Earnings Call Transcript - IBCP Q3 2023

Operator, Operator

Hello all, and welcome to Independent Bank Corporation's Third Quarter 2023 Earnings Call. My name is Olivia, and I'll be your operator today. I'll now hand you over to your host, Brad Kessel, to begin. Please go ahead.

Brad Kessel, President and Chief Executive Officer

Good morning, and welcome to today's call. Thank you for joining us for Independent Bank Corporation's conference call and webcast to discuss the company's third quarter 2023 results. I am Brad Kessel, President and Chief Executive Officer, and joining me is Gavin Mohr, Executive Vice President and Chief Financial Officer; and Joel Rahn, Executive Vice President of Commercial Banking for Independent. Before we begin today's call, I would like to direct you to the important information on Page 2 of our presentation, specifically, the cautionary note regarding forward-looking statements. Anyone who does not already have a copy of the press release issued by us today, you can access it at the company's website, independentbank.com. The agenda for today's call will include prepared remarks followed by a question-and-answer session and then closing remarks. Independent Bank Corporation reported a third quarter of 2023 net income of $17.5 million or $0.83 per diluted share versus net income of $17.3 million or $0.81 per diluted share in the prior year period. The increase in the 2023 third quarter results as compared to 2022 is primarily due to a decrease in the provision for credit losses, a decrease in noninterest expense, partially offset by a decrease in noninterest income and net interest income and an increase in income tax expense. For the third quarter of 2023, we generated an annualized return on average assets and return on average equity of 1.34% and 18.68% respectively, as compared to 1.40% and 20.48% in the third quarter of 2022. The item most impacting the comparable third quarter 2023 results included the positive changes in fair value due to the price of our mortgage servicing rights. Our team continued its positive momentum in the third quarter, achieving strong financial results with solid balance sheet growth, a stable net interest margin, disciplined expense management, and healthy asset quality. Capitalizing on the current operating environment, we gained new banking relationships with clients, and we appreciate our value proposition as a leading commercial bank with robust treasury management solutions, industry expertise, and client-centric service. This success led to double-digit annualized growth in loans and deposits despite expecting lower loan growth in the fourth quarter due to seasonality; we have a solid pipeline of high-quality relationship opportunities. With the loan-to-deposit ratio at 82%, we believe we have the capacity to continue supporting the ongoing growth of our loan portfolios. We have a very granular deposit portfolio with just 23% of our deposits uninsured. In addition, we have a high level of available liquidity with $2.1 billion in secured borrowing access and borrowing capacity on unpledged securities. Overall, our deposit base continues to perform well. Total deposits at September 30 were $4.6 billion, up $112.6 million or 10.5% annualized during the third quarter and $206.5 million or 6.3% annualized year-to-date. During this nine-month period, we have seen some level of remixing of our funding as customers take advantage of the interest rate spread opportunities. Our noninterest-bearing deposits are down $128.1 million, savings and interest-bearing checking are down $43.4 million, reciprocal deposits are up $197.3 million and time deposits are up $156.4 million, while brokered time deposits are up $24.3 million. This past quarter, while continuing to see some remixing of the deposit base, the pace significantly slowed with noninterest-bearing deposits declining by $13.9 million or 4.8% annualized during the third quarter. We have included in our presentation a historical view of our cost of funds as compared to the Fed fund spot rate and Fed effective rate for the quarter. Our total cost of funds increased by 23 basis points to 1.80%. Through the third quarter, the cumulative cycle beta for our cost of funds is now at 32.6%. At this time, I would like to turn the presentation over to Joel Rahn to share a few comments on the success we are having in growing our loan portfolios and provide an update on our credit metrics.

