Earnings Call Transcript - IBCP Q4 2021

Operator, Operator

Good morning, and welcome to the Independent Bank Corporation Reports 2021 Fourth Quarter and Full Year Result Conference Call. All participants will be in a listen-only mode. Please note this event is being recorded. I would now like to turn the conference over to Brad Kessel, President and CEO. Please go ahead.

Brad Kessel, President and CEO

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 fourth quarter and full year 2021 results. I am Brad Kessel, President and Chief Executive Officer. And joining me is Gavin Mohr, EVP and Chief Financial Officer; and Joel Rahn, EVP, Commercial Banking. 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. If anyone does not already have a copy of the press release issued by us this morning, 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. Slide 4 provides a good summary of our historical results. I am very pleased with the high level of performance by our team, generating strong core results for yet another quarter and now for the full year 2021. We continue to execute on our strategies of investing in people and technology. During the fourth quarter, we saw good growth in net interest income, stabilization of our net interest margin, and across-the-board loan growth, net of PPP. Our commercial pipeline is at its highest level in many quarters, and deposit gathering continues to be robust, driven by existing customers as well as the addition of new customers. In addition, while mortgage gains have tapered down, they continue to be solid, and our current strategies continue to generate positive growth in interchange revenue. On the asset quality front, I could not be more pleased with our net recoveries for the full year, as well as commercial watch credits at just 3.1% of the portfolio and a very low level of past-due loans. We are excited about the momentum we have in our markets, and we look forward to continuing these trends into 2022. Turning to Page 5, Independent Bank Corporation reported fourth quarter 2021 net income of $12.5 million or $0.58 per diluted share versus net income of $17 million or $0.77 per diluted share in the prior year period. The highlights included an increase in net interest income of 10.6% over the fourth quarter of 2020, net gains on mortgage loans of $5.6 million, and total mortgage loan origination volume of $424.6 million. Net growth in portfolio loans of $21 million or 2.9% annualized; excluding PPP loans, increased by $84.9 million or 11.8% annualized. Continued strong asset quality metrics are evidenced by loan and charge-offs during the quarter, as well as a low level of nonperforming loans and nonperforming assets, and our payment of a $0.21 per share dividend on common stock on November 15, 2021. Turning to Page 7, for the year ended December 31, 2021, the company reported net income of $62.9 million or $2.88 per diluted share, compared to net income of $56.2 million or $2.53 per diluted share in 2020. The increase in full year 2021 net income as compared to 2020 primarily reflects an increase in net interest income and a decrease in provision for credit losses, which were partially offset by a decrease in non-interest income, an increase in non-interest expense, and income tax expense. Highlights for the full year of 2021 include increases in net income and diluted earnings per share of 12% and 13.8% respectively, annualized return on average assets and average equity of 1.41% and 16.1% respectively, net gains on mortgage loans of $35.9 million, and record total mortgage origination volume of $1.9 billion. Net growth in portfolio loans of $171.4 million or 6.3% annualized. Net growth in deposits of $479.7 million or 13.2% annualized. We paid $0.84 in dividends, which is a 5% increase compared to 2020, and tangible common equity per share increased by 6.1% to $17.33 per share. Page 8 provides a good snapshot of our loan and deposit metrics for our Michigan markets. I would point out that our two loan production offices opened in Ottawa County and Macomb County during the third quarter of 2021, and are off to a strong start. As a result, we do plan to open a new full-service office in Ottawa County during the first half of 2022. Turning to Page 8, we display several key economic statistics for the state of Michigan. Overall, we are seeing continued improvement in the unemployment rate for Michigan, now at 5.9%, above the national average of 3.9%. However, the state of Michigan has 282,000 fewer workers employed today compared to pre-COVID. Labor shortages are having a noticeable impact on many segments of our economy, including an increase in wages in our markets and reductions in business operating hours. In addition, supply chain shortages are also constraining many businesses in our markets. Regional average home sale prices continue to climb as inventory levels in many of our markets remain at record lows, negatively impacting the overall volume of home sales. That said, we continue to have very strong application levels for new home purchases. On Page 10, we provide a couple of charts reflecting the composition of our deposit base, as well as the continued growth in this portfolio while working to effectively manage our overall cost of funds. Extensive government stimulus continues to result in increased deposit levels for many of our customers. Turning into Page 11, we have a few highlights relating to Independent Bank’s digital transformation. Following our second quarter whole bank conversion, we continue to see good utilization and growth rates in our ONE Wallet, ONE Wallet+, and the Treasury ONE platform. At this time, I would like to turn the presentation over to Joel Rahn to share a few comments on our loan portfolio.

