Earnings Call Transcript - MBWM Q2 2025

Operator, Operator

Good morning, and welcome to the Mercantile Bank Corporation Second Quarter 2025 Earnings Conference Call. Please note that this event is being recorded. I would now like to turn the conference over to Nichole Kladder, Chief Marketing Officer of Mercantile Bank. Please go ahead.

Nichole Kladder, Chief Marketing Officer

Hello, and thank you for joining us. Today, we will cover the company's financial results for the second quarter of 2025. The team members joining me this morning include Ray Reitsma, President and Chief Executive Officer; as well as Chuck Christmas, Executive Vice President and Chief Financial Officer. Our agenda will begin with prepared remarks by both Ray and Chuck and will include references to our presentations covering this quarter's results. You can access a copy of the presentation as well as the press release sent earlier today by visiting mercbank.com. After our prepared remarks, we will then open the call to your questions. Before we begin, it is my responsibility to inform you that this call may involve certain forward-looking statements such as projections of revenue, earnings, and capital structure as well as statements on the plans and objectives of the company's business. The company's actual results could differ materially from any forward-looking statements made today due to factors described in the company's latest Securities and Exchange Commission filings. The company assumes no obligation to update any forward-looking statements made during the call. Let's begin. Ray?

Raymond Reitsma, President and Chief Executive Officer

Thank you, Nichole. My comments will focus on the factors driving our robust second quarter 2025 operating results and the key elements of our strategic partnership with Eastern Michigan Bank, which was announced this morning. Commercial loan growth for the first 6 months of 2025 was $114 million or an annualized rate of 6.2%. This growth occurred despite customer reductions in loan balances, primarily from asset sales, which aggregated $154 million for the period with $99 million attributable to the second quarter. We expect continuation of this trend with somewhat elevated CRE payoffs in the third quarter. Lending commitments are down slightly from the first quarter of 2025 but remain at a solid level of $437 million, and discussions and progress remain at historically high levels. Given the uncertainty inherent in the current economic environment, the pace at which these may turn into accepted commitments is also uncertain. Taken together, we expect loan growth of 1% to 2% in the third quarter and 3% to 5% in the fourth quarter. In the mortgage portfolio, we continue to successfully execute initiatives that reduce the volume of loans that reside on our balance sheet in favor of selling production in the secondary market. Our mortgage team continues to build market share despite challenges from relatively high interest rates. Positive outcomes include a 23.4% increase in mortgage banking income for the first 6 months of 2025 compared to the first 6 months of 2024 and a decrease over the last year of $50 million in residential mortgages on the balance sheet. Asset quality remains strong as nonperforming assets totaled $9.7 million at June 30, 2025, or 16 basis points of total assets. Past due loans represented 6 basis points of total loans at the end of the second quarter. Our lending teams are the first line of observation and defense to recognize areas of emerging risk. Our risk rating model is robust with continuing emphasis on current borrower cash flow, providing sensitivity to any emerging challenges within a borrower's financial situation. That said, our customers continue to report strong results to date despite the uncertainty and rapid change that has been present in the operating environment. Net interest income grew significantly in several key areas during the first 6 months of 2025 compared to the respective 2024 period. As mentioned earlier, mortgage banking income grew 23.4% as our team grew market share in a difficult interest rate environment. Service charges on accounts grew 18.1%, reflecting growth in our deposit base and increased activity levels. Payroll services grew at 15.2% as our high-service model continues to build momentum in the marketplace. Credit and debit card income grew 3.7%. Interest rate swap income recovered significantly in the second quarter compared to the first quarter as borrowers' rate expectations align with the use of the product. The deposit base of our company has been and will continue to be an area of significant focus. Our efforts to date have resulted in a 13% increase in local deposits at June 30, 2025, compared with June 30, 2024, which helped reduce our loan-to-deposit ratio from 107% to just under 100% over the same period. The strategic partnership with Eastern Michigan Bank provides a powerful supplement to our organic growth deposit-gathering activities. In fact, Eastern Michigan checked several or multiple boxes based on Mercantile's strategic objectives. In addition to lowering the loan-to-deposit ratio, reducing the pro forma cost of funds, and enhancing the on-balance-sheet liquidity, we are afforded entry into new markets with a well-established franchise with proven leadership. Eastern has a clean credit profile and a strong track record of profitability. Mercantile and Eastern share a culture of excellent customer service and experience and investment in the communities we serve, and the combination of our companies will position us for continued growth and momentum. As noted in our release, we will be transitioning to Jack Henry in early 2027. One of the many unique traits that attracted us to Eastern Michigan is their decades of experience with our new core provider; their institutional knowledge will help ensure that our transition is as frictionless as possible for our customers and employees. In addition to attractive strategic characteristics, the combination with Eastern has financially attractive traits, including double-digit earnings accretion, mid-single-digit tangible book value dilution, and a mid-3-year earn-back period. We have waited for more than a decade since our last M&A activity for a partner like Eastern Michigan to come along, and our patience has been rewarded. We are pleased to be joining forces with our new colleagues at Eastern Michigan Bank and look forward to great success in the years ahead. That concludes my remarks. I will now turn the call over to Chuck.

