First Western Financial Inc Q1 FY2020 Earnings Call

Good day, everyone, and welcome to the first quarter 2020 conference call. I would now like to turn the call over to Mr. Tony Rossi of Financial Profiles. The floor is yours, sir.

Thank you, operator. Good morning, everyone, and thank you for joining us today for First Western Financial's First Quarter 2020 Earnings Call. Joining us from First Western's management team are Scott Wylie, Chairman and Chief Executive Officer; and Julie Courkamp, Chief Financial Officer. We will use a slide presentation as part of our discussion this morning. If you've not done so already, please visit the Events and Presentations page of First Western's Investor Relations website to download a copy of the presentation. Before we begin, I'd like to remind you that this conference call contains forward-looking statements with respect to the future performance and financial condition of First Western Financial that involve risks and uncertainties, including the impact of the COVID-19 pandemic. Various factors could cause actual results to be materially different from any future results expressed or implied by such forward-looking statements. These factors are discussed in the company's SEC filings, which are available on the company's website. I would also direct you to read the disclaimers in our earnings release and investor presentation. The company disclaims any obligation to update any forward-looking statements made during the call. Additionally, management may refer to non-GAAP measures, which are intended to supplement, but not substitute for the most directly comparable GAAP measures. The press release available on the website contains the financial and other quantitative information to be discussed today as well as the reconciliation of the GAAP to non-GAAP measures. And with that, I'd like to turn the call over to Scott. Scott?