Joel Rahn, EVP, Commercial Banking

Thank you, Brad. On Page 12, we provide an update on our $2.9 billion portfolio. For the fourth quarter, commercial balances decreased $19.2 million. However, if you exclude PPP activity, our commercial balances increased by $45 million for the quarter, and for the year, excluding PPP loans, our commercial portfolio grew by 9.4%. Looking more closely at the growth of the third and fourth quarters, the commercial portfolio increased at an annualized pace of nearly 19%. As Brad said, our commercial pipeline is very strong, and we expect solid commercial loan growth in the first quarter of 2022. In the fourth quarter, our residential mortgage balances increased by $38.7 million, and installment balances increased by $1.6 million. Our mortgage pipeline, while down from peak levels, continues to display strength. We remain optimistic about our ability to accelerate the earning asset rotation from lower-yielding investments to higher-yielding loans. We continue to believe we're on track to grow loans at a low double-digit pace in 2022. We turn to Page 13, where we provide an update on our loan COVID-related modifications, which declined to $2.3 million or 0.1% of total loans in December 31. Of these modifications, the majority are in our residential mortgage portfolio. Moving to Page 14, we provide an update on the bank's administration of the SBA Paycheck Protection Program. As of December 31, 2021, we had $26.2 million in balances outstanding and $806,000 in net unaccreted fees. We expect fees on remaining loans to be forgiven and fees to be accreted into interest income during the first quarter of 2022. On Page 15, we display the concentrations of our $1.2 billion commercial loan portfolio. Consistent with prior quarters, you'll note that 63% of the portfolio is comprised of various C&I categories, the largest of which is manufacturing at $114 million or 9.5%. The remaining 37% of the portfolio consists of commercial real estate, with the largest concentration being retail at $109 million or 9%, and office, the majority of which is related to medical, at $72 million or 6%. The portfolio is very granular in nature, and our credit metrics indicate that this portfolio has held up very well through the pandemic and the resulting supply chain pressures. So at this time, I'd like to turn the presentation over to Gavin to share a few comments on our investments, capital, financials, credit quality, and our outlook for 2022.

