our forecast assumes a forward rate curve that reflects economist predictions for a 25 basis point rate increase in May with Fed activity remaining muted thereafter. Net interest margin is expected to be relatively flat for the remainder of the year. We now expect the 2023 effective tax rate to fall within a range of 18% to 19%, including the impact of the amortization of tax credit investments placed in service in recent years. We will continue to evaluate tax credit opportunities and our effective tax rate will be positively impacted by taking advantage of further investments. That concludes my prepared remarks and updated guidance. I'll now turn the call back to Marty.

Thank you, Jack. Overall, despite a tough operating environment, I believe our company is off to a productive start in 2023. We reported strong loan growth in the first quarter and announced a strategic expansion into Central New York that enhances our commercial and industrial lending focus. We continue to report strong and stable asset quality metrics and reinforce our risk management culture with the hire of Gary Pacos as Chief Risk Officer. Gary is a talented risk professional with more than 30 years of progressive compliance, consumer credit, and operations experience in the banking industry, and we look forward to his contributions as we continue to grow. During the first quarter, we were also pleased to announce a 3.4% increase in our quarterly cash dividend, underscoring our Board's confidence in our strategy and earnings potential. While we are navigating a challenging time for our industry and country brought on by recessionary concerns and heightened funding pressures, I continue to be optimistic about what we can achieve in 2023. Our Upstate New York footprint remains financially stable and has historically weathered recessions well. Our Mid-Atlantic team serves the attractive Washington, D.C. and Baltimore market. As a community bank with local leadership and local decision-making, we believe our consistent focus on building meaningful relationships with our clients will support growth of our loan and deposit portfolios while setting us apart from larger players in our markets and driving value into the company. Looking ahead, we are focused on protecting our margin, effectively managing expenses, and introducing our relationship-based approach to banking, Banking-as-a-Service, wealth management, and insurance to new customers throughout our markets and beyond. That concludes our prepared remarks. Operator, please open the call for questions.

And our first question today goes to Alex Twerdahl of Piper Sandler.

First question. Jack, I think I heard you say that there was $1 billion of cash flows from the securities portfolio over the next year. Is that correct? It seems like a really big number relative to the size of the portfolio.

Yes. The $1 billion in cash flow is combined between the securities portfolio and the loan portfolio. So if we were to break that down, we'd estimate about a little north of $150 million from the securities portfolio and then about $900 million off the loan portfolio.

And the expectation for that, just given your comments on loan growth potentially slowing down from here, I mean, you basically hit your guidance in the first quarter here with the loan growth. Is that most of that is going to go to either reinvestment in the securities portfolio or paying down higher cost in deposits or borrowings?

Yes, likely first pay down borrowings and then reinvestment in the securities portfolio should loan growth taper off.

And then just to keep going on loan growth, I mean, it was a big quarter, especially commercial real estate grew pretty substantially. Can you comment a little bit on how the pipelines look today relative to the end of the year? And then also the color you gave on commercial real estate and the credit quality and all that kind of stuff was very helpful. But I'm just curious if standards have changed internally for you guys in terms of what you're willing to look at or do in light of some of the ongoing issues in the industry?

So Alex, just to reinforce, our approach to credit remains consistent. We've been operating in a market with a pretty tight underlying economy in terms of its growth. So our borrowers are disciplined. Our approach to providing credit has been disciplined. We have been thinking about, though, in light of the current issues in the industry, working with our teams to ensure that we're getting a sufficient return on our loans, introducing a liquidity premium relative to our real estate lending and being very communicative with our borrowers, understanding where they stand in understanding what our appetite is to continue to grow in that segment. But we, as I said, are very comfortable with our sponsors and the activities that we have currently with our loan portfolio and those in the pipeline. The pipeline remains relatively stable. The demand for our type of banking is strong. It's unfortunate that we're working through a very serious situation relative to the bank failures, but the role of a bank of our size in the markets that we serve is critical and our borrowers and customers know that.

Can you provide more details about the nearly $200 million in the D.C. market and clarify if there is any office exposure in the Central District of D.C.?

So that's where we've talked about the exposure to significant activity in the last year has been related to medical buildings that are tied to medical centers, hospitals, medical campuses, et cetera. That is where, in my comments, we talked about the development loan to an office in the Central Business District related to a publicly traded sponsor to a publicly traded A-rated long-term tenant.

I would just add, Alex, from a credit standpoint, those originations generally come with fairly low leverage at loan to values of about 45% on average origination.

I wanted to start with a follow-up on the loan growth expectations, particularly regarding the anticipated slowdown in the second half of the year. I'm interested in understanding what factors are influencing this perspective. Is it something you are observing in the market or a decision made internally? Your loan to deposit ratio remains relatively low compared to the industry average. You mentioned that the pipeline is stable, demonstrating strong demand, and the new loan rates seem favorable for the margin. I'm curious how all these factors contribute to the belief that loan growth will decelerate. Is this driven by your actions or market conditions? It appears there are opportunities to continue growing loans throughout the year if viable risk-adjusted opportunities exist.