Okay. Thanks, Tony, and good morning, everyone. Thanks for dialing in for our first quarter call. Given the extraordinary changes in the operating environment brought on by the COVID-19 pandemic, we want to spend most of our time on the call today providing an overview of our response, discussing the impact we're seeing on our clients and providing some additional disclosures around our loan portfolio. I'm going to begin on Slide 4, talking about our operational response. We've always had a well-documented and tested business continuity management plan, and many of our business functions have the ability to work remotely. We started advanced planning in January when the threat of COVID-19 was beginning to emerge, so we were well prepared when we activated the business continuity plan in early February as the crisis began to accelerate. We began holding daily meetings of our pandemic response team across functional teams of senior leaders throughout our organization. We each took responsibility for holding daily meetings with our client service, finance, risk management and communications teams to identify issues to be addressed and develop appropriate responses. At all times, our top priority was protecting the health and safety of our associates and our clients. We've been able to keep all our offices open and functioning, although we've moved to an appointment-only model for client service to reduce the amount of exposure for both associates and clients. We transitioned approximately 90% of our associates to work from home without any meaningful impact on our level of productivity. Throughout the crisis and the transition to a more remote work environment, all our support functions have continued to operate at 100%, and we continue to provide an exceptional level of client service. The robust digital and online banking platform we built was well prepared to handle the increased usage we saw in March and now in April, and it has been instrumental in helping us effectively serve our client needs while we scaled back in-person services. We've also made a number of adjustments in our benefits programs to support our associates during this crisis. This includes providing additional paid time off and leave options for any associates personally impacted by COVID-19. Changes to our medical plan include COVID-19 testing and treatment at no additional cost to associates and adding telemedicine and behavioral telemedicine services at no cost to our associates as well. And we continue to support our communities. We've honored our sponsorship commitments for all the nonprofits that we support despite the cancellation of their fundraising events. In addition to that, we've made COVID-19-related donations in support of our philanthropic pillars targeting economic development, the arts and equality. Moving to Slide 5, I want to talk about client engagement and support efforts. First, within our trust and investment management business, we had our clients well positioned prior to the crisis emerging due to tactical shifts we've made over the last year to move to more conservative positions. Throughout 2019, we moved client allocations to the lower end of their targeted equity weightings as equity prices continued to appreciate without underlying fundamental improvements in our opinion. Then as concerns about COVID-19 started to grow in February, we reduced those equity holdings even further by reducing non-U.S. allocations and moving clients to higher cash positions. Finally, we've taken advantage of the extreme market volatility to increase our trading activity in order to maximize our tax loss harvesting for clients. As a result, our clients have been well positioned throughout this crisis and have outperformed relative to their benchmarks. Looking at our commercial banking operations, we implemented a proactive calling program to reach out to all of our borrowers, get real-time information and assess the impact that COVID-19 was having on their businesses. We then took all the data we gathered to place each client into a risk category, which has informed our allowance methodology. We started to put relief programs in place to support our borrowers. On a case-by-case basis, we're providing payment deferrals, payment date extensions and/or temporary waivers on financial covenants. As of April 24, we have granted $55.8 million in loan deferrals. In addition, although we have not previously been an active SBA lender, our team worked very hard to get our processes for participating in the Paycheck Protection Program up and running. Our initial focus was on helping our existing clients access funding through the PPP. But our process was efficient enough that we had the capacity to begin offering PPP to other companies that weren't previously our clients. We started being contacted by lots of companies that couldn't get a response or any assistance from their existing bank. So this turned into a really good opportunity for us to develop new commercial relationships. Through April 24, we had $162.8 million in PPP loans approved, of which $162.1 million have already funded, and 41% were new relationships with whom we plan to build into strong clients. Turning to Slide 6. I want to review some of the notable trends we've seen. Before the crisis really started to hit, we were having a very nice quarter. We were seeing strong loan and deposit growth. We had $123 million in new loan production in the first quarter, which represents one of our highest quarters ever. Even with the crisis starting to have more of an impact in March, we finished the quarter with an annualized loan growth of 18% and annualized deposit growth of 34%. The strong deposit flows are coming from both existing clients and new clients that we added in the first quarter. As we saw a steady expansion in our net interest margin, we began to redeploy the liquidity we built up last year from our strong deposit growth as well as proactively reducing deposit rates with the change in fed rates. We're very pleased with the performance of the business, although there were two nonrecurring items that negatively impacted our financial results. One was a loss in held-for-sale intangibles of about $550,000, which related to the decline in the fair market valuation of our LA fixed income team, primarily related to changing market conditions. The other was a $4 million unrealized net loss that we booked against our mortgage loans held for sale. The uncertainty of COVID-19's impact on the economy caused major disruptions in the mortgage market. Sharp fed fund and U.S. treasury rate reductions, as well as capacity, liquidity, and delinquency concerns in the mortgage industry, caused the value of mortgage loans and loan servicing to decline rapidly and significantly relative to mortgage hedges, resulting in about a $4 million loss in value during the month of March. Looking at other notable trends. Unlike what some other banks have reported, we have not seen any meaningful change in credit line utilization rates since the crisis started. So the loan growth we're showing is not the result of existing clients drawing down on credit lines as a precautionary measure. Our loan pipeline is slightly down from pre-crisis levels but remains relatively healthy. We've tightened underwriting standards and are being much more conservative on our loan approvals and making sure that the new loans we book are very low risk. We've seen pretty consistent production in our mortgage activity, which at this point is being largely driven by demand for refinancing. On the next few slides, we want to show some additional detail around our loan portfolio. On Slide 7, we show the composition of our loan portfolio. The largest segment of the portfolio is residential mortgage loans. Due to the nature of our client base, these loans are made to very strong borrowers, and we would expect this portfolio to hold up very well even in an extended recession. The average loan-to-value on this portfolio is about 64%, with the average FICO score of 769, so we're well secured with strong creditworthy borrowers. The rest of the portfolio is also well diversified. As of March 31, the mix of loans was 58% commercial and 42% consumer. Moving to Slide 8, we show the breakdown of the commercial loans by industry. About half the commercial portfolio is real estate, rental, and leasing related. After that, the two big segments are finance at 16% and health care and social assistance at 10%. We then drop to a number of smaller industries that each comprise 2% to 4% of the total commercial portfolio, with very little exposure to the industries that have been hit hardest by COVID-19. On Slide 9, we show the breakdown of our commercial real estate portfolio by property type. This is also a very well-diversified portfolio, with the largest segment being office and office condos at 17% of total CRE loans, with commercial buildings adding another 12%. We'll show our hotel, restaurant, retail, and energy sector exposure in the next slides, but in other sectors of concern, travel, transportation, and entertainment, we have no exposure. Again, we have little exposure to these areas that have been hit hardest in recent months. Continuing to Slide 10, you can see just how little exposure we have in these areas. We have about $18 million in energy-related loans. These loans are not lent directly to energy companies but rather to individuals with business or personal exposure to the energy industry. This is a well-secured portfolio with business assets, first deeds of trust, and investment management assets collateralizing most of the loans. We have just three hotel loans totaling about $11 million. The largest of these is in a prominent geographic area, and we have strong credit enhancements in the form of multiple sources of repayment and a personal guarantee from a strong guarantor. Finally, we have just six borrowers with restaurant loans, with an average loan size of just under $700,000. So very little exposure to that industry. We have minimal unused commitments to either hotel or restaurant borrowers, so the outstanding balances in these two industries will not be increasing in the near future.