Gavin Mohr, EVP and CFO

Thanks, Joel, and good morning, everyone. I'm starting at Page 18 of our presentation. Net interest income increased by $3.3 million from the year-ago period. Our tax-equivalent net interest margin was 3.13% during the fourth quarter of 2021, which is up one basis point from the year-ago period, and down five basis points from the third quarter of 2021. I will have some more detailed comments on this topic in a moment. Average interest-earning assets were $4.3 billion in the fourth quarter of 2021, compared to $3.98 billion in the year-ago quarter and $4.3 billion in the third quarter of 2021. Page 19 contains a more detailed analysis of the linked quarter increase in net interest income and a decrease in the net interest margin. Our fourth quarter 2021 net interest margin was negatively impacted by three factors: a decrease in yield on securities available for sale had an impact of negative one basis point; growth in liquid assets had an impact of negative four basis points; and the change in the loan mix and loan yield had an impact of negative three basis points. We will comment more specifically on our outlook for net interest income and net interest margin for 2022 later in the presentation. Moving on to Page 20, non-interest income totaled $15.8 million in the fourth quarter of 2021, compared to $22.4 million in the year-ago quarter and $19.7 million in the third quarter of 2021. Fourth quarter 2021 net gains on mortgage loans totaled $5.6 million, compared to $15.9 million in the fourth quarter of 2020. The decrease in these gains was due to a decrease in the mortgage loan sales volume and in the mortgage loan pipeline as well as lower loan sales profit margins. Mortgage loan applications remained strong, although refinancing applications slowed in the fourth quarter of 2021. Our purchase mortgage volumes continued to be strong. Positively impacting non-interest income was a $1.3 million gain on mortgage loan servicing due to a $0.6 million or $0.02 per diluted share after-tax increase in value due to price and a $1.3 million decrease due to paydowns of capitalized mortgage loan servicing rights in the fourth quarter of 2021. As detailed on Page 21, our non-interest expense totaled $34 million in the fourth quarter of 2021, compared to $32.7 million in the year-ago quarter and $34.5 million in the third quarter of 2021. Compensation increased by $0.6 million compared to the prior year quarter due to raises that were effective at the start of the year. The hiring of new lenders and increased overtime related to data processing conversion. Performance-based compensation decreased by $1 million due to a higher accrual catch-up in the fourth quarter of 2020. The fourth quarter of 2021 included $0.9 million of costs related to the reserve for unfunded lending commitments due to an increase in unfunded lending commitment balances. We will have more commentary on our outlook for non-interest expense later in the presentation. Page 22 provides data on non-performing loans, other real estate, non-performing assets, and early-stage delinquencies. Total non-performing assets were $5.3 million or 4.11% of total assets at December 31, 2021. Loans 30 to 89 days delinquent decreased to $2.3 million at December 31, 2021, compared to $2.4 million at September 30, 2021. Page 23 provides some additional asset quality data, including information on new loan defaults and classified assets. I would highlight that there were no new commercial loan defaults for the full year 2021. Page 24 provides information on our TDR portfolio, which totaled $37 million at December 31, 2021. This portfolio continues to perform well, with 96.4% of these loans being current at December 31, 2021. Moving on to Page 25, we recorded a provision for credit losses expense of $0.6 million in the fourth quarter of 2021, compared to a provision credit of $0.4 million in the year-ago quarter and a provision credit of $0.7 million in the third quarter of 2021. The allowance for loan losses totaled $47.3 million, or 1.63% of portfolio loans on December 31, 2021. This ratio increases to 1.64% when excluding the PPP loans and the remaining Traverse City State Bank acquired loans. Page 26 is our update for 2021 outlook to see how our actual performance during the year compared to the original outlook that we provided in January of 2021. Our outlook estimated loan growth in the low single digits; loans increased by $21.1 million in the fourth quarter of 2021 or 2.9% annualized. Growth in mortgage and installment loans was offset by a decline in commercial loans due to a $63.8 million decrease in PPP loan balances in the fourth quarter of 2021. Excluding PPP loans, total portfolio loans grew at an 11.5% annualized rate during the full year of 2021, above our forecasted range. For the full year 2021, net interest income increased by 5% over 2020, which is higher than our forecast. However, the net interest margins for the full year of 2021 were 24 basis points lower than the full year 2020 net interest margin of 3.34%, which is a steeper decline than our forecast. Higher than anticipated deposit growth has largely been deployed into lower-yielding investment securities, which is the primary reason for these variances. The fourth quarter 2021 provision for credit losses was an expense of $0.6 million. This is below our forecasted 2021 full-year provision range of 0.25 to 0.35 of average total portfolio loans. The primary drivers of this decrease in provision for credit losses were a decrease in the adjustment to the allocations based on subjective factors and an increase in recoveries of loans previously charged off. Non-interest income totaled $15.8 million in the fourth quarter of 2021, which is within our forecasted range of $13 million to $16 million. The mortgage loan pipeline continues to be solid, although refinance activity slowed down in the fourth quarter of 2021. Non-interest expense was $34 million in the fourth quarter, outside our $28.5 million to $29.5 million targeted quarterly range. Increases in compensation and employee benefits, data processing, and expenses related to the reserve for unfunded lending commitments were the primary categories that caused non-interest expense to exceed the target range. Our effective income tax rate of 19.2% to 18.6% for the fourth quarter and full year 2021 respectively was a bit lower than our forecast. This is due in part to higher than expected levels of tax-exempt interest income. Lastly, the company purchased 814,910 shares at an average cost of $21.19 for the full year 2021. Turning to Page 27, this will summarize our initial outlook for 2022. The first section is loan growth. We anticipate loan growth in the low double-digit range and are targeting a full-year growth rate of 10%. We expect to see growth across all three loan categories. This outlook assumes an improving Michigan economy. Next is net interest income, where we are forecasting low single-digit growth of 1% to 3% over the full year 2022. We expect the net interest margin to trend lower compared to the full year 2021 by 10 to 15 basis points, primarily due to declining yields on earning assets. This forecast assumes a 25 basis point increase in June and September, targeting the federal funds rate for 2022, with long-term rates expected to rise slightly by year-end. Full year 2022 provision expense for the allowance for credit losses of approximately 0.15% to 0.2% of average loans would not be unreasonable. Related to non-interest income, we estimate a quarterly range of $13 million to $17 million. We expect mortgage loan origination volumes to decline by approximately 21% in 2022, combined with declining margins on sold loans. Our outlook for non-interest expense is a quarterly range of $30.5 million to $32.5 million for the total for the year, which is 3% to 5% below 2021 actuals. We expect total compensation and employee benefits and conversion-related expenses to be lower in 2022 compared to 2021. Our outlook for income tax is an effective rate of approximately 18.5%, assuming the statutory federal corporate income tax rate does not change during 2022. Lastly, we believe the share repurchases will be at the midpoint of our authorization of approximately 5% of outstanding shares. That concludes my prepared remarks. I would now like to turn the call back over to Brad.

