Earnings Call Transcript - FISI Q2 2021

Operator, Operator

Good day, and welcome to the Financial Institutions, Inc. Second Quarter Earnings Conference Call. After today's presentation, there will be an opportunity to ask questions. Please note, today's event is being recorded. I'd now like to turn the conference over to Shelly J. Doran, Director of Investor and External Communications. Please go ahead, ma'am.

Shelly J. Doran, Director of Investor and External Communications

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.

Marty Birmingham, President and CEO

Thank you, Shelly. Good morning, and welcome to our second quarter 2021 earnings call. It was another strong quarter for our company. Net income of $20.2 million or $1.25 per diluted share was the second highest in company history. Net income was down slightly from the first quarter's $20.7 million or $1.27 per share and significantly higher than second quarter 2020 net income of $11.1 million or $0.67 per share. We once again benefited from a positive provision in the quarter, experienced growth in our wealth management and insurance businesses and continue to contain expenses despite critical investments being made in technology and people. Pre-tax pre-provision income for the quarter was $21 million, a $3.1 million decrease from the first quarter of 2021 and a $3.7 million increase from the second quarter of 2020. I want to thank my fellow associates for their dedication in serving our clients across all business lines. They are delivering strong outcomes for our customers, communities, and shareholders. It was an eventful and successful quarter for our retail branch team. During the month of June, we opened 2 new Five Star Bank branches in the City of Buffalo. Buffalo has long been a focus for company growth. With these openings, we have grown our presence in the greater Buffalo area to 6 branches. While still early, both branches have received warm welcomes in their respective neighborhoods. The new branches are located in areas undergoing significant redevelopment and revitalization, and we look forward to contributing to the positive momentum. We also look forward to delivering our unique style of community banking to our new neighbors. On Monday, we are relocating our existing Five Star Bank branch in the City of Elmira. The new branch in a newly constructed building is about 1,600 feet from the existing branch. This relocation is exciting for our Elmira customers and our associates, and will result in a more efficient footprint and annual cost savings for the company. All 3 new branches are designed to serve as financial solution centers with no teller lines and no barriers between associates and customers. They feature a blend of technology, including interactive teller machines as well as the comfort of working directly with our certified personal bankers. The new design requires less staff and provides a cost-effective, lower square footage approach to aligning services with shifting customer needs and preferences. This includes advancements in financial technology that enable consumers to bank from virtually anywhere at any time. The new branch openings and Elmira branch relocation are a continuation of our retail branch evolution.

Jack Plants, CFO

Thank you, Marty. Good morning, everyone. I want to start today's discussion by examining key areas and making comparisons to the first quarter of 2021. For this quarter, net interest income was $37.7 million, reflecting a slight decline from the previous quarter, even with an increase in average interest-earning assets. This decline was mainly due to lower PPP fee accretion. In the second quarter of 2021, around $95 million of PPP loans were forgiven compared to $87 million in the first quarter, resulting in a fee accretion of $1.5 million in the second quarter versus $2.9 million in the first quarter. The fees on PPP loans vary, with smaller loans typically having higher percentage rates, and we experienced forgiveness of a higher percentage of larger loans in the second quarter. The net interest margin was 3.06%, down 23 basis points from the linked quarter. We faced added pressure on our excess liquidity this quarter due to seasonal public deposits, which contributed approximately 12 basis points to the NIM compression compared to the linked quarter. The mentioned reduction in PPP loan fee recognition also negatively affected NIM by about 11 basis points. Nevertheless, we continue to see stability in the margins of our core balance sheet, evidenced by steady credit spreads on new originations compared to last quarter and last year. The provision for credit losses was a benefit of $4.6 million this quarter, up from a $2 million benefit last quarter. Improved national unemployment forecasts, positive trends in qualitative factors, and lower net charge-offs led to the second consecutive quarterly release of credit loss reserves. Net recoveries amounted to $394,000 this quarter compared to charge-offs of $887,000 in the previous quarter. The second quarter particularly benefited from commercial-related net recoveries of $294,000 and indirect net recoveries of $426,000. Our indirect business saw fewer repossessions, and we also experienced a lower loss per unit thanks to the recent rise in used car prices. These elements resulted in a $3.5 million decrease in the allowance for credit losses this quarter, bringing it down to $46.4 million. As discussed previously, in the fourth quarter of 2020, we identified specific customers and industries as being most at risk due to the pandemic. We classified about 20 loans totaling $127 million as criticized assets and set aside a specific reserve of $4.7 million. This specific reserve increased by $2.4 million in the first quarter to $7.1 million and decreased by around $200,000 to $6.9 million as of June 30. At the end of the quarter, approximately $112 million of these loans remained in the criticized asset category. We are hopeful that these credits will normalize after the pandemic. While we have seen improvements in the performance indicators for several of these credits, we do not intend to release specific reserves until the credits return to a normal payment status. The allowance for credit losses on loans as a percentage of total loans was 128 basis points at quarter end, down 8 basis points since March 31.

