Earnings Call Transcript - FISI Q4 2020

Operator, Operator

Good morning, and welcome to Financial Institutions, Inc. Fourth Quarter and Full Year 2020 Earnings Call. Please note this event is being recorded. I would now like to turn the conference over to Shelly Doran, Director of Investor & External Relations. Please go ahead.

Shelly Doran, Director of Investor & External Relations

Thank you for joining us for today's call. Providing prepared comments will be President and CEO, Martin 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 historical SEC filings available on our Investor Relations website for a Safe Harbor description and a detailed discussion of the risk factors relating to forward-looking statements.

Martin Birmingham, President and CEO

Thank you, Shelly. Good morning, everyone and welcome to our fourth quarter 2020 earnings call. Despite the many ongoing challenges presented by the COVID-19 pandemic, thanks to the commitment and significant effort of the collective five-star team, 2020 proved to be a year of strong performance across an array of key outcomes. We generated record high net income of $13.8 million in the quarter or $0.84 per diluted share as compared to $12.3 million or $0.74 per share in the third quarter of 2020 and $13.1 million or $0.79 per share in the fourth quarter of 2019. Pre-tax, pre-provision income in the fourth quarter was also the highest in company history at $21 million, a $1.7 million increase from the third quarter of 2020 and a $4.9 million increase from the fourth quarter of 2019. Revenue growth and expense discipline, reflecting the impact of our enterprise standardization program resulted in a fourth quarter efficiency ratio of 55.8%. We took two actions during the fourth quarter to provide important flexibility in managing our balance sheet in the months ahead. The first was in October when we sold $35 million of 10-year, fixed-to-floating rate subordinate notes with an annual interest rate of 4.375%. After 5 years, it becomes floating rate debt redeemable at our discretion. We were comfortable with our capital levels before the offering, but deemed it prudent to take advantage of low interest rates to add capital for use in organic and strategic growth opportunities, and to further strengthen the bank's capital ratios. The second action was the establishment of a stock repurchase program for approximately 5% of our outstanding common shares. Shares may be purchased in open market transactions and pursuant to any technical requirements of a 10b5-1 trading plan. We did not buy back shares during the fourth quarter due to blackout restrictions. However, our plan went into effect on January 11, and we have repurchased a total of about 127,000 shares since then. In December, we announced the planned acquisition of a Rochester-based insurance brokerage firm, Landmark Group. Landmark will be acquired in our SDN Insurance Agency subsidiary and their principals will remain with SDN to lead our Rochester insurance operations. The Landmark acquisition will expand our insurance business in Rochester in the Finger Lakes region, an important growth market for us. Kelly and Chris Shea, Landmark’s Chairman and President, are highly respected. Their philosophies are consistent with ours and they have a very strong commitment to their clients. We see upside in leveraging our banking and wealth management offerings to their clients and their insurance offerings to local Five Star customers.

Justin Bigham, CFO

Thanks, Marty. Good morning, everyone. Marty said it very well. 2020 really was a year of strong performance across an array of key outcomes, most importantly, the fundamentals which is well measured by pre-tax pre-provision, which increased over 8% year-over-year. Additionally, we also generated over 2% of operating leverage from 2019 to 2020, excluding branch restructuring charges. With that said, let me start by providing comments on several key areas with comparisons to the third quarter of 2020. Net interest income for the quarter was $36.2 million, an increase of 682,000 from the linked quarter. The increase was driven by a number of items that increased our interest-earning assets which I'll cover now. In December, we started to see PPP loan payoffs through the forgiveness process. Approximately $17 million of these loans were forgiven, and we accelerated approximately 240,000 in net interest income from origination fees in connection with the payoffs. Net interest margin was nine basis points lower than the linked quarter, which is lower than we projected, primarily due to a higher than expected increase in our liquidity position. Specifically, new deposit growth was higher and seasonal decline in municipal deposits were slower than we forecasted, which on a combined basis significantly increased our overall liquidity position. Some of this excess was deployed into collateral-eligible, mortgage-backed securities in an effort to reduce the NIM pressure associated with interest on excess reserves at the FRB. While we couldn't fully deploy the excess cash due to the delayed, but expected seasonal public outflows in December, the incremental yield improvement of our investment purchases was about 100 basis points better than the interest earned on cash held at the FRB. About 5 basis points of the NIM decline is attributable to the investment portfolio and 4 basis points is attributable to the Federal Reserve cash position.

