First Western Financial Inc Q2 FY2020 Earnings Call

Good day, ladies and gentlemen, and welcome to the First Western Financial Q2 2020 Earnings Conference Call. As a reminder, this conference call is being recorded. I would now like to turn the conference over to your host, Mr. Tony Rossi, Financial Profiles.

Thank you, Katrina. Good morning, everyone, and thank you for joining us today for First Western Financial's Second 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 have 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?

All right. Thanks, Tony, and good morning, everybody. Before we get into the discussion of our second quarter results, I'd like to take a moment to thank all our colleagues at First Western for their extraordinary efforts during this challenging time. Throughout this crisis, we've been able to maintain exceptional customer service levels and continue the strong momentum we have in our business development efforts. It's a testament to the culture that we built here at First Western, and I'm extremely proud of the way our team consistently finds ways to overcome obstacles and deliver for all our stakeholders. And now turning to our results. In our IPO 2 years ago, we said that we thought we were at an earnings inflection point where the operating leverage built into our business model could produce strong earnings gains, which played out in 2019 and has accelerated year-to-date in 2020. In the second quarter, we generated net income of $8.7 million or $1.10 in earnings per share, which represents a record level of profits for the company. It was an exceptional quarter and one that reflects the inherent advantages that we have in managing through the impact of the COVID-19 pandemic. From a defensive standpoint, unlike a lot of banks our size, we don't do much small business lending, where it appears the pandemic is having the greatest impact. And we have minimal exposure to more stressed industries, such as hotels and restaurants. We also underwrite our loans with conservative criteria that requires low LTVs, high debt service coverage ratios and personal guarantees in many cases. Our client base consists of a lot of knowledge-based companies and workers, meaning they've been able to shift to a work-at-home environment without much disruption to their business. Accordingly, we continue to see relatively normal levels of loan, deposit and investment management activity from our clients. As a result, we've seen generally stable asset quality during the pandemic, and our projected losses remain relatively low. From an offensive standpoint, the investments we made in expanding our residential mortgage platform over the past few years have enabled us to capitalize on the strong demand for refinancings. As a result, we had a record quarter of mortgage originations and a net gain on sale of mortgage loans. This helped drive a 57% increase in our gross revenue compared to last quarter and a substantial increase in earnings. One of our key priorities in gaining scale to enhance our operating efficiencies and improve our earning power, and we had exceptional balance sheet growth in the second quarter due to a combination of factors. We've been exceptionally productive with the PPP program, which has allowed us to support our existing clients as well as add many new attractive clients. And given the nature of our clientele, we're seeing many stronger borrowers wanting to capitalize on investment opportunities that they're seeing in the current environment, which helped us to generate approximately $70 million in organic loan growth outside of PPP loans. The final contributor was the branch purchase and assumption agreement we completed in May. By completing the transaction ahead of the scheduled timeline, we were able to reduce the deposit premium that we paid by a full 1%, making the transaction even more attractive from a financial standpoint. Even with the accelerated timeline, we're able to complete an updated review of the loans associated with the branches we added to determine the impact they had experienced from the pandemic. As a result of that review, we excluded the adversely graded loans from the final transaction. The integration has gone very smoothly, and loan and deposit balances have remained very stable since the closing. We're on track to complete the planned branch consolidations in August, at which point we'll be able to realize more of the projected expense synergies from this transaction. Moving to Slide 4. We'll provide additional detail on our earnings this quarter. We had approximately $325,000 in acquisition-related expenses this quarter related to the branch acquisitions. When these expenses are excluded, our net income was $8.9 million or $1.13 earnings per share. Turning to Slide 5. We want to provide a couple of data points regarding the economic trends we're seeing in our Colorado markets. This information comes from the Opportunity Insights economic tracker by way of their website, tracktherecovery.com. Relative to January before the pandemic started to hit the United States, consumer spending in Colorado was down about 37% through mid-April but subsequently recovered to just 10% - 11% down at the beginning of July. Similarly, small business revenue in Colorado was down 39% at the beginning of April but rebounded to a decrease of 19% at the beginning of July. So we're seeing generally improving trends in our markets as businesses adjust to the new normal, which should continue to improve as more businesses and investors adjust. Turning to Slide 6. We'll look at the trends in our loan portfolio. Our total loans held for investment increased $382 million or 36.6% from the end of the prior quarter. $192 million of the increase was attributable to PPP loans, while we added $124 million through the branch acquisition. The remaining $66 million was attributable to organic loan growth outside of PPP loans. We had loan production of $311 million in the quarter with $192 million coming from PPP, and the remaining $119 million coming from new business development outside of this program. This was partially offset by $72 million in payoffs and paydowns. The PPP loans and the loans added through the branch acquisition have made our portfolio more diversified and lowered our concentration in 1-4 family residential mortgage loans. The 1-4 family loans declined from 29.4% of total loans held for investment at June 30 from 39.6% of total loans at the end of the prior quarter. Moving to Slide 7. We'll take a closer look at our deposit trends. Our total deposits increased $228 million or 19.4% from the end of the prior quarter. The branch acquisition contributed $65 million to total deposits, while PPP-related balances contributed about $62 million to our quarter end balances. Almost all the growth we had in deposits this quarter came in our lower-cost, noninterest-bearing and money market categories. As a result, we continue to see significant improvement in our deposit mix. Over the past year, nonmaturity deposits have increased to 89.1% from 82.4% of our total deposits. Turning to trust and investment management on Slide 8. Our total assets under management increased $116 million from the end of the prior quarter, primarily due to improved market conditions.