Thanks, Scott. Turning to Slide 11, we show our capital ratios and note that we are very well-capitalized and have more than $750 million in available liquidity sources. This does not include the PPP liquidity facility, which is another source of liquidity that we plan to tap into through the PPP program. We feel confident that we have the capital and liquidity to continue to support our clients throughout the duration of this crisis. And despite the initial impact of the crisis, we continue to create additional value for our shareholders as our tangible book value per share increased by approximately 2% during the first quarter and 12.7% from a year ago. I'll turn the call back over to you, Scott.

Thanks, Julie. And Julie can walk us through any of our usual financial slides, which are in the back of the deck, as requested in the Q&A. Turning to Slide 12, I want to talk about our near-term outlook. It goes without saying that the uncertainty around the severity and duration of the crisis makes forecasting beyond the current quarter extremely difficult. So for the time being, we're just going to provide some of our expectations for the second quarter, setting aside for the moment the Q2 impact of our Simmons Bank Colorado branch acquisition and our SBA PPP activity. As I said earlier, the loan pipeline is still relatively healthy, so we should continue to see good organic growth this quarter. Our net interest margin improved in Q1 from 3.01% in January to 3.23% in March. Absent further rate changes in PPP distortions, we expect it to remain at that level in Q2. Our fee income in Q2 should also normalize without the mark-to-market mortgage disruption in late March noted earlier. We put in place some expense control initiatives during the crisis, and as a result, we would expect our core noninterest income expense to be in the $14 million to $14.5 million range in the second quarter. In terms of capital management, we remained active with the share repurchase program throughout a portion of the first quarter. But as the crisis deepened, we halted our purchases, and for the time being, we expect to remain out of the market so that we can fully preserve our capital for supporting clients and communities. We expect the SBA PPP activity to have a significant positive impact on Q2 revenues and earnings, as noted above, which may carry into Q3. Finally, we've continued to move forward with our branch purchase and assumption agreement with Simmons Bank, and it's on track for closing in mid-May, providing a 14% discount in the deposit premium we'll pay to the seller. This is a very attractive transaction from our standpoint and allows us to deepen our presence in our core market in a way that will be immediately accretive to earnings. We'll acquire three branches and one loan production office in the Denver area. One of the branches is in a very attractive area that we have been looking for a possible de novo opening. So we'll be retaining that branch while considering consolidating the other three locations into existing First Western locations that are close in proximity. The transaction will provide both banking talent and an attractive commercial client base that we believe will provide good cross-selling opportunities in the future. With the cost savings generated from the branch consolidation, the transaction will be strongly accretive for us, between 7% and 8% accretive to EPS in 2020 and 15% to 16% in 2021, although there will be some one-time deal expenses in Q2. And with that additional scale that we're adding, we expect to realize some additional improvement in our operating efficiency ratio. We've included the rest of our usual slides in the back of the deck here and would be happy to add any additional color needed around those items. But at this point, let's open the call up for questions.

Your first question comes from Mr. Gordon McGuire from Stephens.

Scott, so I appreciate the commentary on the loan pipeline being a little bit down, but still pretty healthy. I guess in terms of capital, you raised subordinate debt this quarter, but overall growth this quarter lowered common capital by about 50 basis points. You have the branch deal coming online that will leverage capital a little bit further. I guess how comfortable do you feel continuing to grow at a faster pace, just given the current economic outlook?

Well, as I said, we're tightening credit standards and we've tightened pricing. Frankly, we're seeing less competitive pricing than we were seeing early in the first quarter. So I think some of that will slow down and margins will continue to improve just based on the pandemic results and banks being less aggressive. I think we've taken a pretty careful look at our forecast for earnings growth and capital from here. And what we've always said is that we thought we had adequate capital to get through the end of 2020. And certainly, from our numbers today, a combination of these normal core operations plus the impact of the PPP revenues and then the impact of Simmons, we feel that we'll have plenty of capital to get through 2020 and into 2021.

Okay. So outside of being a little bit more tighter on spreads and on credit, you don't feel the need to completely pull your foot off the gas to preserve capital at this point?

We don't have any plans to stop growth or shrink. I would tell you, we are being cautious in growth. It's an interesting time, though, with 41% of PPP won at First Western was for new clients. And those new clients are people that are either referred by clients that are happy here and were really pleased with the job we did for them, or they're people that we've been soliciting that, for whatever reason, didn't want to go to the trouble of moving and now get mad at their current bank and they moved over. So I think that this is kind of an extraordinary opportunity, frankly, for us to bring in some really great clients. I don't know how much of that's going to be on the loan side initially. I mean, obviously, the PPP is a starting point. But certainly, we've got something like a hundred treasury management proposals out or in process right now, which we've never seen any number remotely like that here. That's a lot of really great new business activity for us. Julie, is there any color you want to provide on the capital?