Brad Kessel, President and CEO

Thanks, Gavin. Slide 28 displays a high level view of our key strategic initiatives. During this past year, we have harvested the fruit of seeds planted in prior years. This included our investments in the mortgage banking business in prior years when others were exiting the business. As a result, over the last few years, we have produced record origination volumes, strong fee income, and a material increase in our overall servicing customer base, with over an 11% increase in balances serviced for others. With the heightened probability of moving to a higher rate environment, we have seen a decline in refinance activity; however, our home finance purchase volume continues to be strong. In 2022, we made significant investments in our overall technology platform to improve customer experience and increase productivity among other goals. We have already seen some very positive results from this investment. I believe we will see continued growth and improved productivity in 2022. Very significant investments were made in human capital in 2021, specifically the recruitment and expansion of our commercial banking team by over 25%. These investments in people are already showing results with this very strong commercial pipeline as we begin fiscal year 2022. We have increased our earnings per share and dividends for eight consecutive years. I believe we are well positioned for 2022 and beyond. At this point, we would now like to open up the call for questions.

Operator, Operator

Our first question comes from Brendan Nosal with Piper Sandler. You may go ahead.

Brendan Nosal, Analyst

Maybe just digging into the cost outlook a little more to start off here. I mean, expenses down 3% to 5% feels fairly optimistic given the inflationary environment. So maybe help us break down that improvement between the three areas that you call out in the guidance slide and then tied into how you can drive a declining comp expense this year despite wage pressure?

Brad Kessel, President and CEO

Yes, thanks Brendan. So referencing the slide, as we talk about the incentive compensation, that's based on the current budget this year. Again, as you are aware how the compensation is structured, we did outperform. So the accrual was higher. We believe next year it will not be the case. So, it's really coming through a reduction in the incentive piece. We also anticipate lower mortgage production. Those incentives that were tied to that production are also coming down beyond just the broad company goals. Additionally, we are looking at reductions in overtime related to the conversion and have greatly reduced, if not fully eliminated, the conversion-related expenses this year. We've seen this quarter decline significantly. And then another point we noticed is an increase in the unfunded lending commitments in 2021, as we've seen the growth that was not necessarily reflected in outstanding balances but shows the availability of credit.

Brendan Nosal, Analyst

Got it all right, that's helpful color. Maybe one more for me turning to provisioning needs and reserve coverage. I mean, a ratio of kind of 1.65ish percent strikes me as very healthy. So the outlook for 15 to 20 basis points of loans in terms of provisioning was probably heftier than I was thinking, given that strong coverage ratio. So can you maybe offer a little insight into how much you have left in COVID factors in the reserve today and how that might allow you to flex that reserve ratio lower as we move through the year? Thanks.