Joel Rahn, Executive Vice President of Commercial Banking

Thanks, Brad. I'll start on Page 7, where we provide an update on our well-diversified loan portfolio. Total loans increased $110 million in the third quarter, with the strongest segment in the quarter being commercial lending, which grew by $88 million. We also realized growth in our mortgage business with that portfolio growing by $34 million. Our installment portfolio experienced a $12 million decline in the quarter as we have strategically pulled back in that area. We continue to see the return on our strategic investment and the expansion of our commercial banking team. The experienced talent that we've added over the past 24 months has been a strong contributor to our commercial growth, which on an annualized basis was 14.5% through the third quarter. Looking forward, based on a strong pipeline and solid liquidity position, we see continued growth opportunity while maintaining our disciplined credit standards. Page 8 provides details on our commercial loan portfolio. As I've indicated in prior quarters, C&I lending continues to be our primary focus, representing 64% of the portfolio. Manufacturing continues to be the largest segment within the C&I segment, comprising approximately 9% or $149 million. The remaining 36% of the portfolio is comprised of commercial real estate, with the largest concentrations being industrial at $157 million or 10.2% and retail at $136 million or 8.9%. It's worth noting that our exposure to the office segment stands at $93 million or 6.1% of our commercial portfolio at quarter end. Our office exposure consists primarily of suburban, low-rise office space, and medical comprises 25% of our overall office exposure. This particular segment of our portfolio continues to perform well. For additional insight into our office exposure, I refer you to the appendix of this presentation. Page 9 provides an overview of key credit quality metrics at September 30. Overall credit quality continues to be excellent. Total nonperforming loans were $4.7 million or 1.2% of total loans at quarter end. Loans 30 days to 89 days delinquent totaled $4.9 million or 0.13% at September 30, which is consistent with last quarter end. At this time, I'd like to turn the presentation over to Gavin for his comments, including the outlook for the remainder of the year.

Gavin Mohr, Executive Vice President and Chief Financial Officer

Thanks, Joel, and good morning, everyone. I am starting at Page 10 of our presentation. Page 10 highlights our strong regulatory capital position. All capital ratios were stable from the linked quarter. Net interest income decreased $0.5 million from the year-ago period. Our tax-equivalent net interest margin was 3.25% during the third quarter of 2023 compared to 3.49% in the third quarter of 2022 and down 1 basis point from the second quarter of 2023. Average interest-earning assets were $4.89 billion in the third quarter of 2023 compared to $4.61 billion in the year-ago quarter and $4.76 billion in the second quarter of 2023. Page 12 contains a more detailed analysis of the linked quarter decrease in net interest income and the net interest margin. On a linked quarter basis, our third quarter 2023 net interest margin was positively impacted by two factors: an increase in yield on loans and investments of 16 basis points and a change in earning asset mix of 5 basis points. These increases were offset by an increase in funding costs of 19 basis points and 3 basis points that were due to changes in funding mix. We will comment more specifically on our outlook for net interest income and the net interest margin for 2023 later in the presentation. On Page 13, we provide details on the institution's interest rate risk position, the comparative simulation analysis for the third quarter of 2023 compared to the second quarter of 2023 calculates the change in net interest income over the next 12 months under five rate scenarios. All scenarios assume a strategic static balance sheet, and the base rate scenario applies the spot yield curve from the valuation date; the shock scenarios consider immediate, permanent, and parallel rate changes. The increase in the base rate forecasted net interest income in the third quarter of 2023 compared to the second quarter of 2023 is primarily due to an improvement in asset mix with an increase in loans and a decline in investments, along with a slight benefit from higher rates. Sensitivity is largely unchanged during the quarter with the exposure to rising rates declining modestly from larger rate increases. Currently, 32% of assets reprice in one month and 44.2% reprice in the next 12 months. Moving on to Page 14. Noninterest income totaled $15.6 million in the third quarter of 2023, as compared to $16.9 million in the year-ago quarter and $15.4 million in the second quarter of 2023. Third quarter 2023 net gains on mortgage loans totaled $2.1 million compared to $2.9 million in the third quarter of 2022. The decrease is primarily due to lower mortgage loan sales volume that were partially offset by increased profit margins and fair value adjustments positively impacting noninterest income, which was $2.7 million of mortgage loan servicing income. This is comprised of $2.2 million of revenue and a $1.6 million or $0.06 per diluted share after-tax increase in fair value due to price, which is partially offset by a $1.1 million decrease due to paydowns of capitalized mortgage loan servicing rights in the third quarter of 2023. As detailed on Page 15, our noninterest expense totaled $32 million in the third quarter of 2023, as compared to $32.4 million in the year-ago quarter and $32.2 million in the second quarter of 2023. Compensation increased $0.2 million compared to the prior year quarter due to raises that were effective at the start of the year and a decreased level of compensation that was deferred in the third quarter of 2023 as direct origination costs on lower mortgage loan origination volume. Performance-based compensation decreased $1.3 million due primarily to lower expected incentive compensation payout for salary and hourly employees and a decrease in mortgage lending related to incentives attributed to the decline in mortgage lending compared to the third quarter of 2022. Data processing costs increased by $0.4 million from the prior year period, primarily due to coordinated processors, annual asset growth, and CPI-related cost increases, along with lower net mortgage process-related cost deferrals due to lower mortgage loan volume as well as the purchase of a new lending solution software in 2023. Page 16 is our update for our 2023 outlook to see how our actual performance during the third quarter compared to the original outlook that was provided in January 2023. Our outlook estimated loan growth in the low double digits; loans increased $110.4 million in the third quarter of 2023, or 12.1% annualized, which is above our forecasted range. Commercial and mortgage loan segments showed positive growth, while installment loans decreased slightly in the third quarter of 2023. Third quarter 2023 net interest income decreased by 1.2% over 2022, which is lower than our forecast of high single-digit growth. The net interest margin was 3.25% for the current quarter and 3.49% for the prior year quarter. The third quarter 2023 net interest income was below our original forecast. The third quarter 2023 provision for credit losses was an expense of $1.4 million or 0.15% annualized, the provision expense was primarily the result of loan growth and a decrease in prepayment speeds, primarily related to jumbo mortgages. The provision expense related to loans in the third quarter of 2023 was lower than our forecasted range. Moving on to Page 17. Noninterest income totaled $15.6 million in the third quarter, which was higher than our forecasted range of $11 million to $13 million. Third quarter 2023 mortgage loan originations, sales, and gains totaled $172.9 million, $115.3 million, and $2 million, respectively. Mortgage loan servicing generated income of $2.7 million in the third quarter of 2023. Noninterest expense was $32 million in the third quarter, within our forecasted range of $32 million to $33.5 million targeted quarterly. Our effective tax income tax rate of 19% for the third quarter of 2023, which was a little higher than our forecast. Lastly, 88,401 shares were repurchased in the third quarter of 2023 at an average share price of $19.15. Year-to-date, 288,401 shares have been repurchased at an average share price of $17.21. That concludes my prepared remarks, and I would now like to turn the call back over to Brad.