Gordon, the only thing I would add is, as you saw, we completed our $8 million subordinate debt raise in the quarter as well. So we do have cash on hand to be able to support the bank as it grows and as we do the acquisition with Simmons.

Okay. Good. As far as the deposit premium paid on the branch acquisition, I think the slide deck or you may have mentioned in your comments that it's going to be a little bit lower. Is that related to the timing of the deal? Or is that kind of a new development?

Simmons and we agreed on a price of 7%, which is technically a 7.06% deposit premium. Simmons was eager to ensure timely closure, so they requested a provision indicating that if we did not close by July 31, we would need to pay 8%. We accepted this condition, but if we close before June 1, the fee will only be 6%. We managed to coordinate for an early closing. While I can't guarantee it completely, we now have all the necessary approvals and all processes are in place, allowing us to close on May 15 and secure approximately 15% savings on the deposit premium.

Okay, good. I'm curious if you've conducted a thorough review of the loans in that portfolio. It seems pro forma that it will be close to 10% of total loans, so I wonder if you've had a chance to examine some of these in detail, similar to the deep dive you've done on your own higher risk exposure.

I want to emphasize the need for caution. We have conducted three rounds of reviews on these loans. Initially, we performed an internal review and then brought in a trusted third-party loan review service that we have previously worked with. They conducted their first round of credit diligence with us in late January or early February. In the second round, we asked the local Simmons team to evaluate each loan and identify potential credit exposures. Just yesterday, we agreed with Simmons to undertake another in-depth analysis with the local team next week to ensure we thoroughly understand the credit situations and can exclude the loans that are not expected to perform well.

Okay, great. Just to clarify, Julie, the guidance for the expenses. That was just pure legacy First Western, no impact from the branches?

That's correct. We need to think of it in three categories: core, Simmons added, and the PPP. Our focus is on these three aspects, but the guidance specifically pertains to the core business.

Your next question comes from the line of Mr. Brady Gailey from KBW.

I wanted to start with the $4 million of value loss in mortgage, I think, in the last month of the quarter in March. Where did that flow through? Did that flow through as a negative in the fee income in the mortgage line?

Yes. It impacts what we consider the growth revenue line, which is essentially net revenues after accounting for hedging expenses and commissions. To clarify how this works, in the fourth quarter of last year, we funded $198 million in mortgage loans. In the first quarter of this year, we also funded $198 million. However, the revenue recognition is actually driven by the locked loans. In the fourth quarter, we locked $161 million, while in the first quarter, we locked $463 million, which represents a tripling of locked volume. The revenues reported in our financials showed $2.6 million last quarter and $2.5 million this quarter. If we had maintained the same margins in the first quarter as we did in the fourth quarter, revenues would have been about three times higher, highlighting the missing $4 million. So what happened to that $4 million? In late March, we experienced two emergency Federal Reserve meetings where rates were cut by 150 basis points. The Fed began purchasing bonds and mortgage-backed securities at an accelerated rate. This led to a downturn in the secondary markets due to concerns regarding servicing value, liquidity, and the market's capacity to absorb mortgages. A person in the mortgage industry described this situation as a rare decoupling from the secondary market concerning the mortgage-backed securities we use for hedging the loans from the time they are locked to when they are sold. As a result, by March 31, we had to mark our long positions in loans and short positions in hedges, resulting in a significant credit spread gap that occurred in late March. This gap was largely unrecognized because it was just a mark-to-market adjustment. However, we anticipated it would normalize, and indeed, 30 days later, we can confirm that it has substantially normalized. We are now closing loans or booking loans at margins better than those we initially saw in the fourth quarter. That summarizes the situation.

So Scott, you did $2.5 million of mortgage fees. You add the $4 million backed that's $6.5 million that has to be a record high for you guys. How do you think that will trend for the rest of the year?

So of course, we don't know, right? A lot of that was refinancing from the big drop in rates that we saw in the first quarter. So that's already slowed. Our originations in Q2 so far are down about 60% in April from what they were in March. But as I say, we've seen a really nice recovery in the margins. In fact, they're better than they were prior to the whole COVID disaster.

All right. Looking at the other fee income, I believe you mentioned in your guidance that fee income should return to normal levels. Can you clarify what you mean by that? Additionally, regarding trust and investment management, it remained relatively unchanged from the previous quarter. Given the market sell-off, which has since rebounded significantly, do you anticipate any pressure on the $4.7 million in revenue as we move through the rest of the year?