Brad Kessel, President and CEO

Yes, another great question. So subjectively, there is currently $12.7 million within the reserve, as we would define as subjective. There are 12 basis points within the reserve that are COVID-related in some form or factor. So, to your point, I guess there could be some potential for adjustments, but what we're really seeing, Bren, is the growth in the pooled factor. As our loans are growing, we've seen strong growth in the mortgage portfolio, and that is one of the most costly in terms of booking assets because of the length of the cash flows that need to be reserved for in the allowance for credit losses. So that's the offset. So actually, quarter-over-quarter, this objective did come down by $1 million, but it was offset by the loan growth.

Operator, Operator

Our next question comes from Damon DelMonte with KBW. You may now go ahead.

Damon DelMonte, Analyst

So first question regarding the margin guidance. I think you mentioned it to be down a bit from where it was this past quarter. Is that guidance taking into account the core margin or is that the reported margin, which included the PPP impact during 2021?

Brad Kessel, President and CEO

Great question, so that is the reported margin. We think the core will be very, very stable through 2022.

Damon DelMonte, Analyst

Okay, all right great that's helpful. And then could you elaborate a little bit more on the revenue outlook? I mean, sorry, the non-interest income outlook. When you consider the decline expected in mortgage banking, what are some of the other positive drivers that we could look for?

Gavin Mohr, EVP and CFO

So one of the factors there are a couple, right? So one, we are factoring in rate increases. I guess are you talking about non-interest income? I apologize. Yes, let me reroute.

Damon DelMonte, Analyst

Yes, non-interest income?

Gavin Mohr, EVP and CFO

Yes, okay. So as we are saying it will be down, we continue to see very good growth in the interchange income, approximately 5% year-over-year, as well as service charges on deposits. We all forecast a decline in SFBS, as I think the industry is anticipating. But we believe that the treasury management related service charges can offset that, so we expect to see growth in Treasury Management area fees as well. So that gives you a little more context.

Damon DelMonte, Analyst

Yes, it does, that's helpful, thank you. And then I guess just lastly, on the loan growth outlook, when you talk about this strong commercial outlook, how do you see that breaking out between C&I and CRE loans? Is one area set up better for growth over the other one, or is it pretty equally split?

Joel Rahn, EVP, Commercial Banking

Yes, this is Joel. By design, we are going to keep that very evenly split. We've been running roughly 60/40 on C&I versus investment real estate, and we like that balance. We want to maintain it. So we're forecasting growth in both of those buckets. It's important to us that we want to maintain that discipline.

Operator, Operator

Our next question comes from Russell Gunther with D.A. Davidson. You may now go ahead.

Russell Gunther, Analyst

Just a quick follow-up on the loan growth discussion. Appreciate the color on the 10% double-digit growth and what you just remarked on CRE versus C&I. Just wondering within the mix of that 10% growth, do you expect it to be similar to 2021? Would there be less of an appetite to portfolio single-family residential today, given a commercial outlook? I just want to get a sense for how you think that 10% breaks down across asset classes?

Brad Kessel, President and CEO

Yes, great question. To indicate, we are sensitive to the mix. I think this year is going to be a good representation of what we'll like going forward. The growth rates are pretty level across the three loan categories next year.

Russell Gunther, Analyst

Okay - that's very helpful. And then you guys mentioned the two LPOs that came online in the third quarter; opening of a full-service in 2022. Do you consider LPOs in adjacent or expansion markets? It sounds like that's not included in your 10% guide. But bigger picture is that something strategically you would look to do?

Brad Kessel, President and CEO

Yes, okay. So I would say right now, we're always open to growing our talented team, and we continue to have ongoing dialogues, so additional LPOs are probably a function of our desire to add new recruits. That said, I do think as Joel mentioned, we've grown the team by a substantial amount in the last year, and there is an important effort to blend them into our culture with the existing team. So I'd say it can happen, but as we forecast for 2022, it is not a huge part of what we're trying to accomplish.

Russell Gunther, Analyst

Understood, and I appreciate your thoughts there, Brad. And then switching gears to the margin. So I appreciate your thoughts, guys, in terms of the NII expectations and your rate assumptions. Could you isolate, Brad, for your thoughts around what a 25 basis point move in Fed Funds means to your margin and what deposit basis you would be assuming in that analysis?