Charles Christmas, Executive Vice President and Chief Financial Officer

Thanks, Ray, and good morning to everybody. This morning, we announced net income of $22.6 million or $1.39 per diluted share for the second quarter of 2025 compared to net income of $18.8 million or $1.17 per diluted share for the second quarter of 2024. Net income during the first 6 months of 2025 totaled $42.2 million or $2.60 per diluted share compared to $40.3 million or $2.50 per diluted share for the respective prior year period. Growth in net income during both time frames largely reflected increased net interest income, lower provision expense, and reduced federal income tax expense, which more than offset increased overhead costs. Interest income on loans increased during the second quarter and first 6 months of 2025 compared to the prior year periods, reflecting strong loan growth that more than offset a lower yield on loans. Average loans totaled $4.7 billion during the second quarter of 2025 compared to $4.4 billion during the second quarter of 2024, equating to a growth rate of almost 7%. Our yield on loans during the second quarter of 2025 was 32 basis points lower than the second quarter of 2024, largely reflecting the aggregate 100 basis point decline in the federal funds rate during the last 4 months of 2024. Interest income on securities increased during the second quarter and first 6 months of 2025 compared to the prior year period, reflecting growth in the securities portfolio and the reinvestment of lower-yielding investments in a higher interest rate environment. Interest income on other earning assets, a vast majority of which is comprised of funds on deposit with the Federal Reserve Bank of Chicago, declined during the second quarter of 2025 compared to the respective prior year period, reflecting a lower yield. Conversely, interest income on other earning assets increased during the first 6 months of 2025 compared to the first 6 months of 2024, reflecting a higher average balance that more than offset a lower yield. In total, interest income was $3.1 million and $6.7 million higher during the second quarter and first 6 months of 2025 compared to the respective prior year periods. Interest expense on deposits increased during the second quarter and first 6 months of 2025 compared to the prior year periods, primarily reflecting growth in money market and time deposit products. Average deposits totaled $4.62 billion during the second quarter of 2025 compared to $4.1 billion during the second quarter of 2024. The cost of deposits was down 18 basis points during the second quarter of 2025 compared to the second quarter of 2024. Interest expense on Federal Home Loan Bank of Indianapolis advances declined during the second quarter and first 6 months of 2025 compared to the prior year periods, reflecting a lower average balance that more than offset higher average cost. Interest expense on other borrowed funds declined during the second quarter and first 6 months of 2025 compared to the prior year periods, largely reflecting lower rates on our trust preferred securities due to the lower interest rate environment. In total, interest expense was $0.7 million and $3.1 million higher during the second quarter and first 6 months of 2025 compared to the respective prior year periods. Net interest income increased $2.4 million and $3.6 million during the second quarter and first 6 months of 2025 compared to the respective prior year periods. Impacting our net interest margin was our strategic initiative to lower the loan-to-deposit ratio, which generally entails deposit growth exceeding loan growth and using the additional funds to purchase securities. A large portion of deposit growth was in the higher costing money market and time deposit products, while purchasing securities provides a lower yield than loan products. Our net interest margin declined 14 basis points during the second quarter of 2025 compared to the second quarter of 2024. Our yield on earning assets declined 30 basis points during that time period, largely reflecting the aggregate 100 basis point decline in the Fed funds rate during the last 4 months of 2024, while our cost of funds declined 16 basis points primarily reflecting lower rates paid on money market and time deposits, which more than offset an increased mix of higher costing money market and time deposits. While average loans increased $299 million or almost 17% from the second quarter of 2024 to the second quarter of 2025, average deposits grew $519 million or nearly 13% during the same time period, providing a net surplus of funds totaling about $220 million. We used that net surplus of funds to grow our average securities portfolio by $184 million