Yes, Eric, this is Jack. I'll take that question. So as Marty mentioned, on the commercial real estate side, we've implemented a liquidity premium in our pricing, which is commanding either a higher level of deposits at the time of origination from a sponsor or a higher level of spread or a combination of both, and that's working out very well for us in the Mid-Atlantic region. We're pricing a lot of deals off of SOFR. Borrowers are taking advantage of the inversion in the yield curve, locking in fixed rate funding themselves when they do a back-to-back swap above that's better than what they could traditionally achieve. It was just priced off of treasuries of the Federal Home Loan Bank. And then we see it on our balance sheet as a nice rich spread over SOFR. So that's achievable in that space from a competitive standpoint. There's still a bit of competition in the Upstate New York market from some smaller banks and even credit unions that have started to play in that space. So I would expect that at our current pricing levels that that pipeline will slow.

Currently, we are sharing the status of our pipeline, which could be negatively affected if a recession that we have all been anticipating actually occurs. If that happens, we expect our customers to respond by potentially delaying projects and making fewer investments in plants and equipment, among other things.

Just curious if you could, I don't remember if I missed it in the prepared comments, summarize maybe the changes you made to deposit service charges and what you would maybe expect the run rate of that until quite going forward following those changes?

Sure. This is Jack. Throughout 2022, we reviewed NSF fees in relation to regulatory guidance and actions taken by our competitors, leading us to eliminate the $40 return item fee. Additionally, we increased the de minimis overdraft amount from $5 to $50, which took effect in the first quarter of this year. Generally, NSF fees or deposit service charge fees are lower in the first quarter seasonally. However, from a run rate perspective, we do not anticipate making any further changes this year.

And one just last one, I think a similar question last quarter. But just curious in terms of the Banking-as-a-Service initiatives, I wonder if you could kind of provide an update? It's been, I guess, kind of 90 days since the last time we chatted about it. I'm just curious where you are in the process? And I know you mentioned you expect $150 million in deposits to be coming on over the next three quarters. But just curious if you could kind of update on the total process? What you've achieved over the next 90 days? And what's on the horizon for the next quarter or two?

Erik, I've asked Sean Willett to join us this morning. He's our Chief Administrative Officer and the leader of these initiatives among many in our company. So Sean, do you want to respond?

Sure. So relative to Banking-as-a-Service, we continue to build out a robust pipeline. In terms of onboarding clients, we have a number of clients that we are in the process of bringing over to our platform. So that's a transition off of other banking platforms. We'd expect a significant bulk of the $150 million to come over in the next 90 to 120 days.

And our next question goes to Damon DelMonte of KBW.

This is Matt Rank filling in for Damon DelMonte. I hope everybody is doing well. As a follow-up to the Banking-as-a-Service question, I was just curious whether you were able to generate deposits in the first quarter. And I want to confirm that I understood the $100 million correctly. Are those deposits coming from companies currently in the pipeline or from partnerships that are already live and onboarded?

So again, this is Sean. I'll take that. In terms of the first quarter, the amount of deposits that we onboarded was negligible because that's really driven by our testing and integration. The clients that we have live, it really depends on the clients, right? Some are transaction-oriented or payments-oriented. So those will drive fee income. The large deposit opportunities are those that we had in pipeline as well as a number of LOIs that we had in flight, and we're now in the process of onboarding those clients. As I said, that will occur over the next 120 days.

And what kind of capacity do you have for that platform? Is there a certain limit to the number of partnerships you can have before you have to significantly scale up either tech or people?

So from a tech perspective, no. What we've done is we've built out our service layer, our platform. We've been very thoughtful in that regard. As it relates to people, yes, there is a runway and we have a resourcing model that we will put into action when we get to that point. But that's well beyond the $150 million that we have projected for this year.

And then last one for me. Just on expenses, you mentioned the recessionary environment looms. Do you have any room to cut expenses should revenues pull back from here on out?

Well, let me start by saying that in the fourth quarter, we worked hard to proactively deal with the headwinds that we knew were coming our way and we did take some meaningful expenses out of the company at that time. It was a tough time to do it, but we knew that was the right thing to do. Unfortunately, again, given the bank failures and what's happened and the increase in volatility of our operating environment, interest rates, et cetera, our expenses, efficiency ratio, the way the math works out is going the wrong way. Many of the investments we've made in people and technology, though, occurred over the last year to 18 months. We want to be very thoughtful in terms of taking expenses out at this point as we bridge to the other side of this economic situation or the operating environment we're in. But Jack, I'll ask you to comment further.

Just to summarize, Matt, I mean, we're focused on longer term opportunities for the organization and the enterprise. I would be cautious to cut expenses to simply benefit earnings in a short period of time. We continue to evaluate every opportunity through a business case to understand and earn back that's achievable inside of a short period of time. As we progress throughout the year, we'll continue to do just that.

We have no further questions. I will now hand back to Marty for any closing comments.

I want to thank everyone for participating this morning. We look forward to continuing to build on this conversation in the second quarter and beyond. Thank you.

Thank you. This now concludes today's call. Thank you so much for joining. You may now disconnect your lines.