Earnings Call Transcript - IBCP Q1 2022

Operator, Operator

Hello ladies and gentlemen, thank you for joining and being present in the Independent Bank Corporation Q1 2022 Earnings Conference Call. My name is Irene and I will be coordinating today's call. I will now hand you over to your host, Brad Kessel, President and CEO, to begin. Brad, 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 first quarter 2022 results. I'm Brad Kessel, President and Chief Executive Officer. And joining me is Gavin Mohr, EVP and Chief Financial Officer, and Joel Rahn, Executive Vice President, 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 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. Slide 4 provides a good summary of our historical results. I am very pleased with our team's continued execution of our operating plan. In doing so, our first quarter 2022 performance generated strong core results with good growth in net interest income, stabilization of our net interest margin, and net growth in each category of loans and total deposits. We were also able to make progress in reducing our non-interest expenses. During the first quarter, inflation was reported at near four-year highs. And we witnessed a very dramatic increase in rates on the middle and long end of the yield curve with the expectation now for multiple Fed hikes through 2022 and into 2023. This recent increase in rates has slowed our mortgage refinance origination volume and decreased this quarter's net gains on mortgage loans sales. However, we have also structured our mortgage business to have an emphasis on supporting home purchase requests. And these volumes continue to be at solid levels. Additionally, the increase in rates also significantly increased the value of our capitalized mortgage servicing rights, somewhat of a natural hedge providing a benefit with higher rates. Over the years, we have shared our intentions and success in generating a diversified revenue stream through three lines of business: commercial banking, mortgage banking, and consumer banking. During 2021, we made significant investments both in talent and technology, primarily in our commercial and consumer banking lines of business. We are seeing some of the early paybacks for these investments with a very strong commercial pipeline and some increased efficiencies in our consumer banking business. Turning to Page 5, Independent Bank Corporation reported first quarter 2022 net income of $18 million or $0.84 per diluted share versus net income of $22 million or $1 per diluted share in the prior-year period. The decrease in the 2022 first quarter earnings as compared to the first quarter of 2021 primarily reflects a decrease in non-interest income and an increase in non-interest expense that were partially offset by an increase in net interest income and a decrease in the provision for credit losses. The first quarter 2022 highlights include an increase in net interest income of 9% over the first quarter of 2021, loan growth of $99 million, or 13.8% annualized and deposit growth of $88.4 million, or 8.7% annualized, a return on average assets of 1.54%, and a return on average equity of 19.38%. In addition, our asset quality continues to be very good, with very low net charge-offs in the first quarter, as well as commercial watch credits at just 2.44% of the portfolio, and a continued very low level of past due loans. These favorable asset quality metrics, combined with reduced reserves related to COVID-19, allowed us to record a negative provision for the first quarter. Page 6 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 are off to a strong start. In 2020, we closed eight branch locations as part of our ongoing branch optimization reviews. During the second quarter of 2022, we will be closing an additional four locations, one each in Kent, Oakland, Lapeer, and Saginaw counties. Annual expected cost savings from the combined closings is expected to be $1.5 million. These closings will reduce our branch network to 58 locations in total. Turning to Page 7, we displayed several key economic statistics for the state of Michigan. Overall, we are seeing continued improvement in the unemployment rate for Michigan, now at 4.7%, slightly above the national average of 3.8%. However, the state of Michigan has 110,000 fewer workers employed today, as 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 also continue to constrain many businesses in our markets. Regional average home prices continue to climb as inventory levels in many of our markets continue at record lows and negatively impact the overall volume of home sales. On Page 8, 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. 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, Executive Vice President, Commercial Banking

