Independent Bank Corp Q2 FY2022 Earnings Call

Good morning and welcome to the Independent Bank Corp. Second Quarter 2022 Earnings Conference Call. All participants will be in a listen-only mode. After today's presentation, there will be an opportunity to ask questions. Before proceeding, please note that during this call we will be making forward-looking statements. Actual results may differ materially from these statements due to a number of factors, including those described in our earnings release and other SEC filings. We undertake no obligation to publicly update any such statements. In addition some of discussion today may include references to certain non-GAAP financial measures. Information about these non-GAAP measures including reconciliation to GAAP measure may be found in our earnings release and other SEC filings. These SEC filings can be accessed via the Investor Relations section of our website. Finally, please also note that this event is being recorded. I would now like to turn the conference over to Chris Oddleifson, President and CEO. Please go ahead sir.

Good morning everyone and thank you for joining us today. I'm once again accompanied by Mark Ruggiero, our Chief Financial Officer; and Rob Cozzone, our Chief Operating Officer. Our second quarter performance is a strong one which is driven by the business fundamentals of our franchise. Net income for this past quarter came in at $61.8 million or $1.32 per share, nicely above both prior quarter and prior year results. Mark will be covering the quarter in greater detail, but highlights include underlying loan activity remains encouraging with net growth of 5% on an annualized basis exclusive of PPP loan runoff. My colleagues are quite active in meeting the credit needs of our customers. In fact, loan closings in the second quarter grew by 35% over the first quarter volumes to nearly $1 billion and loan pipeline stands at healthy levels as well. Core deposits have now reached 87% of total deposits and remain a source of great strength and economic value. Higher-cost CDs continued to iterate allowing us to maintain a very low five basis points total deposit costs. Our balance sheet management has enabled us to clearly benefit from rising rates as evidenced by the notable increase in net interest margin this quarter. And we were positioned to continue to benefit from further rate increases that are widely expected. Mark will comment on this in a moment. Fee revenues were strong this quarter across a range of sources. Our investment management business continues to excel and we're encouraged by the volume of new inflows along with the ongoing success of our internal referrals. Expense levels remained well-managed as our operating efficiency measure declined to 52% this quarter. Credit quality continues to be benign with minimal net losses and stable non-performing levels experienced in the second quarter, and capital levels remain in fine shape, which gave us the confidence to proceed with a modest share buyback in the second quarter. We continue to make progress in several important fronts. The assimilation of East Boston Savings Banks continues to proceed very smoothly. My new branch colleagues have adapted quite well to our processes and platforms, all major systems have been fully integrated, and we are actively pursuing new business opportunities we've identified in our expanded markets and acquired customer bases, all of which we're very excited about. We successfully opened our new branch in Westborough in Maine in May, bringing our total retail presence to eight in Worcester County. Our expansion into this market and the broader Metro West area is an important part of our growth strategy. Customer reception to our brand and offerings has been very encouraging thus far. We've been hard at work enhancing our digital banking capabilities with respect to account access and opening as payment networks and our banker platform to ensure we remain responsive to customer preferences. We're also in the process of streamlining our front-end processes, especially related to our lending platforms and continue to more fully leverage Salesforce throughout the company. Turning to the economic picture, now the labor market as we all know is showing continuous strength, the focus remains heavily on the inflation. Inflation surged again in June and the Fed has reiterated their commitment to combat increased pricing with rate hikes. The Fed is expected to continue with rate increases, but market uncertainty is on the rise. The price spot here is at each increase provides a tailwind to income as Mark will discuss in a moment. We feel we've positioned ourselves in a flexible manner to deal with a highly uncertain operating environment. And should we enter a period of pronounced slowdown or begin to witness unfavorable competitive practices, especially on the lending side, we will react with as much discipline as we have in the past, which has served us well over the long-term. In the meantime, we remain highly focused on serving our loyal and growing customer base. We build strong relationships with our customers and provide them with award-winning level of service for our highly motivated Rockland Trust colleagues. In fact, a point that is well worth mentioning, again, is that during the first quarter, we received the number one ranking in New England at J.D. Power 2022 U.S. Retail Banking Customer Satisfaction Study. Before signing off and handing it over to Mark, I'd like to acknowledge our Director, Frederick Taw, who has reached retirement age. I have valued his insight and support during his tenure on our Board and we wish him well. And with that, I'll turn it over to Mark.