Yes. So I agree with your comment. What is normal, right? Who knows? But what I guess I was trying to say there is historically, and it's been kind of remarkably true over the 18 years or so at First Western now, where we have about a 50-50 split between revenues that are net interest income and revenues that are noninterest income. I guess what I was really trying to say there is I think that that's going to move back in that direction in Q2. We have two main components. There's a number of components in the fee income, but the two big ones are the planning, trust and investment management fees and the mortgages. So the mortgages we kind of already talked about, and I think that that will be more in line with what we saw in Q2 and Q3 of last year, which is the bigger season in Colorado in most of our footprint. So that's, I think, where we would expect things to be there. Of course, who knows, right? We've had a strong April. I don't know where May and June are going to be. It seems like we're seeing good demand going into May. On the PTIM fees, most of those fees are calculated on a daily average. So most of the first quarter, the markets were relatively strong. We talked about how we had moved our clients into a more defensive position. We would expect our client portfolios to significantly outperform, for example, the S&P 500 headline. In fact, they did. And then you look at the bounce back we've had, and I think that will be helpful in Q2 as well, since we're working off of daily averages of that the fees are calculated off of.

Our next question comes from the line of Ross Haberman from RLH Investments.

So could you just go back over? I guess you were talking about the hotel and restaurant exposure. If I understood it, you basically were saying you thought they were pretty deep-pocketed guarantors. Would that be the way you would describe it?

Well, we have $11 million in exposure there. I can tell you that something like 80% of that is to a single property and borrower and guarantor. This is a prime project in a great location with a borrower that has multiple sources of repayment and a strong guarantee behind it as well. So if this is indeed the longest, deepest recession that we've seen since the Great Depression, is that hotel going to have a problem? Maybe. But in terms of feeling comfortable about a hotel loan today, I think that that's about as well positioned as we could be. And as I say, that accounts for the vast majority of that $11 million.

I got it. Okay. And I got on a little late. Did you say what your fees were being on the PPP loans, which originated in this chapter one as well as the chapter two?

So of course, that story is still being written. But what we know as of last Friday, we had done $162.5 million, Julie?

$162.1 million, yes.

$162.1 million in loans, and the total fees there, I think, are just over $4 million. And then in PPP 2, so far, we've done some number like $42 million. I think the fees would be another $1 million or so out of that. So I think some number in the low $5 million is where we're headed right now. We're still seeing new applications, and the program is still open as of today, but the volume has dropped way down for us.

And did you discuss yet in terms of what you're seeing in terms of the deferred loans? Your thoughts about how you are going to go back and set any allowance for June?

Yes. So we had kind of three initiatives that when we became concerned in March about where this was heading from a credit standpoint, we had all of our relationship folks call all of our borrowers and ask them how they were doing and ask them if they needed some additional assistance from us. We guided them into either a change in terms if they needed that, where we were going to lower the rates. Our floating rates are almost all at their floors. We don't want to lose loans to good clients to competitors. If we have to drop the floor a little bit or lower the rate a little bit, we'd rather do that than lose the client. So that was the first option. Second option was some kind of payment extension or deferral. Then the third option was to participate in one of these SBA programs, including the Paycheck Protection Plan. Through all that process, as of April 24, last Friday, we ended up with $55.8 million in loan payment or extension deferrals. That's about 5% of our portfolio, a little over 5%, which I think is a really good number. It's a lot lower number than what we're seeing from some of our peer banks.

And just one final question. Did you touch upon any sort of real estate-related exposure, direct and/or indirect? And that's my final question.

We shared on Slide 9 of the deck a breakdown of the types of properties in the CRE, and Page 8 talks about the loans by the NAICS code. Julie, is there any other color you want to add related to the CRE mix? I think the interesting thing here for me, I shouldn't ask Julie to speak and then keep talking, but here we go. I was thinking about this as kind of primary risk where you're lending to a restaurant or a retail or hotel and secondary risk where you're lending to a borrower that has owner-occupied CRE that has a restaurant as a tenant on the first floor. We try to give you information on both of those by looking through the loan portfolio composition on Page 7, then the breakdown by an NAICS code, which you see there, very little direct or primary exposure to these high-risk areas. Page 9 then talks about the breakdown of our CRE property types. Page 10 talks about the direct and indirect exposure to the stressed industries, which, again, for energy, it's not energy loans; they're loans to people that have energy exposure. That's how we broke it down in the presentation, Ross. Okay, everybody. Well, thanks so much for dialing in. We really appreciate your interest and your support for First Western. Interesting times, and I hope you feel like we're making good progress here. Thanks again for dialing in.

This concludes today's conference call. Thank you, everyone, for joining. You may now disconnect. Have a great day.