Marty Birmingham, President and CEO

Thank you, Jack. I would like to close with a few governance and organizational updates. In mid-June, we announced that Susan Holliday was elected Chair of the Board of Directors. Susan has been a member of our Board since 2002 and most recently served as Vice Chair. She is past Chair of the Management Development and Compensation Committee and most recently served as Chair of the Nominating and Governance Committee. Susan was the owner, President and Publisher of the Rochester Business Journal from 1988 to 2016 and is currently the CEO of Dumbwaiter Design. Her community involvement is extensive, and she serves on numerous nonprofit Boards. I've known Susan for many years, and I'm very pleased that she is now serving in this critical role. She brings strong integrity, inquisitiveness, willingness to challenge and a collaborative approach to the role of Chair. I want to take a moment to thank former Board Chair, Bob Latella for his dedicated service. We have benefited greatly from Bob's leadership and are grateful that he has agreed to remain on the Board. At the June annual meeting of shareholders, 2 new directors were elected. Mauricio Riveros and Mark Zupan. Mauricio and Mark are exceptional additions, and they bring diverse work and life experiences, representing incremental skills, experience in market knowledge and will benefit our organization. Our Board of Directors is committed to diversity and inclusion and through thoughtful succession planning and refreshment has achieved the following levels of diversity and tenure. 5 new directors have been added to the Board over the past 5 years. Gender and ethnic diversity has strengthened. 50% of the Board's 10 independent directors represent diverse groups, with 3 women, each of whom hold key Board leadership positions and 2 directors who belong to a racial or ethnic minority group, one of whom holds a key Board leadership position. Board tenure is balanced with 5 members between 0 years and 5 years, 3 members between 6 years and 10 years and 3 members with tenures of more than 10 years. Advancing diversity and inclusion is an area of focus for management as well. Last September, we established a Diversity And Inclusion Advisory Council to evaluate company practices and provide learning opportunities to educate, build inclusion acumen and foster a sense of belonging. The council comprises associates from diverse personal and professional backgrounds across our geographic footprint. I serve as sponsor for the council and continue to be inspired by the passion of its members. Our work here is critical and will be ongoing. The company continues to take a thoughtful and prioritized approach in returning our associates to the office. Currently, 70% of our workforce has returned to the primary office location and 100% of our client-facing associates returned to primary locations earlier this month. We remain mindful of the COVID variants and are following, not only state and federal guidelines, but also maintaining many of the safeguards we successfully instituted throughout the pandemic, including continued social distancing, active vaccination tracking and hybrid working arrangements. Operator, this concludes our prepared remarks. And we are ready to open the call for questions.

Operator, Operator

Thank you. We'll now begin the question-and-answer session. Today's first question comes from Damon DelMonte with KBW.

Damon DelMonte, Analyst

So I just had a question on the outlook on net charge-offs that was provided. You guys said 20 to 30 basis points for the full year. If you kind of look at what you've done in the first half of the year, that implies upwards of 35 basis points of net charge-offs in the back half of the year. So, I guess, my question is, do you feel that with where the reserve level is today, 134 on ex-PPP loans, that you'll need to cover those expected charge-offs? Or are you able to let the reserve run down from here?

Jack Plants, CFO

Hey, Damon, this is Jack. So from a NCO level, we're expecting that guidance to revert back to what we've seen historically. But from an allowance standpoint, looking at that pool of specific reserves we have from the COVID deferrals, there's about $7 million still there and as those stabilize when they come off their deferral. And we expect to have some release of those reserves. So from an overall allowance standpoint, I would expect that to migrate back down to historic levels.