Thanks, Brad. On Page 10, we provide an update on our $3 billion loan portfolio that I'll provide some insight on. For the first quarter, the commercial segment of the portfolio grew by $54 million. However, when you exclude PPP activity, our commercial balance has increased by $74.5 million. This falls on a strong fourth quarter of 2021 where we experienced commercial loan growth of $45 million, also excluding PPP activity. Our annualized commercial growth rates over the past six months is 21% and based on strong pipeline, we expect strong commercial growth in the second quarter of 2022 as well. In the first quarter, our residential mortgage balances increased by $30.4 million and our consumer installment loan portfolio grew by $14.6 million. We remain optimistic about our ability to continue the earning asset rotation from lower yielding investments to higher yielding loans, and believe we're on track to grow loans at a low double-digit pace throughout 2022. On Page 11, we display the concentrations of our $1.3 billion commercial loan portfolio. C&I lending continues to be our primary focus, representing 65% of the portfolio. Manufacturing is the largest single concentration within the C&I segment, comprising approximately 11% or $136 million. The remaining 35% of the portfolio is comprised of commercial real estate with the largest concentrations being retail at $112 million or 9%, and industrial at $91 million or 7%. By design, this portfolio is very granular in nature. And our credit metrics, which Gavin will cover in a moment, reinforce that this portfolio has held up very well through the pandemic and resulting supply chain pressures. So at this time, I'd like to turn the presentation over to Gavin to share comments on our investments, capital, financials, credit quality, and our outlook for 2022.

