First Merchants Corp Q1 FY2021 Earnings Call

Good afternoon, and welcome to the First Merchants Corporation First Quarter 2021 Earnings Call. All participants will be in a listen-only mode. This presentation contains forward-looking statements made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act. Such forward-looking statements can often be identified by the use of words like believes, expect or may and include statements relating to First Merchants business plan, growth strategies, loan and investment portfolio; asset quality, risk and future costs.

Good morning, everyone, and welcome to First Merchants first quarter 2021 conference call. We released our earnings today at approximately 8:00 AM Eastern Standard Time. Hopefully, you've all found your way to our slide presentation. But if not, you can access the slides by following the link on the second page of our earnings release. Betsy, thanks for the introduction and for covering the forward-looking statement on Page 2. On Page 3, you will see today's presenters and our bios to include President, Mike Stewart; Chief Credit Officer, John Martin; and Chief Financial Officer, Michele Kawiecki. Page 4 is a nice one-page snapshot of the First Merchants geographic footprint and a few relevant financial highlights for your review. We feel the first quarter return on assets of 1.39% and return on tangible equity of 15.87% reflect the strength of First Merchants overall balance sheet and our earnings model. We're also pleased to see that our stock price has returned to levels that are more reflective of a top quartile performing bank with a price tangible book multiple as of March 31 of just over 2x of tangible book. Now, Mike Stewart will cover Slide 5 and 6 and provide some line of business commentary.

Thank you, Mark and good afternoon. As you look at the next two slides, I want to provide an update on our line of business activities and their contribution to the quarterly results that Michele and John will review in detail and provide insight into the geographic markets we serve. I'll start with our Private Wealth Advisory business. We closed on the previously announced acquisition of Hoosier Trust Company on April 1. Their business of trust and investment services will integrate with our existing businesses in the Indianapolis market. We welcome the team from Hoosier Trust and their clients as part of the First Merchants family.

Yes, thanks, Mike. Now, if you turn to Page 7, we just have a few more highlights before Michele covers the details of the financials. As my quote mentioned in the press release and consistent with Mike's comments, we're really pleased to be back in the office and serving our customers in a more personal way again, as the vaccination rollout progresses nicely in our entire footprint. Michael Joyce, the President of our First Merchants Private Wealth Advisors, and his team are very excited about the acquisition of Hoosier Trust, and the addition of $1.5 million of annual revenue that now is part of his business. Mike mentioned some of the brand consolidations. And I would just point out that, at least to date through our earnings day today, we've consolidated 13 of the 17 announced locations. We continue to reinvest the savings into the digitization initiatives that we discussed on previous calls. Our initial digital investment is being channeled into Terafina, a new online account origination platform. Along with that investment in technology, we've also made significant investments in IT talent in order to optimize our investment and to create a real state-of-the-art user experience. The PPP program dominated our lending efforts in Q1, at least as you look at the details of the numbers, and we realized fee income from that program of about $7.5 million through the amortization and forgiveness process. Michele will discuss our CECL adoption, which is now complete, and we combined with capital and financial metrics, the bank is positioned to maximize future growth opportunities.