Damon DelMonte, Analyst

So you think you need like another quarter or 2 on that pool of loans to have comfort where you could begin to release those specific reserves?

Jack Plants, CFO

Yes. I mean, the passage of time hasn't been long enough to establish a trend there. They're coming off deferral in the fourth quarter and couple of them are coming off in the first quarter of 2022.

Marty Birmingham, President and CEO

Yes. To clarify, our strategy for providing relief and the COVID bridges we've previously mentioned will continue until the end of the year. This decision was based on our conversations and guidance from regulators, as we aimed to offer support throughout the pandemic. Once we reach that period, we'll start evaluating the removal of those loans from the specific categories you're referring to.

Damon DelMonte, Analyst

And then I guess just a quick question on the core margin outlook. Just to make sure I understand this correctly. Jack, you're saying like, discontinued excess liquidity and the repricing of loans at lower than legacy portfolio yield is going to kind of cause the core margin to grind down a little bit lower for at least another couple of quarters?

Jack Plants, CFO

Yes. There is cash flow from our core portfolio that we are reinvesting at current market yields. Credit spreads have been performing well, which is a positive trend for us. However, the excess liquidity is what is impacting the margin. Thank you, Damon.

Operator, Operator

And our next question comes from Marla Backer with Sidoti.

Marla Backer, Analyst

A couple of questions. First of all, you're talking about excess liquidity, and I'm thinking that, that's something that other financial institutions operating in your markets are also clearly experiencing. What are you seeing in terms of pricing in some of your key products as a result of that?

Jack Plants, CFO

Well, as I mentioned earlier, from a pricing standpoint, we've only really guided on credit spreads and our credit spreads have been very stable relative to the prior year.

Marla Backer, Analyst

And switching topics in terms of the Elmira branch relocation. Is this a model if you find that it's successful with the Elmira branch, is it a model that you're thinking you might replicate with other older branches?

Marty Birmingham, President and CEO

In my prepared comments, I want to highlight that we recognize the opportunity and responsibility to operate our branch network efficiently and effectively. This is important for both the company and our customers, as well as the markets we serve. The short answer is yes; this can serve as a model for us moving forward. Our financial solution centers represent our modern approach, and they have evolved to their third version in terms of size, configuration, technology application, and staffing levels. Specifically regarding Elmira, we worked together to significantly reduce the annual lease expense at this location, allowing us to introduce more flexibility and efficiency in how we deliver branch services where we operate.

Marla Backer, Analyst

So in terms of achieving cost savings, you're talking about a combination of reducing the footprint of the branch as well as reducing staff levels at branches that you open going forward? Is that the right way to think about it?

Marty Birmingham, President and CEO

Staff, its footprint, and in this case, since we didn't own it, it's annual lease expense. It's a meaningful savings.

Marla Backer, Analyst

Can you provide any insights on the benefits you are experiencing from your new community banking unit at this point?

Marty Birmingham, President and CEO

So I'll ask Justin respond, but before I do. I'll say that I'm very pleased with the overall organizational approach that we are operating under right now in terms of leadership of our community bank, our commercial bank, our administrative functions and our risk functions as well as our human capital. And, obviously, Jack is participating in this call. So Justin?

Justin Bigham, Chief Community Banking Officer

Hi, Marla. It's Justin. Things are progressing really well with the new structure. It takes time to adjust and start developing strategy while considering the changes and our approach to community banking. In the upcoming quarter or two, you will begin to notice some external changes regarding how we view the community bank and our value proposition for the future. I look forward to sharing more information on that as we move into the next couple of quarters.

Operator, Operator

Our next question comes from Bryce Rowe, Hovde Group.

Bryce Rowe, Analyst

I wanted to kind of follow-up on one of Damon's questions there about the specific reserves against the COVID sensitive loans. So Jack, you noted a drop from $127 million to $112 million, was curious, if that was kind of normal schedule in terms of loans coming off of deferral? Or did they come off early?

Jack Plants, CFO

Hey, Bryce, this is Jack. Yes, those were 2 loans that we saw stability in their performance. So they came off the deferral program early and returned to normal payment status.