and reduced our average Federal Home Loan Bank of Indianapolis Advances portfolio by $69 million. Our second quarter of 2025 net interest margin was 2 basis points higher than it was during the first quarter of 2025 and up 8 basis points from the fourth quarter of 2024, coming on the heels of an aggregate 100 basis point reduction in the Fed funds rate during the last 4 months of 2024. We remain committed to managing our balance sheet in a manner that minimizes the impact of changing interest rate environments on our net interest margin. We recorded a provision expense of $1.6 million and $3.7 million during the second quarter and first 6 months of 2025, which generally reflects increased allocations on specific financially stressed lending relationships, changes to economic forecasts, and loan growth. The recording of net loan recoveries and sustained strength in quality metrics continue to mitigate additional reserves associated with loan growth. Noninterest expenses were $3.6 million and $4.8 million higher during the second quarter and first 6 months of 2025 compared to the respective prior year periods. The increase largely reflects higher salary and benefit costs, including annual merit pay increases and market adjustments. Higher data processing costs also comprise a notable portion of the increased noninterest expense levels, primarily reflecting higher transaction volumes and software support costs along with the introduction of new cash management products and services. We were able to reduce our federal income tax expense by $1.5 million via the acquisition of transferable energy tax credits during the second quarter of 2025. The recording of the tax benefit resulted in a second-quarter effective tax rate of about 13% compared to a projected effective tax rate of 19%. We are scheduled to close on another transferable energy tax credit by the end of July, which will reduce our federal income tax expense by about $750,000. Additional acquisitions of transferable energy tax credits may be made from time to time, subject to our investment policy, tax credit availability, and tax credits derived from our low-income housing and historic tax credit activities. We remain in a strong and well-capitalized regulatory capital position. Our bank's total risk-based capital ratio was 13.9% as of June 30, 2025, about $218 million above the minimum threshold to be categorized as well-capitalized. We did not repurchase shares during the first 6 months of 2025. We have $6.8 million available in our current repurchase plan. On Slide 23 of the presentation, we share our latest assumptions on the interest rate environment and key performance metrics for the remainder of 2025 with the caveat that market conditions remain volatile, making forecasting difficult. This forecast is predicated on no changes in the federal funds rate during the remainder of 2025. We are projecting loan growth in a range of 1% to 2% during the third quarter and in a range of 3% to 5% for the fourth quarter. The third-quarter forecast takes into account several expected larger balance CRE payoffs that Ray mentioned. We forecast our net interest margin to be in a range of 3.50% to 3.60% for the third quarter and in a range of 3.55% to 3.65% for the fourth quarter. We are projecting a federal tax rate of 16% for the third quarter and 19% for the fourth quarter. The third-quarter forecast takes into account the scheduled purchase of a transferable energy tax credit by the end of July. Expected quarterly results for noninterest income and noninterest expense are also provided for your reference. In closing, we are very pleased with our operating results and financial condition during the first 6 months of 2025 and believe we remain well positioned to continually successfully navigate through the myriad of challenges faced by all financial institutions. That concludes my prepared remarks. I'll now turn the call back over to Ray.

Raymond Reitsma, President and Chief Executive Officer

Thank you, Chuck. That concludes the prepared comments from management. We will now move to the question-and-answer portion of the call.

Operator, Operator

Operator instructions. And your first question today will come from Daniel Tamayo with Raymond James.

Daniel Tamayo, Analyst

Maybe starting on the expense side. I guess, first, curious if you could get just a little more detail on how the cost savings will play out in terms of the timing with the core system change happening in kind of into '26, early '27. How much cost savings you'll get prior to that? And then the core savings change system change itself, what kind of cost savings you're expecting from that and the actual cost to go through that, curious as well.