Thanks, Mark. My comments will begin on Slide 8. We experienced significant balance sheet growth during the quarter, which you can see on Lines 1 through 4, its total assets increased by $562 million or 16%. We had $590 million of deposit growth during the quarter, reflecting an influx of stimulus payments, coupled with organic growth. This liquidity funded $76 million of loan growth and an investment of $554 million in the bond portfolio. We are pleased to report net income on Line 17 increased by $4.3 million or 38.5% over the fourth quarter, leading us to earnings per share of $0.91 which is shown on Line 22, which is an $0.08 increase over the prior quarter. I will walk through the income and expense components in more detail on later slides. On Line 23, you will see that tangible book value per share declined by $1.29 this quarter. As Mark mentioned, we adopted the CECL standard at the beginning of the year, which caused tangible book value per share to decline by $1.26. Additionally, the increasing yield curve caused a reduction in the unrealized gain on the investment portfolio, which is reflected in the accumulated other comprehensive income component of equity. So that also caused a reduction in tangible book value this quarter as well. Moving up to Line 19, return on average equity increased by over 1% to a strong 10.75%. In the highlights, an increase in pre-tax, pre-provision earnings of $1.2 million over Q4 2020 is noted, which brings the pre-tax, pre-provision return on average equity to a strong 12.7%. The efficiency ratio shown on Line 21 was a low 50.23%. We feel all these ratios reflect a strong and efficient core business that will produce greater needs in the future. On Slide 9, we show the highlights of our investment portfolio. The top right graph shows the trend in the portfolio yield. The yield on the portfolio declined by 8 basis points during the quarter, which was more than we anticipated. That was the result of significant portfolio growth invested in yields that were lower than where the portfolio was averaging. However, the portfolio contributed $19 million of interest income this quarter, an increase of $1.8 million over the prior quarter, and the overall portfolio yield continues to outpace that of peers. On the bottom left are some investment highlights. We are pleased to see the current purchase yield increase to 2.7%, up from the purchase yield of 1.65% at the beginning of the quarter. The roll-off yield for the remaining year is 2.54%, so we could see a bit more compression in overall portfolio yield over the course of the year depending on how the rate environment shapes.

Thanks, Michele, and good afternoon, everyone. I'll begin my comments on Slide 17 by reviewing the loan portfolio and including industry concentrations that provide an update on loan modifications, touch on the residual pandemic impacted loan portfolios with an update on the PPP loan program, before closing with some asset quality updates. So turning to Slide 17, in the quarter, we had $76 million of loan growth led by the sponsor finance business, construction lending portfolio, and public finance activities. This also included PPP loans, which grew by $75 million as we continued our participation mentioned earlier in the program during the first quarter. Mortgage loan production remains strong as we head into the second quarter as we operate a mostly originate-and-sell model. As Mike mentioned earlier, with some decline in home equity and consumer balances, which are really related to home refinance. The core commercial portfolio remains diversified and balanced with a skew towards manufacturing centered in our geographies with core scalable business lines leading our growth. Turning to Slide 18, on the left side of the slide, I have highlighted the PPP reduction, both in aggregate and by year to help provide a sense of the average dollar loan still outstanding by phase or year. I've also included the details for the $186 million and you want to make a note of this or 337 applications that have been submitted for forgiveness to the SBA and which are under review, or highlighting the loans eligible for the streamline forgiveness process for those loans under $150,000. While there are a number of factors at play as we contemplate forgiveness and fee recognition, I view the forgiveness peaking in the second quarter and third quarters, while containing a tail as we head into ‘22 and beyond. Moving to the right side of this slide, continued modification deferral tracking from last quarter with $65 million and 49 loans with 13 of the 49 being really just small dollar consumer loans. The residual result of the pandemic on the portfolio is remarkably muted after peaking early last year at over $1 billion in modifications. The bar chart below highlights the concentration of the deferrals in the hospitality industry with $49 million of the $65 million above related to the hospitality industry. So turning to Slide 19, and I broke it out the senior living and hospitality-related portfolios. The demand drivers below include universities, corporate, like convention-related hospitals, and transit, like vacation or roadside properties which make up the hotel portfolio. As activity returns to more normal levels related to those demand drivers, the expectation is that the performance in this space will continue to improve. We are reviewing the hotel portfolio quarterly and continue to see improvement in specific property results as we go through those reviews. Now with the senior living portfolio, as we had it in the pandemic, we were already focused on some specific projects and markets where we are seeing saturation due to the effect of the pandemic that led certain projects to experience weakened occupancy followed by payment difficulties which are highlighted in the asset quality slides on Slide 20. So flipping to Slide 20, overall asset quality remains stable. We had a $3.6 million decrease in nonaccruals associated with the $2.6 million of charge-offs related to two senior living projects previously moved to nonaccrual. Other real estate owned is relatively low with a book balance of $600,000 resulting overall in a 65 basis point level of NPAs and 90 days past due loans and ORE. Classified loans were stable as well, down $2.3 million with net charge-offs of $3.6 million or 16 basis points. The portfolio continues to trend in the right direction with the help of the PPP program and an improved economic environment. This has led to better overall borrower financial performance heading into 2021 and improvement in the residential, excuse me, residual pandemic impacted portfolios. So flipping to Slide 21, I've once again included the asset quality roll forward, which reconciles changes in asset quality. New non-accrual loans on Line 2 fell back from the fourth quarter and were only $6.5 million compared to the $16 million in the prior quarter. Growth charge-offs were higher at $4.3 million as we recognized the previously mentioned $2.6 million loss associated with the two senior living-related loans, which have an original loan balance of roughly $27 million. Overall, ending NPAs and 90 days past due remain stable and improving as highlighted on Line 13. And then finally, I would just close by saying that we continue to focus on ways to ensure improvement of the residual pandemic portfolios as we wind down the delivery of new PPP loans and continue to extend our balance sheet to new business across all regions and business lines. Thanks for your attention. I'll turn the call back over to you, Mark.