Martin Birmingham, President and CEO

Thank you, Justin. The pace of activity in 2021 is certainly not slowing. We successfully launched the current round of the Paycheck Protection Program on Tuesday, January 19. Our online application and submission process is working well, and there's been strong interest from new and existing customers in applying for their loans with Five Star Bank. To date, we have processed more than 800 applications for approximately $100 million in PPP loans. And the SBA has already approved $39 million. We're using an experienced and well-respected FinTech partner for the online application process or loan portal. We learned a great deal from last year's program and the rollout from the SBA in 2021 has been much smoother. Accordingly, the experience for our associates and customers is greatly improved in the current round. Our organization continues to adapt and evolve to meet the needs of our customers necessary in our fast-changing world. Our new portal should enable us to process a significant amount of loans in 2021. But it all depends on demand in the availability of funds. We've also been working with our community partners to provide information and assistance to low-income and minority communities regarding the Paycheck Protection Program. Conversations with these community partners highlighted the need for necessary communication and support to minority and underbanked businesses by a locally based financial institution. At the onset of the first round of the loans in 2020, many minority businesses either missed out or felt as though they missed out on needed funding. A very high percentage of minority businesses are sole proprietorships, have no employees, and typically don't benefit from stable banking relationships. In mid-January, we worked with Rochester-based community partners to provide a webinar titled, 'Ensuring Access for All'. Discussion focused on the program and recent changes, and we let minority businesses know that Five Star Bank is here to help no matter how large or small the loan. We will be good shepherds of the PPP program and help as many in our communities as we can. We have a wonderful opportunity to help many new and existing customers that will, in turn, strengthen relationships and lead to new business and an even brighter future for Five Star. We also continue to work with our customers on the forgiveness of 2020 PPP loans. As of December 31, 2020, 110 loans totaling $17.4 million had been forgiven out of a total of approximately 1,700 loans. As of last week, we had received forgiveness applications from only about 45% of borrowers. We believe this is due to customer expectations of potential changes in the forgiveness process, which did occur with the new CARES Act 2.0. Changes made in the application process for loans of $150,000 or less are much simpler, and additional expenses are now allowable for forgiveness. We are still awaiting the new simplified form to be released by the SBA and of the more than 950 customers that have not sent in their forgiveness application, 770 were loans of $150,000 or less. The SBA has now paid off $44 million of our PPP loans, with another $49 million submitted and approved by the bank for forgiveness. The SBA has 90 days to pay off the loans submitted; although to date, they have been paying them much quicker. I am proud of our many accomplishments in 2020. Despite the pandemic and its many challenges, we delivered uninterrupted banking services while keeping our customers and associates safe. We provided customer relief and helped approximately 1,700 customers obtain PPP loans. Our new online and mobile banking platform was launched in late spring to provide improved accessibility to customers during a time when they needed the ability to bank from anywhere, anytime. Major improvements and processes and operations were implemented, and we streamlined our branch network, all as a result of the enterprise standardization program. In the fourth quarter, we completed an unsecured debt offering and a stock repurchase program, important actions to support our balance sheet and provide opportunities. Progress was made for the opening of our two new branches in Buffalo, and we announced a nice bolt-on insurance acquisition. And our strong community support continued through grants, donations, and investments. Because of the dedication, adaptability, and commitment of my associates, we were able to accomplish all these things and deliver impressive financial outcomes. While year-over-year, net income and earnings per share were negatively impacted by the COVID-driven increase in provision, we generated 7% growth in total revenue, comprised of net interest income and non-interest income. Non-interest expense, excluding the impact of non-recurring charges incurred in connection with the branch transformation, increased only 4.6% in 2020, and includes significant investments in technology, such as our digital banking platform. Income tax expense benefited from our ongoing investment in historic and low-income tax housing projects. We recognize that many uncertainties remain, and I look forward to 2021 with hope for progress by our leaders and providing essential support for the vaccination rollout and pandemic relief in the reopening of our economy. Operator, this concludes our prepared comments and we are ready to open the call for questions.

Operator, Operator

Thank you. The first question today comes from Alex Twerdahl of Piper Sandler. Please go ahead.

Alex Twerdahl, Analyst

Hi, good morning.

Martin Birmingham, President and CEO

Morning, Alex.