Charles Christmas, Executive Vice President and Chief Financial Officer

Yes, Daniel, I'll address that first question. With the acquisition of Eastern Michigan Bank, we anticipate the cost savings to be staggered, primarily occurring between the expected completion in the fourth quarter and the first quarter of 2027, when we finalize our core conversion. As we mentioned in our presentation, we expect to achieve nearly $5.5 million in cost savings, with about 50% of that realized in 2026 and over 90% in 2027 due to the impact of the first quarter, and then 100% thereafter. Another aspect of our synergies involves utilizing the excess liquidity at Eastern Michigan Bank; our analysis indicates that improving their loan-to-deposit ratio to 80% translates to approximately $150 million we can reallocate from the investment portfolio to the loan portfolio. The anticipated conversion date in February 2027 coincides with the expiration of our current provider's contract the following month, allowing us to prepare effectively for the core conversion. As Ray noted, the fact that Eastern Michigan has been using Jack Henry for a long time provides us with an unexpected yet significant intangible benefit. We are continuing to assess the costs and savings related to the core conversion, and we will not incur a termination fee with our current provider since our timing aligns with the contract expiration, which can often be quite expensive. We are exploring our partnerships in digital banking and considering transitioning that to Jack Henry as well, which may involve some costs depending on the move, but we have some challenges to address with Jack Henry in that regard. We expect to see considerable cost savings starting in 2027 post-conversion. While it's difficult to assign specific figures at this stage, we are confident about the savings from switching to Jack Henry. Nonetheless, I want to emphasize that while the potential cost savings are significant, our primary motivation for this conversion is to ensure a core system that is reliable and delivers the best service and products to both our employees and customers. We are genuinely excited about this upcoming change in the next 1.5 years.

Daniel Tamayo, Analyst

Great. Appreciate it. And then maybe looking at the Eastern Michigan loan portfolio. Just curious if there's anything in that overall book that you guys are in a plan to roll off or not interested in maintaining and then kind of thoughts on where you're looking to really grow that book on the extreme side of the state?

Raymond Reitsma, President and Chief Executive Officer

I'll take a swing at that, Danny. So the book that they have is high quality. It served them well for a long period of time. And importantly, it has been part and parcel to growing that superior deposit base that they have. So our initial inclination is not to change anything in that loan book in any sort of material way. As we go forward, we see an opportunity to do more in the mortgage banking business in that footprint. And also on the larger size end of the business, there'll be some opportunities there as well where we can bring some added capacity to the marketplace. So I'd say those are the two primary opportunities to grow their loan book.

Operator, Operator

And your next question today will come from Nathan Race with Piper Sandler.

Nathan Race, Analyst

Thinking about kind of the deposit and loan growth outlook going forward. Over the last 12 months, your deposit growth has been twice that, if not more, than what you've grown loans at. So just curious how you're thinking about additional intentional growth within the securities portfolio and just if you expect deposit growth to maybe more so just keep pace with loan growth just given the excess liquidity and the improvement to the loan-to-deposit ratio that will be additive on the deal.

Charles Christmas, Executive Vice President and Chief Financial Officer

Yes, we have always prioritized deposit growth and will continue to do so. We are excited about the markets we serve and the loan growth opportunities they present now and in the future. While we strive to reduce our loan-to-deposit ratio to around 95% or slightly lower, our partnership with Eastern Michigan Bank will help us achieve that efficiently. Additionally, we are focused on refining our deposit base. Currently, a portion of our deposits comes from brokers, and while that has been beneficial, we would prefer to increase local deposits. We aim for local deposit growth to help reduce our reliance on broker deposits. We expect our loans to grow by approximately 5% to 8% annually. Even when we reach our desired loan-to-deposit ratio, if we continue to grow our loan portfolio, we must also grow our deposits by the same rate. This is an ongoing commitment for our company. While we have maintained a relatively high loan-to-deposit ratio, we want to assure everyone that deposit growth has been a focus, and we have successfully kept pace with the growth of our loan portfolio over the years. Therefore, deposit growth will always remain a key focus for us moving forward.