Thanks, John. If you look at Slides 22 and 23, they are just nice snapshots that highlight the track record of First Merchants from both a growth perspective and financial performance. Then Page 24 is really a listing of some of the priorities that we're focused on as a management team to really drive our performance over the next several years as we continue to grow the company. I feel like we're making great strides across the board, both in our lines of business and administratively. As the year progresses, we'll be sharing even more detail about performance under each of these 10 items that we're listing. So, I feel like the quarter was pretty clean and easy to understand. If there's anything that feels extraordinary to us, it's just the impact of PPP in a number of different ways throughout the balance sheet and the income statement. But we clearly appreciate your investment, and we appreciate your attention today. And that's it this time, we are happy to open up the conference for Q&A.

Our first question comes from Scott Siefers from Piper Sandler. Please go ahead.

Good afternoon, everybody. Thank you for taking the question. First question is on the margin. So, sort of the core margin excluding PAAs and PPP is down only a couple of basis points, I think you suggested, Michele, once you account for day count. So where does it go from here relative to that 311 level?

Yes, I think our core net interest margin, I was just looking at even the month of March, which is always kind of a great jumping off point because of the February noise and our core margin for March was 310. So that's probably a good indicator of where we're going to be. I think if there's any compression at all, it would probably depend on how much incoming liquidity we have. This quarter, we had really great growth in deposits and put it to work in the investment portfolio. To the degree that we can get that invested in our loan portfolio, obviously, the yields are higher, and that's a little more helpful for margin. So I think it's probably dependent on liquidity growth. Otherwise, I would still expect stability in our margin.

Okay, perfect. That's great. Thank you. And then let's see, just with the reserve, I guess the timing of when you guys adopted CECL makes it a bit more complicated than others. But maybe what's sort of the steady-state reserve that we would be working down toward? In other words, in the CECL adjustment, presumably there was, I guess, like a COVID adjustment in there as well. So what would you consider sort of a steady-state reserve that we end up working back down toward?

It likely depends on your definition of a steady state in the economic environment. One thing I suggested is that at the end of 2019, unemployment was at a 50 year low, which may not represent a steady state. However, at that time, our disclosures indicated we had a reserve of $80 million before the pandemic. We estimated a $55 million increase in reserve would have occurred then, bringing our coverage ratio to about 150%. The concept of steady state can vary, but that serves as a relevant data point.

All right. That's perfect. So it seems then like absent any real surprises, we'd be sort of working the reserve down in combination with loan growth and maybe just some credit leverage, meaning under providing relative to charge-offs over the next several quarters. Is that fair enough?

I think that's right, yes.

Okay, perfect. Thank you. And then I guess one final question. I think you guys have about $20.5 million in remaining PPP fees. Do you know how that breaks out roughly between rounds?

Yes. So Round one, we have unearned fees of $7.2 million. And then on round two, it is 13.3.

Okay, perfect. All right. That does it for me. Thank you very much.

Thanks, Scott.

Our next question comes from Terry McEvoy from Stephens. Please go ahead.

Hi. Thanks. Good afternoon, everybody.

Hi, Terry.

Maybe just was hoping to get your thoughts on future loan growth. There was real strength in the sponsor finance book, construction was up, and in a few areas, as you mentioned, home equity was down. So maybe some comments on loan pipeline in ex-PPP, what you'd expect over the coming quarters, where there could be some upside and where do you think there could continue to be some roll off? Thanks.