Brad Kessel, President and Chief Executive Officer

Thanks, Gavin. These strong results, which our company has been delivering quarter-over-quarter, year after year for some time, are directly attributable to our talented team, their focus on personalized service, investing in our communities, and making banking easy. Our financial results once again gained us recognition in being named one of 31 banks and thrifts that comprise Piper Sandler's Small All-Star Class of 2023. Our team is very proud of this recognition. We intend to finish 2023 strong, with our focus continuing to be on investing in our team, leveraging our technology, and supporting our communities. In doing so, we will continue the rotation of earning assets out of lower-yielding investments into higher-yielding loans. With the strong value proposition offered as a leading commercial bank, we believe we can continue to grow our deposit base while managing our cost of funds and controlling our noninterest expenses. Accordingly, we are excited about the opportunities we have to continue our growth trends. We've built a strong franchise, which positions us well to effectively manage through a variety of economic environments and continue delivering strong and consistent results for our shareholders. At this point, we would now like to open up the call for questions.

Operator, Operator

Our first question today comes from Eric Zwick of Hovde Group. Your line is open.

Eric Zwick, Analyst

Thank you. Good morning, everyone. I wanted to first start on, I guess, kind of the loan growth and your comments about fourth quarter likely to be a little bit slower due to seasonality, but the pipeline is still very strong. So, I expect that to start to pick up again in the beginning of next year. Wondering if you could just add a little commentary in towards the mix of the pipeline, where you're seeing strength today from kind of a product type and maybe industry as well?

Joel Rahn, Executive Vice President of Commercial Banking

Yes. This is Joel. On the pipeline, it is still very solid as we head into the fourth quarter. And of course, commercial pipeline tends to be pretty long. So that will take us into the early part of next year. It really is a pretty diverse mix. I really can't point to any one area that is stronger. We're seeing growth in C&I, again, is our primary focus, and we are seeing those opportunities. We've seen good opportunity in the medical-related space, interestingly enough, and that's again because of long-term relationships that our bankers have had in the community. And some select commercial real estate, primarily industrial, has been a focus for us right now. So that would be just some additional color from my vantage point.

Eric Zwick, Analyst

I appreciate that. And then you mentioned you've strategically pulled back from the installment portfolio. Just curious if you could add maybe a bit of additional commentary there is that you're just seeing better opportunities in other areas? Or is it kind of a cautionary stance due to just kind of the uncertain economic outlook? Or just curious how you're thinking about that portfolio today.