Gavin Mohr, EVP and Chief Financial Officer

Thanks, Joel, and good morning, everyone. I'm starting on Page 12 of our presentation. Page 12 contains details on our investment securities portfolio. Net unrealized losses increased in the second quarter of 2022 from year-end 2021 to $61.5 million net of swaps. Increasing rates in the first quarter of 2022 is primarily responsible for the increase in unrealized losses. These unrealized losses do not impact regulatory capital levels. The investment securities portfolio has a very strong credit profile, making credit losses unlikely. Excluding any credit impairment, the investment security will recapture the current unrealized losses as they mature. Approximately 30% of the portfolio has a variable rate structure including swaps. Page 13 highlights our strong regulatory capital position. Reduction in the CET1 ratio and the total risk-based capital ratios is due to an increase in risk-weighted assets of $161.2 million in the first quarter of 2022. Net interest income increased by $2.7 million from the year-ago period. Our tax equivalent net interest margin was 3% during the first quarter of 2022, which was down 5 basis points from the year-ago period and down 13 basis points from the fourth quarter of 2021. I will have some more detailed comments on this topic in a moment. Average interest-earning assets were $4.49 billion in the first quarter of 2022 compared to $4.05 billion in the year-ago quarter and $4.43 billion in the fourth quarter of 2021. Page 15 contains a more detailed analysis of the linked quarter decrease in net interest income and net interest margin. Our first quarter 2022 net interest margin was negatively impacted by two factors: decline in PPP loan balances had a negative 13 basis point impact and change in loan yield and mix excluding PPP decreased margin by 1 basis point. That was partially offset by an increase in investment yield of 2 basis points in the quarter. We will comment more specifically on our outlook for net interest income and the net interest margin for 2022 later in the presentation. On Page 16, we provide details on the institution's interest rate risk position. The comparative simulation analyses versus first quarter 2022 and fourth quarter 2021 calculates the change in net interest income over the next 12 months. The base rate scenario assumes a static balance sheet and applies the spot yield curve from valuation date. The increase in the base rate forecast in net interest income in the first quarter 2022 compared to the fourth quarter 2021 is primarily due to an increase in rates, which resulted in higher forecasted earning asset yields as well as higher forecasted earning asset balances. Most of the increase in the interest income was on term earning assets pricing off the two to seven year part of the curve. The majority of the bank's funding basis consists of non-maturity deposits, which price off the overnight fed funds rate, means that did not change non-maturity deposit rate after the first fed hike. Thus the spread between term earning assets and the bank's non-maturity funding widened notably, resulting in the expansion of the forecasted net interest income. Currently, 17% of assets reprice in one month and 31.8% reprice in the next 12 months. The institution maintains an asset-sensitive position primarily due to a federal funding base. We will continue to evaluate strategies to manage net interest income through hedging as well as product pricing and structure. Moving on to Page 17, non-interest income totaled $18.9 million in the first quarter of 2022 as compared to $26.4 million in the year-ago quarter and $15.8 million in the fourth quarter of 2021. First quarter of 2022 net gains on mortgage loans totaled $0.8 million, compared to $12.8 million in the first quarter of 2021. The decrease in gains was due to a decrease in mortgage loan sales volume and the mortgage loan pipeline, as well as lower loan sale profit margins. Margins were negatively impacted by approximately $3.8 million and the fair value adjustment on a portfolio of saleable construction loans. Mortgage loan applications remain solid, although refinancing applications have slowed and the mortgage production mix has rotated to a lower percentage of saleable loans. Positively impacting non-interest income was a $9.6 million gain on mortgage loan servicing due to an $8.5 million or $0.31 per diluted share after-tax increase in fair value due to price and a $0.9 million decrease due to paydowns of capitalized mortgage loan servicing rights in the first quarter of 2022. As detailed on Page 18, our non-interest expense totaled $31.5 million in the first quarter of 2022 as compared to $30 million in the year-ago quarter and $33 million in the fourth quarter of 2021. Compensation increased by $2.3 million compared to the prior year quarter due to raises that were effective at the start of the year. A decreased level of compensation that was deferred in the first quarter of 2022 has direct origination costs on lower mortgage loan origination volume and increase in lending personnel and higher healthcare insurance costs. Performance-based compensation decreased by $0.6 million due primarily to a decrease in mortgage lending volume compared to the first quarter in 2021. The first quarter of 2022 included $0.4 million of recoveries related to reserves for unfunded lending commitments, due to a decrease in unfunded lending commitments. We will have more comments on the outlook for non-interest expense later in the presentation. Page 19 provides data on non-performing loans, other real estate non-performing assets and early-stage delinquencies. Total non-performing assets were $5.4 million or 0.11% of total assets at March 31, 2022. Loans 30 to 89 days delinquent totaled $2.7 million at March 31, 2022 compared to $2.3 million at December 31, 2021. Page 20 provides some additional asset quality data including information on new loan defaults and on classified assets. I would highlight there were no new commercial loan defaults for the first quarter of 2022. Page 21 provides information on our TDR portfolio that totaled $36 million at March 31, 2022. This portfolio continues to perform well with 96.5% of these loans being current at March 31, 2022. Moving on to Page 22, we recorded a provision for credit losses credit of $1.6 million in the first quarter of 2022 compared to provision credit of $0.5 million in the year-ago quarter and a provision expense of $0.6 million in the fourth quarter of 2021. The allowance for loan losses totaled $45.6 million or 1.52% of the portfolio loans at March 31, 2022. Page 23 is our update for 2022 outlook to see how our actual performance during the first quarter compared to the original outlook that we provided in January of 2022. Our outlook estimated loan growth in low-single-digits. Loans increased by $99 million in the first quarter of 2022 or 13.8% annualized. Commercial mortgage and installment loans all experienced growth in the first quarter of 2022. Excluding PPP loans, total loan portfolio grew at 16.7% annualized rate during the first quarter of 2022, above our forecasted range. First quarter 2022 net interest income increased by 9% over 2021, which is higher than our forecast. However, the net interest margin for the first quarter of 2022 was 5 basis points lower than the first quarter of 2021, net interest margin of 3.05%, which is less than our original forecast. The first quarter 2022 provision for credit was $1.6 million. This is below our forecasted 2022 full-year provision range of 0.15% to 0.2% of average total portfolio loans. Primary drivers of the decrease in the provision for credit losses were a decrease in adjustments allocations based on subjective factors due in part to the expected reduction in risk related to COVID-19. Non-interest income totaled $18.9 million in the first quarter of 2022, which is higher than our forecasted range of $13 million to $17 million. First quarter 2022 mortgage loan originations, sales, and gains totaled $270.2 million, $221.7 million, and $0.8 million respectively. The decrease in net gains on mortgage loans sold was primarily due to lower sales volume, decreased profit margin on mortgage loan sales, and a decrease in fair value adjustments on the mortgage loan pipeline. Mortgage loan servicing generated a gain of $9.6 million in the first quarter of 2022, due primarily to a positive $8.5 million fair value adjustment due to price. The year-over-year decrease in non-interest income could be outside of our original forecast due to lower gains on sales of mortgages in the coming quarter. Non-interest expense was $31.5 million in the first quarter, in the middle of our $30.5 million to $32.5 million targeted quarterly range. Our effective income tax rate of 18.6% for the first quarter of 2022 was at the lower end of our forecast. Lastly, the company purchased 59,002 shares at an average cost of $23.46 for the first quarter of 2022. That concludes my prepared remarks. I would like to turn the call back over to Brad.