Raymond Reitsma, President and Chief Executive Officer

Okay. Great. That's helpful. And then just thinking about Eastern Bank, it seems like they're kind of underpenetrated on the C&I side of things, particularly relative to your franchise. So just curious if you anticipate any cost saves maybe being reinvested in some commercial hires across that footprint? And just how you kind of think about the C&I growth opportunities over there.

Unknown Executive, Executive

Yes. As we think about the C&I opportunities, we think about it across the entire footprint. There's certainly some within theirs. But as you look at Southeast Michigan, West Michigan, and the Lake Shore, there are pockets in all of those markets where we could grow our lending presence even further and believe that we have the opportunity to do it. So there's no absence of pockets where we can grow our loan portfolio and to get this boost of liquidity will enable us to have the fuel to do that. So in short, there's abundant opportunities to grow our commercial loan portfolio.

Nathan Race, Analyst

Okay. Great. If I could just ask one last one on the pro forma balance sheet composition, Chuck, I think in the deck, you guys alluded to repositioning a portion of the securities portfolio. So just curious how much you expected to kind of remain in cash just to fuel loan growth going forward?

Charles Christmas, Executive Vice President and Chief Financial Officer

Yes. I think when we look at that investment portfolio, and certainly, that's where the excess liquidity stands, they've done a great job of managing that portfolio. It's got a relatively short duration. It matches up with Mercantile quite nicely. And it's got a lot of laddered maturities, which provides for a relatively constant cash flow coming off that portfolio. So we don't have any expectations of having to sell any of the securities. But as those securities mature, we'll certainly look at our loan pipelines in relation to our cash at the Fed and determine if we need to reinvest those proceeds into securities or if we can need to use those cash flows to fund the loan growth. Certainly, we expected most of it to be the latter over the next couple of years, but we'll just manage that as time comes.

Operator, Operator

And your next question today will come from Damon DelMonte with KBW.

Damon DelMonte, Analyst

Just a question on the expense guide and the outlook. Chuck, does that incorporate any additional costs that are going to have to go into the system conversion? Has that been quantified yet?

Charles Christmas, Executive Vice President and Chief Financial Officer

No, we have a schedule for expected expenses from now until the first quarter of 2027. We do not anticipate any significant expenses for the remainder of this year related to that. There may be some at the very end of this year or very beginning of next year, and we will provide more details in October. However, the guidance I provided does not include any major costs related to the conversion for the rest of this year.

Damon DelMonte, Analyst

Got it. Okay. That's helpful. And then with regards to the outlook for fee income for the back half of the year, I think it's like $9 million to $10 million per quarter. Can you just kind of walk us through a little bit of the step down from this quarter's result to that $9 million to $10 million range? Is that mortgage banking? Or is that maybe more from the interest rate swap income?

Charles Christmas, Executive Vice President and Chief Financial Officer

The answer is yes. It's in both of those. We had very strong quarters, as Ray outlined in his prepared remarks, in both the swaps and the mortgage banking, and we do expect some step down in both of those relative to the second quarter. But I think that's much more a comment made to the very strong second quarter we've had versus any disappointment or that base with regards to what we think the next couple of quarters will be.

Damon DelMonte, Analyst

Got it. Okay. That's great. And then, I guess, on the timing of the closing, I know there's a lot of hurdles to get over. But I mean do you think this is more of a beginning of the fourth quarter or kind of like right at year-end type of an event just from a modeling perspective?

Charles Christmas, Executive Vice President and Chief Financial Officer

Yes. We're looking at it in the back half of the fourth quarter, kind of either November 30 or maybe right at year-end. As you indicated, it's going to be primarily predicated on when the regulatory agencies give approval. But given what we've seen over the last quarter or two, we're hopeful to get this wrapped up by, like I said, November 30 or by year-end.

Operator, Operator

Before we conclude our question-and-answer session, I would like to turn the conference back over to Ray Reitsma for any closing remarks.

Raymond Reitsma, President and Chief Executive Officer

I'd just like to thank you for your participation in today's call and for your interest in Mercantile Bank. That concludes today's call.

Operator, Operator

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