William Kessel, President and Chief Executive Officer

Yes, Eric, that's a great question. It's twofold. First, we are really excited about the ongoing demand for our commercial banking team in our markets. We appreciate that asset class, including its yields and risk profile. Therefore, we decided to prioritize our capital allocation towards that direction. Second, we are closely monitoring the consumer because there are many discussions about a slowdown, which is affecting their savings levels. Additionally, our consumer installment area has typically been supported by production directly from our branches and our indirect channels, such as marine and RV. We are currently more cautious about the RV sector due to a significant surge during the pandemic, so we are keeping a close eye on those collateral values. Hopefully, that helps.

Eric Zwick, Analyst

Very helpful. I have one last question. Considering expenses, I noticed that the first slide included some commentary on expenses, and you mentioned that there are opportunities for additional efficiencies as you optimize delivery channels. On Slide 18, there’s a list of target areas for process improvements and cost control. I'm curious about what the biggest opportunities are for keeping expenses under control as we look into 2024. Do you have a target in mind for the efficiency ratio, or are you generally aiming for additional improvements over time?

William Kessel, President and Chief Executive Officer

I'm really pleased with the positive trend in our efficiency ratio, which has improved from the 70s to the 60s, and now we're in the high 50s. We believe we can continue to lower that number. One key factor is our core conversion, which we initiated in May 2021. We're finding ways to gain efficiencies with the various interconnected technologies. There are opportunities in the back office, and we're also focusing on optimizing our branch network. We're actively using teller recycle machines, which present significant opportunities across our entire footprint. These are just a few examples. Every team is focused on improving how we operate, serving customers better, and becoming more efficient. I'm excited about the potential for further improvement.

Eric Zwick, Analyst

Thank you for taking my question.

Operator, Operator

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

Matthew Renck, Analyst

This is Matt Renck filling in for Damon DelMonte. I hope everybody is doing good today. My first question was, are there any potential impacts from the UAW strike on your business? And do you think it could drive provision higher if the local economy starts to suffer?

William Kessel, President and Chief Executive Officer

So, Matt, thank you for the call. We're in Michigan, which is part of our footprint. Let's begin with the commercial aspect. Joel, you've been in touch with our team and customers, so could you provide us with an update?

Joel Rahn, Executive Vice President of Commercial Banking

Yes, the main uncertainty is the duration of the strike. We've been in regular communication with the customers who would be directly affected. Fortunately, this represents a minor portion of our overall customer base. The customers impacted by the strike currently amount to about $60 million, which is roughly 3.5% of our portfolio, for context. Our portfolio is well diversified, and we are not heavily invested in automotive supply. We are speaking with these customers weekly, and so far, the impact of the strike has been minimal. However, if the strike continues, it may eventually affect even the Tier 2 suppliers, leading to layoffs. As of now, we have not observed that happening.

William Kessel, President and Chief Executive Officer

Yes, Matt, I would add that in our consumer portfolio, we've received just a few inquiries from customers asking what we can do if the strike continues. The number of inquiries has been very small and has not significantly affected our performance metrics so far.

Matthew Renck, Analyst

Okay. Great. And I don't know if you can share it, but is there a point in time for the strike reaches that's like in your mind, that's when the trouble starts? Is it midway through next year, is it through the end of this year? If you could share that?

Joel Rahn, Executive Vice President of Commercial Banking

It's difficult to specify. In my opinion, the impact on the supply chain will become noticeable soon, probably within the next 30 to 45 days. When we first spoke to our customers at the beginning of the strike in mid-September, the general sentiment was that they could manage for about a month to six weeks. However, if the strike continues beyond that, it will begin to affect our production. So, I believe it will happen sooner rather than later, but we are all hoping for a resolution within the next 30 to 60 days.

Matthew Renck, Analyst

Okay. Great. Thank you for the color. And then one last question for me. Just on the securities portfolio, could you remind us, do you have a targeted percentage of earning assets you want to work that down to or maintain?

Gavin Mohr, Executive Vice President and Chief Financial Officer

Yes. So, 12% to 15% would be the target, and we will just evaluate as we move down to that ratio based on the broader liquidity profile of the bank.

Operator, Operator

We have no further questions on the call at this time. So, I'll turn the call back over to you, Brad, for closing remarks.

Brad Kessel, President and Chief Executive Officer

Thank you, Lidia. In closing, I would like to thank our Board of Directors and our senior management for their support and leadership. I also want to thank all of our associates. I continue to be so proud of the job being done by each member of our team. Each team member in his or her own way continues to do their part towards our common goal of guiding our customers to be independent. Finally, I'd like to thank each of you for your interest in Independent Bank Corporation and for joining us on today's call. Have a great day.

Operator, Operator

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