Sure. Mike Stewart here. I'll try to give you some more insight. Again, the activity levels that I look forward to continue to give us in that position that we talked about regularly in that mid to single high-digit loan growth, and I really feel like that's where our pipelines currently are. When you look across the segments that you'd asked about, our commercial industrial activity, businesses are performing well, absent supply chain issues and maybe some labor nuances. Their business volumes are growing and reinvesting back in businesses and the activity level that we see. Beyond just M&A activity with replenishment of equipment and real estate is just continuing to grow. The investment real estate has remained robust for us on the areas that we focus on. As John points out, we don't focus on hospitality as an example, or traditional retail, but we think about multifamily and what's going on in suburbia, what's going on with industrial warehouse space, in particular, really good asset classes in this distribution model that continue to grow and we're very active in that space. I feel good about that. Yes, the sponsor activity is a nice part of our business focused on that C&I. There's good equity sitting on the sidelines ready to put that money to work and M&A activity of the sponsors has gone from a low point in the second quarter of last year and continues to build as they find good opportunities. We are positioned well in that space. That’s also augmented with some of our continued people focus that we talked about last quarter. Our commercial teams across all of our markets have invested in additional skill set capabilities to round out the size of the organization we are, whether it's in our new Michigan marketplace or back in our Ohio markets in Indiana. New talent growing in our opportunities just gives us more looks across the way. The consumer portfolio, we're just going to keep watching what focuses, what happens there when you think about the consumer at large, digital stimulus checks, the need of them to spend, and we're starting to see the spend activity increase when you look at credit card usage in that regard. So we very well might see an uptick in our consumer portfolios as time goes on. But that's a relatively small piece of our overall loan book.

Appreciate that. Thank you. And maybe as my follow-up, a question for Mark. Capital is high, the reserve is high. Depending on who you ask, and you mentioned it on Slide 4 here, the stock price is relatively high at 2x tangible book. I guess my question is, you're in a great position to take advantage of this M&A window that might be open. What are your thoughts on M&A? And any specific markets kind of stand out? Or specific bank sizes that you're comfortable with today? Thank you.

Yes, thanks, Terry. Yes, we do feel like the balance sheet is well positioned for growth in a number of different ways. With strong liquidity, we have a great team that I think is really actively engaged in growing our loan portfolio organically as well as our fee income sources. M&A is something that if you look at our history, it's clear that we usually have about one acquisition a year. And we'd love to stay on that pace. So we're more active. Our footprint, which we always talk about is just being Indiana and the four contiguous states. We typically think of organizations that are less than 25% of our total asset range. So we're active and we're busy and continuing to have great communication with CEOs to evaluate their options. We'll see if something happens this year, but we're certainly interested and would love to continue to put our capital to work.

Great. Thank you, Mark.

Thank you, Terry.

Our next question comes from Daniel Tamayo from Raymond James. Please go ahead.

Good afternoon, everybody. Maybe just we touch on the expense outlook. I think last quarter, you guys mentioned that the expectations were somewhere in the range of $68 million to $70 million per quarter. We're running a little bit below that in the first quarter, which is obviously a good thing, but with the investments that you talked about, including the partnership with Terafina, how are you thinking about that quarterly run rate going forward?

Yes, I think I would reinforce the guidance that we gave last quarter with that expense run rate of $68 million to $70 million. Expense management this quarter was really outstanding, but I do think total expenses will creep up a little higher as we get further into the execution of our plans and strategic initiatives.

Okay, terrific. Following up on the discussion, Mark, regarding M&A, considering we're at 2x tangible book and you have the share repurchase authorization, how do you feel about share purchases at the current prices? If not, what might be a good entry point to consider getting back into that? Thanks.