Brad Kessel, President and CEO

Slide 24 displays a high-level view of our key strategic initiatives. In 2021, we made significant investments to our overall technology platform to improve the customer experience and increase productivity amongst other goals. We have already seen some very positive results with this investment and I believe we will see continued growth and improved productivity in 2022. While the current operating environment contains numerous challenges and much uncertainty, it also provides many opportunities. We are excited about the momentum we have in our markets and look forward to continuing these growth trends for the remainder of 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 from Piper Sandler. Brendan, your line is open.

Brendan Nosal, Analyst

Hey, good morning folks. How are you doing?

Brad Kessel, President and CEO

Good, Brendan. Thank you.

Brendan Nosal, Analyst

Okay. Just to start off here maybe on the mortgage piece, I was hoping you can provide a little bit more color on the dynamics that drove the compression quarter-over-quarter, particularly that fair value mark and then kind of tying your thoughts on mortgage for the rest of the year as it seems into the overall update in fee guidance. Thanks.

Gavin Mohr, EVP and Chief Financial Officer

Maybe I'll start by saying that the biggest impact on the fair value mark for the quarter was from a construction portfolio that can be sold. As you know, construction timelines have been longer than usual for completion. As these loans are closed, they are marked to market each quarter until the mortgage is finalized. We had an existing portfolio from 2021 with lower interest rates compared to the current market. As rates rise, the market value of that portfolio, which was hedged, decreased because it's challenging to hedge a 12-month construction loan. The $3.8 million adjustment in fair value is mainly due to this mark-to-market change. I want to note that we have mitigated additional risk from that portfolio, so we won't see significant mark-to-market adjustments in the future.

Brendan Nosal, Analyst

All right. That's certainly helpful. Then maybe kind of turning to the expense side of things, certainly nice to see the run rate improve so much quarter-over-quarter. And then there's the additional savings from the closed branch locations later on in the year. Just kind of curious about the way that you're accruing for a comp at the start of the year, meaning are you accruing at a level that reflects the potential revenue benefits of a higher short-term interest rate environment later on in the year?

Gavin Mohr, EVP and Chief Financial Officer

Yes. Yes.

Brendan Nosal, Analyst

All right. Fantastic. Thanks for taking the questions.

Operator, Operator

Our next question comes from Damon DelMonte from KBW. Damon, your line is now open.

Unidentified Analyst, Analyst

Hi, this is Matt Rank filling in for Damon DelMonte. I hope everybody's doing well today.

Brad Kessel, President and CEO

Hi, Matt.

Unidentified Analyst, Analyst

First question, as you remix the earning assets, do you have a targeted range or percentage of securities to average earning assets?

Brad Kessel, President and CEO

I don't have a target, I would say this. The security is, I anticipate the security balances to decline through 2022. So if we can, if we can redeploy those cash flows into loans, you will see dollar for dollar that move out of the securities portfolio. So obviously that the current allocation is much higher than it was historically targeted. We'd like to see it come down.

Unidentified Analyst, Analyst

Okay. Got it. Got it. And then just one last question if I can get your updated thoughts on share repurchases for the year. Thanks.

Brad Kessel, President and CEO

Sure, Matt. That's a good question. This is Brad, and as you can see from our report, we participated in the market on a small scale during the first quarter. Looking ahead, our decision to remain in the market depends on our trading position, our growth needs—both organically and through potential acquisitions—and our overall capital levels. Therefore, you can expect a continuation of our historical patterns.

Operator, Operator

Our next question comes from Russell Gunther from D.A. Davidson. Russell, you may go ahead.

Manuel Navas, Analyst

Hi, this is Manuel Navas on for Russell. Good morning.

Brad Kessel, President and CEO

Good morning.

Manuel Navas, Analyst

As you assess your loan growth performance and the outlook for the entire year, are you starting to get a sense of potentially stronger growth in the first half, with a bit more caution expected in the second half, or do you prefer to wait and see how loan growth develops?