Bryce Rowe, Analyst

Are there prospects for the $112 million balance to be resolved earlier than the Q4-Q1 timeline you have outlined?

Jack Plants, CFO

Yes, there is potential for those loans to come off. We'll see then return to normal payment status. We monitor them very closely. We stay very closely credit on them. The determination at this point in time is, we just want to see trends and stability. We feel optimistic about them. So that we expect that they are moving in the right direction at this point in time.

Bryce Rowe, Analyst

I wanted to ask about the PPP program. Jack, I kind of missed what you said about the forgiveness for round one. Can you just tell us what the respective balances are for round one and round 2 as of the end of the second quarter?

Jack Plants, CFO

At the end of the quarter we had about $172 million in total PPP loans outstanding. $70 million of that was related to the 2020 round one vintage and $107 million related to 2021 vintage.

Bryce Rowe, Analyst

And then remaining fees tied to PPP, you can certainly break it out as 1.0 and 2.0, but just total remaining fees would be helpful?

Jack Plants, CFO

Yes. I can break it out. We have $1 million remaining on the 1.0 vintage and $4.7 million on 2.0 vintage.

Bryce Rowe, Analyst

I wanted to ask about the excess liquidity you've highlighted, which we have also seen across the industry. You have increased the bond portfolio by about $100 million each quarter for the past three or four quarters. Is that the current plan, or are you more focused on understanding the flows, which will influence your bond purchases?

Jack Plants, CFO

So we're trying to strike an appropriate balance between growing net interest income and managing net interest margin. And having that excess cash, sitting with the Fed is obviously been weighing on both metrics. So we've been very particular about choosing the bonds we want to purchase and growing the portfolio in a methodical way that doesn't put an undue extension of duration to the portfolio, but provides the ability to lean on the portfolio for liquidity purposes in the future as we get through this excess federal reserve balance.

Bryce Rowe, Analyst

And then one last one from me. You noted the recoveries on the indirect side, lower repossessions and higher values. It certainly feels like the higher value side of used cars or cars will continue here. Do you have a sense from a repossession perspective if that might continue, or was this more of an anomaly here in the quarter?

Jack Plants, CFO

Yes. The trends we've been seeing with our repo rates are at historic lows. But what's really driving that is that the average loss per vehicle is down significantly, and that's coupled with the increase in used car prices, but we expect the reversion to normal levels over time.

Operator, Operator

And our next question comes from Alex Twerdahl with Piper Sandler.

Alex Twerdahl, Analyst

I just want to ask, I think over the last couple of years, the indirect portfolio had been sort of shrinking as a percentage of the overall pie, maybe more supplementary than anything else. Just curious, just given all the liquidity out there and certainly the strength in indirect auto, the car market recently, if the thought process around that portfolio has changed. And maybe it can be actually a bigger percentage of the pie from here?

Marty Birmingham, President and CEO

The long-term thought process has remained consistent. However, it has undeniably been a crucial strategic capability that we've depended on during this time of excess liquidity in the system, which has impacted both our balance sheet and the overall market dynamics. As we know, the business line has shown remarkable robustness. Our comfort in continuing to engage in the short term stems from the fact that our program is now in its 16th year and has maintained consistency, focusing on fundamentally strong credit. The stability of our credit performance is clear, and we feel very assured about it, appreciating the capability we've had over the last 18 months.

Alex Twerdahl, Analyst

And then I'm just curious what you're seeing out there from an M&A perspective, not just whole bank, but also some of the fee-based businesses that you guys have bolted on over the past couple of years. If there's going to be some opportunities to do some more of those types of transactions later this year?

Marty Birmingham, President and CEO

Well, we remain open to those opportunities and are interested in continuing to bolster our fee-based business platforms. And we're very excited by the progress that's being made with our Landmark acquisition. That was a modest acquisition in terms of impact, in terms of earnings dilution and accretion. But it was very important for us in terms of driving our Rochester presence as well as the market knowledge that the principles have brought to us. And so as those other opportunities surface, we'll be open to them and consider them whether they support our wealth or insurance operations.

Operator, Operator

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

Marty Birmingham, President and CEO

Thank you, Rocco. I want to thank all who participated in the call this morning. We look forward to continuing to build on our communication with investors in the future. Thank you.

Operator, Operator

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.