Thank you, Chris. Similar to last quarter, my comments will reference the information included in the earnings presentation deck from our 8-K filing last night, which is also available on our website and today's investor portal. Let's jump into slide four of that deck. In the second quarter of 2022, GAAP net income was $61.8 million, with diluted EPS at $1.32, indicating significant increases from the previous quarter's results. It’s important to note that there were no non-GAAP related items in the second quarter. The key drivers for this quarter include a 4.9% annualized net loan growth when excluding PPP loans, supported by strong consumer loan activity. While overall cash balances decreased, we continued to strategically deploy cash into the securities portfolio to enhance profitability. The core net interest margin, excluding purchase accounting and PPP impacts, rose to 3.23% for the quarter, up from 3% in the prior quarter, and the reported margin also showed a positive increase. I will provide more details on the impact of the rising rate environment shortly. New core deposit account activity remained strong, although the overall reduction in deposit balances was mainly due to lower time deposits. The provision for the quarter was zero, reflecting strong asset quality metrics. The quarter also saw higher fee income and a slight increase in operating expenses, which I will elaborate on soon. Additionally, the company repurchased 1.3 million shares under its share repurchase program during the quarter. In summary, we view the results for the quarter as a strong testament to our solid core fundamentals and a balance sheet positioned for increased profitability and shareholder value in the future. On both a GAAP and operating basis, we achieved a 1.24% return on assets, an 8.49% return on average common equity, and a 13.01% return on tangible common equity for the quarter. Consistent with last quarter, tangible book value was adversely affected by comprehensive losses related to available-for-sale security unrealized losses and declines in hedge fair valuation, leading to an $0.84 decrease in tangible book value to $40.31 as of June 30th. Now, moving to slide five, we will discuss some key components of the quarter’s results. Including PPP, the loan portfolio slightly increased to $13.7 billion. Excluding PPP, total loans grew at a robust annualized rate of 4.9% for the quarter. The consumer portfolios primarily drove this overall increase, with most residential production retained on the balance sheet and significant demand for home equity products noted. Additionally, excluding PPP loans, we observed substantial growth in the C&I and construction categories, both benefiting from increased line utilization. However, commercial real estate balances decreased by $106 million, or 1.3%, due to heightened pay-off activity in the East Boston portfolio and legacy portfolios. Slide six provides further details on loan activity for the quarter. As indicated on the left side of the slide, commercial loan origination activity was robust, with total closed commitments of $557 million. A large part of this production stemmed from construction and other line of credit financing, even though total outstandings did not reflect the same rate of increase observed in the second quarter. This bodes well for future increased utilization. Furthermore, the approved commercial pipeline stood at $372 million as of June 30th, significantly up from the prior quarter's $307 million. Our market opportunities mainly center around one to four family, condo, and apartment asset classes in commercial real estate and construction activity, while the retail trade sector remains a solid source of deal flow on the C&I side. The slide also indicates that PPP balances have been reduced to $31 million as of June 30th, generating $1.8 million of net fees recognized compared to $3.5 million in the prior quarter, with remaining unearned net fees now totaling $600,000. On the right side of the slide, we highlight some key metrics related to our strong consumer book activity for the quarter. Given the company's balance sheet position and secondary market pricing during the quarter, approximately 92% of the mortgage activity was retained within the portfolio. Historically, in periods where the refinance market slows amidst a rising rate environment, we see our strong home equity products demonstrate significant value. Following a long period of subdued growth, the second quarter witnessed solid closing activity, leading to the earlier mentioned growth in home equity balances. Moving on to slide seven, the quarter's deposit activity was in line with our expectations, with declines in time deposits and money market accounts driving an overall reduction in deposits. As we transition into a rising rate environment, a continued focus on core deposit relationships is likely to result in some rate-sensitive funding exiting the bank in the second half of 2022, while allowing us to maintain sufficient funding levels and manage our overall deposit costs effectively. As of June 30th, core deposits comprised 86.8% of total deposits, and the cost of deposits for the quarter remained low at only five basis points for the fourth consecutive quarter. This transition sets us up nicely, as we move to slide eight to discuss net interest margin results for the quarter. As presented in previous quarters, this slide provides insights into the reported margin and breaks down volatile or non-recurring items to reconcile back to a core net interest margin. As noted, both the reported and core net interest margins saw a respectable increase compared to the prior quarter. Notably, the core net interest margin, excluding PPP fees and purchase accounting impacts, rose 23 basis points compared to the prior quarter margin. This increase reflects the company's asset-sensitive positioning and a favorable remixing of its excess liquidity. An update on the margin guidance shows key aspects of the company's asset sensitivity, which