Alex Twerdahl, Analyst

I was hoping you could give us a little bit more color on the loans that were downgraded this quarter. Was it just loans that were on modification or did you go through more of an extensive process, looking at the whole loan book to arrive at that bucket of loans that were put into the criticized classified categories?

Martin Birmingham, President and CEO

So Alex, I'm sure you can appreciate that's been a fundamental focus of our risk and our commercial team for the most part of the last 10 to 11 months, and the overarching approach that we've taken has been to make sure that whatever actions we're taking are logical, they're reasonable, they're defensible, and ultimately documented because so much of what we're trying to manage through here is not explicitly guided for from a regulatory accounting perspective. In terms of the CARES Act, and the specific provisions that it provides for in our case, TDR relief from an accounting and regulatory perspective, but as well, the spirit and intention of the CARES Act to provide support to help good customers that didn't have anything to do with obviously, a pandemic impacting them as negatively as it has. So we've worked as an organization to develop an addendum to our credit policies that we've called our COVID addendum to basically manage through and guide us through this process. And as part of that, Alex, one of the things by definition, if we are dealing with and helping customers effectively bridge to the end of the pandemic through relief and modifications, we’ve elected to call those loans special mention by definition, so we are watching carefully. We also want to make sure it's as transparent as possible for all of our constituencies: our investors, our regulators, our auditors, and as well the teams inside the bank that are working with these loans. So, to your question, Alex, we have individually analyzed each of these credits, and ultimately through the policy that we developed, but the core conclusion was focused on their sustainability to get beyond the pandemic and to return to normal operations in a post-COVID world. So that's the fundamental approach that we've taken dealing with our COVID addendum, incorporating, as I said, our best logical, reasonable approach, defensible to whatever regulatory guidance was out there. But ultimately, it's a policy that we developed to support this question and this issue. And, as Justin talked about, our CECL loss drivers were in terms of our model, signaling stronger employment numbers, and we, as a result, worked in terms of our qualitative factors and the underlying risk that's out there and continues to be out in the economy and making sure that those were appropriately adjusted. In the fourth quarter, we identified those lists as part of this COVID bucket of loans that we believe had the highest loss flow risk and segregated them and took appropriate action relative to provision expense. So, Justin, I'll stop there, and you can help Alex with more specifics.

Justin Bigham, CFO

Yes, Alex, to clarify your question about deferrals, the answer is no; it encompasses a broader assessment of the portfolio. Within that $127 million pool, approximately $44 million consists of loans that are not in deferral. These loans vary in circumstances, but a notable example includes a construction or stabilization project that has been paused. While the borrowers are making payments, the project is on hold due to factors such as a lack of events at an event space. We have a small number of loans in this situation that we are closely monitoring and have classified as criticized assets to ensure oversight, as Martin explained. Additionally, around $83 million of the total deferred loans have been transitioned as well, which accounts for the total of $127 million. Regarding deferrals, as detailed in our materials, we had about $99 million on deferral at year-end, which is now lower. A few loans initially scheduled to resume normal payments in January, February, and March have already returned to their payment schedules, so these loans were not added to the criticized pool despite being on deferral, because we anticipated their return to normalcy. We have been closely tracking this portfolio, including not just the $127 million but our overall COVID exposure for quite some time, and we feel we have it under control now. We believe the reserves we have set aside are sufficient based on our current understanding, and they appear adequate for the COVID exposure.

Alex Twerdahl, Analyst

Thank you for all the additional color. Do you have, by any chance, things like LTVs weighted LTVs on that bucket of criticized classifieds?

Justin Bigham, CFO

Yes, so we did do a very robust analysis that included looking at the latest appraised value. I will tell you the LTVs, what's interesting about COVID, Alex, as I'm sure you can imagine, is the latest appraisal, the variation that occurs during COVID relative to values is pretty dramatic. So when we looked at it, we actually applied a pretty significant discount to our current appraisal, and we had a handful of loans after applying that discount that we were concerned about, and that handful of loans is sort of the loans that we've set aside some dollars for, if that provides any color.

Alex Twerdahl, Analyst

Okay, understood. And then, just in your fee income guidance that you went through, I just missed that. Would you mind repeating that, please?

Justin Bigham, CFO

Yes, sure. Just to make sure I get it right. I'm going to actually look at it here. So low single digit growth in non-interest income, and that's excluding gain on investment securities.