Brad Kessel, President and CEO

Yes, great question. The 25 basis points is one to two basis points of margin, and that's with a very low beta. We think that the first couple of moves will allow us to hold back on increasing deposit rates for the low beta assumption there.

Russell Gunther, Analyst

Okay, very helpful. And then the last one for me is within your NII guide, what do you guys think in terms of the investment portfolio overall size in terms of growth or potential contraction in 2022?

Brad Kessel, President and CEO

Yes, so there is an asset rotation that we are optimistic will take place in 2022. I don't anticipate the size of the portfolio drastically shrinking, but maintaining current levels or slightly declining would be reasonable through the year, depending on when we experience the loan growth.

Operator, Operator

Our next question comes from Daniel Cardenas with Boenning & Scattergood. You may now go ahead.

Daniel Cardenas, Analyst

Quick question on the lending side. Could you give us a little bit of color as to the competitive factors that are out there, specifically as it relates to pricing in your various markets? Do you see that as a headwind to loan growth in 2022?

Brad Kessel, President and CEO

Let's break that down. Let's go with commercial first and Joel, maybe talk a little bit about that.

Joel Rahn, EVP, Commercial Banking

Yes, I mean, you know, the pricing is always a factor. And when the whole industry is looking for any assets, you know, there's been a lot of competition that's squeezed the pricing. We don't see that environment being dramatically different in 2022 than it was, frankly, in 2021. Yes, there is a little bit of an increase in the forecast for rate hikes that will help a little bit. In the bond market already do, so I mean, we're seeing pricing, you know, yield on fixed-rate loans increasing, following the Treasury market, but we've got some smaller community banks around the state that always seem to lag that. So it keeps pressure on our margins a little bit as rates are rising because the industry doesn't move in tandem obviously. Everyone's got a slightly different philosophy. So yes, there's going to be continued pressure there, but we're finding a way to win business at fair returns and with a focus on really good product quality.

Brad Kessel, President and CEO

And I think to add that over on the mortgage side, it is very competitive. You know, both the saleable and non-saleable sides, there's pressure on the margins there. We've seen, as an example, I think that jumbo pricing, which historically you'd have some type of premium to the conforming, has been pricing right on par with conforming pricing. We have considered that in our forecast, and we're fighting hard as Independent believes in being in the business for the long haul. It may be a little more challenging during the early part of the year, as we move through Q1, but yes, the mortgage side is definitely heightened in terms of its overall competitiveness.

Daniel Cardenas, Analyst

Okay excellent. And then how should I think about deposit growth going forward? I don't think it's going to keep lockstep with loan growth. But what's kind of the outlook on the deposit side in 2022?

Gavin Mohr, EVP and CFO

I can take first shot, Gavin. You know, we've seen over the past couple of years deposit growth outpace loan growth significantly. We think that's going to flip this coming year; it will be very difficult to forecast the surge in deposits, if you will, and how long they'll stick. I think it's directly related to how fast rates move. We're forecasting deposits to be pretty flat.

Brad Kessel, President and CEO

Returning to a much more historical run rate, to that 2% level, rather than what we've seen in the last few years.

Daniel Cardenas, Analyst

Okay, excellent. And then last question from me: as your digital platform continues to gain traction, how do you guys think about your branch franchise? Is that something that would begin to contract as your digital platform grows, or is that not necessarily the case?

Brad Kessel, President and CEO

Daniel, that's a great question. Over the last eight to 10 years, the branch footprint that Independent has fielded has significantly changed. We had over 100 locations in the early 2010/2011 timeframe, and over the years, we've really paired it back. At the same time, we more than doubled the average deposits per branch. In 2020, we consolidated another eight locations. In 2021, we completed a whole bank conversion; really the moving forward with the digital transformation will help us as we go forward. We likely will have some additional branch optimization. We're constantly looking at location profitability; we're looking at the average number of transactions per FTE, and that has continued to decline. It would be reasonable to see us scaling back in the coming quarters.

Operator, Operator

This concludes our question and answer session. I'd like to turn the conference back over to Brad Kessel for any closing remarks.

Brad Kessel, President and CEO

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 our associates that 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 would 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

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