indicates that any movements in short-term interest rates, primarily Fed funds, one month LIBOR, term SOFR, or prime, would lead to immediate repricing benefits in our Federal Reserve cash balances of $1.3 billion and about 34% of our loan portfolio tied to these indices. During the quarter, to balance our interest rate risk profiles and current earnings, we executed an additional $300 million in macro-level loan hedges, consisting of $150 million in variable-to-fixed rate instruments and $150 million in interest rate call hedges. This strategy partially mitigates the loan benefits from rising rates long-term while still allowing for immediate earnings improvement in the near term. In the longer term, the total macro hedge portfolio of $1.2 billion, combined with loans that have index floors currently in the money, will help offset some of the asset repricing benefits previously mentioned. Overall, about 20% to 25% of total loans, on a net basis, would immediately benefit from rising rates. As previously noted, market pressures will significantly impact the speed of deposit rate increases during this rate cycle. Moving to asset quality, slide nine highlights key metrics worth noting. Non-performing loans remained relatively steady at $55.9 million as of June 30th, with net charge-offs at just $200,000 or 1 basis point on an annualized basis. Total delinquencies increased slightly to 0.4% of the portfolio, and total loan deferrals decreased by another $108 million to $197 million, or 1.4% of the total portfolio, with most set to mature before 2023. Given these stable metrics and modest loan growth, we recognized zero provision for loan loss, maintaining the allowance for credit loss as a percentage of loans at 1.06%. Now, shifting to non-interest items, slide 10 outlines results for non-interest income for the quarter, with a few highlights. Deposit account interchange and ATM fees saw significant increases from the previous quarter, primarily due to seasonal activity upticks. Despite a market-induced reduction in assets under administration from $5.7 billion last quarter to $5.2 billion as of June 30th, overall investment management fee income increased, backed by strong retail and insurance commission income and seasonal tax preparation fees. Additionally, despite challenging market conditions, we experienced strong inflows of new money in 2022. Our seasonal sales representatives, coupled with new hires, have had success in both legacy and newly acquired markets. Finally, as previously mentioned, our capability to absorb fixed-rate lending products has posed challenges for both mortgage banking and loan level swap income in the second quarter. Moving to the next slide, total operating expenses were $90.6 million, reflecting a 2.4% increase from the prior quarter when excluding last quarter's $7.1 million in merger-related costs. Noteworthy items in second-quarter expenses compared to last quarter included rising incentive compensation within salaries and benefits, along with decreased snow removal costs in occupancy and equipment. In terms of other non-interest expenses, the increase was mainly attributed to consulting cost increases linked to operational initiatives, larger unrealized losses on equity securities, and annual director equity awards. The tax rate for the quarter saw a slight increase to 24.8% due to projected earnings rises. To conclude on slide 12, I will provide updates regarding 2022 guidance. For commercial loan growth, inclusive of PPP and small business loans, total commercial loans have decreased about 1.8% year-to-date. As we've explained, this is mainly driven by the expected runoff of PPP loans and East Boston acquired commercial real estate. For the second half of 2022, we anticipate flat to low single-digit growth, which would likely result in a steady to low single-digit percentage decrease in balances for the full year. In terms of residential loan growth, while we expect reduced demand in the second half, we anticipate mid-single-digit growth, leading to an overall estimate of around 20% growth for 2022. For home equity, we expect the positive momentum from Q2 to carry into the latter half of 2022, with anticipated growth in the low to mid-single-digit percentage range over six months, resulting in mid to high single-digit growth for the entirety of the year. With respect to deposit growth, we are pleased with our ability to generate new core operating accounts in both legacy and acquired markets. However, the rising rate environment and high liquidity levels allow us to strategically permit some time deposits and rate-sensitive balances to run off, likely leading to steady or modest declines in total deposits in the latter half of 2022. Furthermore, with the recent June rate hike and anticipated future increases, the earlier guidance regarding immediate asset repricing impact and a strong deposit franchise will continue to contribute positively to core net interest margin benefits moving forward. For provision levels, despite overall strong asset quality, concerns about looming recessionary pressures are valid. While it’s challenging to predict the impact due to numerous variables, we expect current allowance levels to remain stable for the near future, with current charge-offs serving as a proxy for future provision levels. Regarding non-interest items, total non-interest income may experience slight decreases mainly driven by reduced investment management income and ongoing pressures on mortgage banking income. Additionally, we are evaluating potential modifications to our overdraft program, though the final impact remains uncertain and the timing for any changes will likely be later this calendar year. Lastly, non-interest expenses are expected to rise in the second half at a low to mid-single-digit percentage rate, primarily due to wage pressures and other inflationary factors. The tax rate for the latter half of the year is projected to be around 25%. That wraps up my remarks, and we will now take questions.