Alex Twerdahl, Analyst

Okay. And then finally…

Justin Bigham, CFO

I'm sorry, I was just going to say the other color that we added in that paragraph was just a reminder that we waived fees this year, right for COVID relief. And that was offset by a really, really strong year of the interest rate swap business as well as mortgage banking. And we are assuming that those two really strong performers are going to moderate a bit next year.

Alex Twerdahl, Analyst

Understood. And then final questions for me. The buybacks. It sounds like you guys are using a 10b5-1 program. Are you able to share with us what the parameters of that program are?

Justin Bigham, CFO

We're really not, Alex. I will tell you that, based on kind of the activity that we've had so far, we're looking at a payback period of less than nine months. And our evaluation of the parameters was based on strong economic return. As you can imagine, you kind of have to evaluate the return of that versus the return of something else. And a less than nine month return is obviously a very strong return.

Alex Twerdahl, Analyst

Great, thanks for taking all my questions.

Justin Bigham, CFO

Thank you, Alex.

Operator, Operator

The next question comes from an analyst. Please go ahead.

Unidentified Analyst, Analyst

Morning, everyone. Justin, I thought the margin guidance for the year was encouraging. Apologize if I missed the detail on this, but can you give us a sense for the macro backdrop you're assuming that supports the margin outlook? Thanks.

Justin Bigham, CFO

Yes, sure. So our margin outlook is based on pretty extensive analysis that we've done, trying to understand how we expect our portfolio to behave. We do expect that we're going to continue to see some pressure on yields, loan yields, but we also continue to think that we're still going to get some benefit out of our deposit book. And, obviously, we can see a lot more into that deposit book than perhaps it's visible externally. But we have a really strong opportunity on certain areas of our deposits and continue to see good CD repricing. Our reciprocal portfolio has a lot of opportunity to come down. If you think about the environment we were in exactly this time last year, rates were high, deposits were extremely valuable. And people were taking CDs if they were doing a one year or two year CD at that time; it was pretty favorably priced. So we do see some opportunity in the deposit book that's going to help compensate for some of the loan yields that we're expecting to compress. We also have an interest rate cap that we talked about a while back a couple, I think it was a couple years ago when we initiated that interest rate cap, and that cap is expiring, and that's going to give us some benefit as well. The real driver of the macro view that’s creating the compression that we see is really driven by the excess level of liquidity. We anticipate that's going to continue. You probably in the guidance heard what we're talking about for deposits. We do think deposit growth is going to be more significant than loan growth next year. And that is going to create some pressure on our NIM, as we try to deploy that cash into something that looks and feels as much like a loan as we can get, which unfortunately, is going to be a lower-yielding asset that a loan would be. So I hope that's helpful. That's the best color I think I can provide just relevant to the macro environment that we see.

Unidentified Analyst, Analyst

That's helpful. Generally speaking, it seems like you are not expecting any improvement in the rate backdrop or the shape of the yield curve. It appears we are just maintaining our current position, which seems to be the overarching assumption you are using to make that assessment.

Justin Bigham, CFO

Absolutely assuming a lot what I call a spot rate environment. Yes.

Unidentified Analyst, Analyst

Okay, great. And then last one for me is on the provision. Did you offer any provision guidance for the year just trying to get a sense for all things being equal? And we kind of the outlook stays with what you guys are assuming now that the reserves build, you feel like is sufficient to kind of carry you through from here?

Justin Bigham, CFO

It's interesting. We didn't provide specific guidance on the provision and focused instead on charge-offs. The reason is that predicting outcomes depends heavily on unemployment forecasts and the progression of the pandemic. If I had clearer insight into those factors, I might be able to better anticipate the outcomes of the CECL model. Making these predictions is quite challenging. I feel confident about our current ratios, both in terms of coverage and reserves. However, that doesn’t mean we will maintain the current reserve level next year; it could increase or decrease based on economic forecasts. It remains difficult to predict, which is why we've provided guidance on charge-offs but not on the overall provision or allowance.

Unidentified Analyst, Analyst

Got it. I appreciate you taking the questions. Thanks, guys.

Justin Bigham, CFO

Of course. Thanks, Joe.

Operator, Operator

This concludes our question and answer session. I would now like to turn the conference back over to Martin Birmingham for any closing remarks.

Martin Birmingham, President and CEO

Thank you very much operator. I want to thank all those that participated in the call this morning and we'll look forward to continuing to build on the conversation in the quarters to come in 2021.

Operator, Operator

This conference has not concluded. Thank you for attending today's presentation. You may now disconnect.