Brad Kessel, President and CEO

Joel, do you want to answer?

Joel Rahn, Executive Vice President, Commercial Banking

Yes, I will attempt to answer that one. I wish I had a crystal ball to tell you. Right now, we're seeing very strong growth. And it's a good mix of new customers to the bank as well as organic growth that we would label as existing customers. That was a very nice split in our first quarter growth. We're seeing that based on our pipeline into the second quarter. Certainly not naive to what, we can't expect to slow later in the year, it's hard to predict that. But at this point, all I can tell you is based on our pipeline where we're seeing good demand, we're seeing businesses expand. We're not seeing signs of a pullback yet. But certainly, we're following the economic conditions closely. It's difficult to say what the second half of the year will look like. Right now, we don't see a slowing up, but the world is changing rapidly with economic news.

Manuel Navas, Analyst

Definitely understandable. What do you see right now in terms of pricing competition, both on the lending side? What do you see on new loans here in April? And on the deposit side as well, is anyone stepping up deposit competition yet?

Joel Rahn, Executive Vice President, Commercial Banking

This is Joel again; I'll answer the loan side. We've seen a lot of pricing pressure and yield pressure, really starting in the second half of last year, as all banks were hungry to grow earning assets. And that has changed. So there's still a lot of pressure on yields, and I expect that that's going to continue here throughout this year. I'll turn it over to Brad or Gavin for thoughts on deposit rates.

Brad Kessel, President and CEO

Well, I think we're not seeing a lot of pressure on the deposit side at this point. And that's going to be very interesting to watch here with each Fed rate hike. And on the mortgage side, I would say it just feels like the market is slow to adjust to what's happening with the yield curve. So I think there is a lot of discussion internally about being disciplined in our pricing. But it is very aggressive on all the home funds today.

Operator, Operator

Our next question comes from Bryce Rowe from Hovde Group. Bryce, your line is open.

Bryce Rowe, Analyst

Thank you. Good morning. I would like to follow up on the previous comment regarding competition. I'm interested in understanding how new loans are being priced in the current environment compared to the portfolio yield for the first quarter.

Joel Rahn, Executive Vice President, Commercial Banking

I am proud of our team for maintaining discipline in achieving our projected yields on the commercial side. This has been challenging, particularly as fixed rates are increasing. Although many of our competitors, as Brad mentioned, do not seem to be keeping up with these changes in their quoted rates, we took a proactive approach, which may have cost us some business. However, we were still able to demonstrate the growth we've highlighted. Gavin, do you have anything to add?

Gavin Mohr, EVP and Chief Financial Officer

Well, I would say I'm joking. Obviously, I'm going to highlight the spread aspect of it in the specific crusher. I do think too, we're seeing a rotation into a higher allocation of variable loans, which obviously is carrying a lower yield as well. If you're just looking at the consolidated portfolio yield.

Bryce Rowe, Analyst

Yes, okay. The last one for me, we've seen pressure on tangible common equity from the fair value market on the securities portfolios, really across the industry here this quarter. Does that compression in tangible common equity ratio change your outlook from a repurchase perspective? Just trying to gauge how you all see that compression? Any views around? It would be helpful. Thanks.

Joel Rahn, Executive Vice President, Commercial Banking

Yes, that's a great question. We've had extensive discussions about it. Internally, we've conducted multiple stress tests regarding further depreciation alongside potential rate hikes. The significant movement we've observed in the yield curve today is primarily in the middle section, which aligns with the duration of our assets or securities. We're hopeful that we may have passed the most challenging phase, although we cannot be certain. Therefore, we are monitoring the situation closely. We are also maintaining conversations with all stakeholders, ranging from the investment community to regulators, who are particularly focused on regulatory capital. While this situation is a consideration, it does not impact regulatory capital and does not definitively dictate whether we will exit the market or continue our current approach.

Operator, Operator

Currently, we have no further questions. Therefore, I will hand back to Brad Kessel, President and CEO 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. 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 for 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

Ladies and gentlemen, this concludes today's conference call. Thank you for being with us today. Have a lovely day ahead. You may disconnect your lines now.