We will now begin the question-and-answer session. Our first question will come from Mark Fitzgibbon with Sandler O'Neill. Please go ahead.

Hey, guys, good morning and Happy Friday.

Happy Friday, Mark.

First, I wondered if you could share with us what the commercial line utilization rate was in the second quarter, I think it was 30% in the prior quarter?

Sure. Yes. So, it only upticks slightly, but certainly trending in the right direction. So, a couple of components within the commercial buckets, Mark, our general C&I line of credit utilization was 31.5%. We also look at our ABL subset within C&I or asset-based lending. That went from 48.9% to 49.2%. So, just a modest uptick there. And on the construction side, that was slightly modestly up as well from 57.1% to 57.9%. So, all just generally, up nominally, but still well below pre-pandemic levels.

Okay, great. And then secondly, I wondered if you could give us an update on that one large $24 million syndicated loan that went non-accrual last quarter. I think you had said previously you thought it would sort of cure in the next quarter or two. Any update on that?

Yes, it is still in negotiations. As you mentioned, this is a larger syndicated credit, so we are not the lead bank on that relationship. However, we still expect a full refinance, although the timing has been pushed back a little. We are now potentially looking at a resolution in early fourth quarter instead of the original timeline. Nonetheless, we anticipate no losses and a full resolution; it’s just occurring a bit later in the calendar.

Okay, great. Mark, we don't see many banks repurchasing stock at two times tangible book value. Can you explain your reasoning for buying back stock at that level? I'm curious why we wouldn't let capital accumulate, especially considering the recessionary concerns you mentioned, or distribute it as a dividend to prevent tangible book dilution. I'm just interested in your thoughts on that.

That is a valid question and something we carefully considered when making that decision. It’s based on a few factors, with the primary one being that we are operating at what we still view as excess levels of capital compared to our optimal operating level. Therefore, we believe a certain level of repurchase activity makes sense given our overall capital levels. Additionally, despite the general concerns about a recession, the rising rate environment provides us with significant earnings potential moving forward. We are confident that, looking at the buyback levels we have set, our earnings capacity will recover that value in a reasonable timeframe, which we believe will provide good long-term shareholder value. While our buyback levels are higher, we believe our earnings potential will compensate for that in a sufficient timeline.

Okay. And then lastly, of the $226 million residential mortgages you guys booked on the balance sheet this quarter, are those mostly hybrid arms? Or is there some 30-year volume in there? And maybe what is the average rate look like on that stuff?

Yes, that's mostly 30-year volume, Mark. The average rate in the second quarter increased to the high threes, which still seems low considering today’s rates. The new volume is significantly higher than that, but for most of the second quarter, we were still discussing rates in the mid to high three percentages. That's what was recorded in Q2. Sure.