Dan, our next Board meeting and annual shareholder meeting is set for May 11th, where we will revisit this discussion. The outlook depends on various factors, but we believe that for the next few years, due to the stimulus and ongoing vaccinations, the economic outlook remains strong and is improving. If this trend continues, it should enhance the attractiveness of our stock prices. My primary objective is to ensure that we maintain our tangible common equity around 9%, as this contributes to a significantly higher return on tangible equity and return on equity. I was very pleased with the 15.87% return on tangible equity we achieved this quarter, and I aim to keep it within that range by managing our capital base to 9% rather than allowing it to rise to 9.5%, 9.75%, or even 10%, as it has in the past. As we consider our options, we will evaluate dividends, which we will likely discuss again at the May 11 Board meeting, share repurchase activities, and how these options align with our cash availability and potential acquisitions as we assess the opportunities ahead.

Terrific. That's all I had. I appreciate the color.

Yes, thanks, Terry or Dan, yes.

Our next question comes from Bryce Rowe with Hovde Group.

Thanks. Good afternoon. Thanks for taking the question here. I wanted to ask about the bond portfolio and opportunities possibly to put more excess liquidity to work there. Obviously, we've seen a big jump in the bond portfolio in the first quarter. I was wondering with the level of excess liquidity continuing to look elevated and possibly be elevated for the foreseeable future here, was wondering if you will continue to add to the bond portfolio in a meaningful way, like you've done here recently.

We believe the volatile liquidity observed in the first quarter was partly due to strong organic growth, with around half of it related to stimulus payments, such as PPP funds or EIP payments. I don't anticipate a similar increase in liquidity for the next quarter. However, if there is any liquidity available, our primary preference will always be to allocate it towards loan growth. Rather than letting it remain in cash, we will likely continue purchasing securities and hold them as available for sale in case we decide to utilize the liquidity for other purposes in the future.

And this is Mark. I will just add, take time, and we're pretty selective in terms of the bonds that we like. You can see that interest-bearing deposits that we have a sizable number, and we're always looking for opportunities for good investments with the right return profile. We'll continue to do so this quarter.

Okay, that's helpful. And as a follow-up, and maybe you all touched on this here recently as well. But in terms of the FHLB advances on the balance sheet came down a little bit here in the first quarter. Just wondering if there are more opportunities to let those roll off with excess liquidity being what it is.

And I do believe we have some maturing yet this year. I actually don't have that schedule in front of me, but to the degree that we have any of those mature, certainly we'll let those roll off. But I'll follow back up with you, Bryce, and I can get you that number once I dig that up.

Okay. That would be great, Michele. Appreciate it. Thanks for taking the questions.

Yes, you're welcome.

Our next question comes from Damon DelMonte with KBW. Please go ahead.

Good afternoon, everyone. Hope everybody is doing well today.

Yes, we are. Thanks, Damon.

Great. Great to hear. So my first question is on fee income. I think you guys noted that there are some seasonal factors that kind of brought numbers down this quarter from last quarter. You alluded to the fact that you get a bit of a rebound here in the second quarter. Michele, can you give a little bit of guidance on a range of what would be a reasonable expectation?

Yes, last quarter, I told you that I thought we could replicate Q4 levels, and that was a good run rate. But we're really seeing some cooling in the derivatives and loan level hedges compared to Q4. If I look at the list that we'll get from Hoosier Trust and also some strong mortgage loan production, I will probably bring that range down a little bit to maybe $25 million to $26 million a quarter.

Okay. That's helpful. And then did you say before as for like a point of reference on the reserve level, that if you added where you were pre-pandemic, plus what you would have expected for CECL, you're talking about something on $150 million of a reserve. Is that what you had said?

Yes, $150 million coverage ratio, yes. I think it would have been like $130 million, maybe.

$130 million, okay. So if you're at $202 million today, or $201 million today, I mean, did you arguably not take a provision for the remainder of this year or next year? I mean, you still have more than $130 million, so.

Yes, and that's a possibility. Yes.

Okay. Okay. Take a look at the model then. Okay. That's all I had. Everything else was asked and answered. Thanks a lot. Appreciate it.

Thank you, Dan.

This concludes our question-and-answer session. I would like to turn the conference back over to Mark Hardwick for any closing remarks.

Thanks, Betsy. Thanks, everyone for your attendance. We appreciate all the questions at the end of the call, and I look forward to talking to you again in another 90 days. So I guess, have a great spring. Thanks.

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