Our next question will come from Laurie Hunsicker with Compass Point Research. Please go ahead.

Yes. Hi, good morning.

Good morning, Laurie.

Wondered if you could help us think about accretion income. Yes, any direction you can give us on accretion income, obviously saw reversal this quarter, just because it's so impactful into NII?

Yes, certainly. For the current quarter's purchase accounting, we don't have many of these left in the portfolio, but there are still some individual loans with a premium fair value mark, mainly from the East Boston acquired loans. As these loans are more likely to prepay due to the current rate environment and refinancing, we saw a few of them with higher premiums pay off this quarter, which contributed to the negative purchase accounting impact. I remain confident that in the long run, we have a significant net discount or credit marks in the portfolio that will lead to positive purchase accounting. I expect this to be around $1 million per quarter. I hope that Q2 was just an anomaly regarding this negative impact.

Okay, that's very helpful. And then it looks like on your expenses, your occupancy went down, can you just remind us I know you had originally said you were targeting 80% cost save with EBSB acquisition by 2022? Are we already there yet? Are you ahead of schedule? Or how should we be thinking about that number?

No, we have achieved all the occupancy cost savings. However, the main factor contributing to this is the reduction in snow removal costs. In the first quarter, this amounted to $1.2 million, which is part of the $1.7 million decline directly related to snow removal expenses. Additionally, the timing of some final exits in the East Boston portfolio likely contributed another $200,000 to $250,000 benefit in Q1 compared to Q2. As of June 30th, all of these cost savings have been realized, and you should expect a solid run rate in Q2 going forward.

Okay, that's perfect. And then just kind of more macro is we're starting to see some warning signals, some cracks in credit, can you help us think about a few things maybe give us a refresh on your office, any details around office, including what's right in Downtown Boston, anything on leverage lending? And then just generally any stressors within the legacy EBSB book, I know they were very, very discounted on an LTV basis. But any stressors you're seeing there, they had larger CRE loans compared to you? Just anything you can help us think about on those three buckets?

Sure. You mentioned some areas that we have always closely monitored to identify potential emerging risks. Regarding the office space asset class, it constitutes about 15% of our commercial real estate portfolio, which is approximately $1.5 billion in outstanding balances. Our exposure to Downtown Boston is quite limited, with less than $300 million directly in Boston Proper and around another $100 million in nearby Greater Boston areas such as Brighton and Jamaica Plain. Overall, our Downtown Boston exposure remains below $400 million, with most of our office properties located in suburban areas, which are performing well without any signs of deterioration. These properties typically feature shorter lease terms, allowing for more flexibility in underwriting. We have consistently pursued personal guarantees and tried to minimize our dependence on single tenant relationships, ensuring lease terms are closely aligned with maturity dates. This disciplined approach has been beneficial, and we will continue to monitor this area closely. Our overall loan-to-value ratios remain robust at approximately 60%, considering current valuations, so we feel reasonably confident. In other categories you mentioned, leveraged lending has decreased to around $150 million as of June 30th, with a few relationships ending. A significant portion of this is related to our security alarm lending, which is always secured by tangible and intangible assets. We have well-defined borrowing base certificates linked to contractual cash flows that support lending in this area, resulting in very nominal exposure. However, it's a credit segment we remain optimistic about. Regarding East Boston, as we have previously stated, there were some larger transactions, and part of that is factored into the office exposure metrics I shared. We maintain conservative credit evaluations there, which we believe provide adequate protection. While there has been noticeable outflow in that category, it does limit our ongoing or future exposure in Downtown Boston. We are keeping an eye on a few specific credits, but overall, we are not witnessing any significant migration towards negative credit asset quality. We're monitoring a handful of cases more closely, but there is no widespread concern at this time.

That's great. That's super helpful. And then just last question. Chris, can you help us think about M&A and how you potentially are thinking about it differently if you're thinking about it differently with the thought of higher interest rate marks laying on tangible book and obviously, you very, very strong stock currency, how you would think about credit marks? You're a very disciplined, very strong acquirer and so we just love your high level thoughts on generally how you're thinking about it. Thanks.

We've experienced significant success with our M&A transactions over the years. It's true that we are very disciplined in our approach, and we hope to maintain this moving forward. As franchises become available, we want to be involved in those opportunities. However, considering the uncertainty in the coming years, we need to give more thought to the implications of this environment. I can't specify our stance on any particular scenario, but it is clear that we need to be more deliberate in our thinking than we have been in the past. Mark, do you have any additional thoughts on this?

No, I think you summed it up well, Chris.

Yes, I mean we still have a nice currency advantage or I'd like to be able to use it.

Great. Thank you.

Our next question will come from Chris O'Connell with KBW. Please go ahead.

Hey, good morning, gentlemen. Circle back, I may have missed it with the initial buyback question. But did you guys indicate if you guys would be continuing to utilize that buyback going forward or not?

We didn't provide direct guidance there, but through the second quarter, the level of activity amounted to about 75% of what we had originally authorized. So, right now, there would be fairly modest impact if we were to continue repurchasing in the third quarter.

Okay.

As always, it's going to be dictated by stock price and our decision at what the appropriate level the buyback is.

Okay, got it. And of the legacy EBSB loans that you guys are kind of continuing to allow to fall off in the back half of this year, what's the average rate on those?

Including the marks we've applied, I believe they were around 3% to 4% because of these adjustments. To be honest, we are facing a quite competitive environment. What we are seeing in terms of exit is often priced very competitively and at rates that we haven't been willing to match in many instances.

Got it. And I guess on that front, could you give us an update on where origination yields are coming on out on both the commercial side and the resi side?

Sure. No, we've been able to really mirror what you've seen occur on the curve. So, when you look at the swap curve or the FHLB curve, that five to seven year part of the curve is up 50 to 60 basis points on average quarter-over-quarter. So, we are experiencing that type of lift in terms of our new originations. So, on the commercial side, we've been getting in the mid 4% range. On the resi, we've moved up on portfolio pricing into the high 4%, close to 5% range in terms of recent volume coming on the books. So, certainly, we've seen nice increases in terms of new originations quarter-over-quarter.

Great. Regarding deposit costs, they have remained stable so far, and the runoff should assist in managing them in the future. Have you considered when there might be broader increases in your deposit costs and the timing of that? How do you foresee it developing in the near term?

Yes. No, very on-point question there, Chris. We've already made decisions, as of late, that will certainly increase deposit costs heading into the third quarter. Just the timing of those decisions manifest themselves yet in the Q2 results. So, we do anticipate based on just the decisions we've made to date, the cost of deposits increasing by about four or five basis points in the third quarter, so going to about 10. If we do get another rate increase here in July, which is very highly likely, I would expect we'll be making additional moves in the quarter. The timing is a bit TBD there, but I think you'll see cost of deposits certainly start to move north of 10 basis points and likely uptick towards the 15 basis point range depending on what we get for rate increases.

Okay, that's very helpful. Thank you. I understand that the deferrals have decreased significantly. It appears that most of them are expected to mature in the fourth quarter of this year. Have you assessed those recently? How do you anticipate that will affect their return?

Yes, for the most part, we would expect the majority of that to come back to full payment status. If you recall a number of those at the time were in asset classes like hotel and accommodation and we took a pretty proactive approach and extending those out for a fairly lengthy amount of time under the CARES Act provisions. That's an asset class space that has really bounced back very strongly, in fact, a lot of our hotel book is really performing at very strong levels. So, I don't have all of the breakdown, but I do know that was a meaningful component of our deferral and I would expect those asset classes to bounce back without any issues. But I can provide more details if needed, Chris, after the call.

Okay, that's great. That’s all I had for now. Thank you.

Thank you.

Thanks Chris.

There are no more remaining questions at this time. And with that, we will conclude our question-and-answer session. I'd like to turn the conference back over to Chris Oddleifson for any closing remarks.

Thank you, Joe and thank you everybody for joining us today. We look forward to chatting with you in three months regarding our third quarter 2022 results. Have a good weekend. And for those of you in a hot area of the country, which I imagine as most of you, stay cool this weekend. Be safe. Bye.

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