Thank you, Scott. Turning to Slide 9. We have summarized our participation in the PPP program and included its impact on various lines, line items, and metrics in the second quarter. We originated $191.7 million of loans and added 281 new relationships through this process. We have earned a total of $5.7 million in fees from the SBA and are amortizing both the loan fees and the loan origination expense over the 24-month expected life of these loans. Should these loans be forgiven at an earlier time, then we will accelerate the recognition of the associated fees and expense. In addition to the impact on our loan balances, we estimate that at June 30, we had $62.4 million in PPP-related deposit balances. We also had $204.3 million in borrowings from the PPP liquidity facility that were used to fund the PPP loan. These loans contributed approximately $600,000 of net interest income this quarter. Backing out the impact of the interest income and interest expense associated with the PPP program, our net interest margin would have improved to 3.22% in the second quarter. We had $2.9 million of deferred loan origination expense related to PPP loans, which served to reduce our salaries and benefits expense this quarter. As I mentioned earlier, this expense will be recognized over the 24-month expected life of the loans or on an accelerated basis if the loans are forgiven. The net income remaining to be recognized is $2.4 million related to PPP fees from the SBA less origination expense. Turning over to Slide 10. We'll look at our gross revenue. As Scott mentioned, we had an exceptional quarter of revenue growth, with increases coming in both net interest income and noninterest income. Turning to Slide 11. We'll look at the details behind that revenue growth and look at the trends in the net interest income and margin. Our net interest income increased $1.9 million or 20.9% from the prior quarter. Approximately, $700,000 of the increase is due to the contribution of the branch acquisition, another $600,000 was due to the PPP loans, and the remainder was due to higher average loan balances resulting from our organic loan growth. Our net interest margin declined 4 basis points to 3.10%, primarily due to a decline in the earning asset yields. This was partially offset by a 48 basis point decline in our cost of deposits. We believe we continue to have some opportunities to bring deposit costs down, while repricing in our loan portfolio has largely occurred, which should help benefit our margin going forward. We also saw a nice pickup in margin towards the end of the second quarter. Excluding the impact of PPP, our net interest margin in the month of June was 3.27%, which is up from 3.16% in the month of May. So the trend points to some expected expansion in our margin, excluding the impact of the PPP program. Turning now to Slide 12. Our noninterest income increased 98.6% from the prior quarter. The increase was primarily due to the record quarter of net gain on mortgage loans sold that we had. Aside from that impact, we had an increase in risk management insurance fees that offset a slight decline in our trust and investment management fees. On Slide 13, we'll show you that we have provided some additional detail on the mortgage operations. We had record level of production in the quarter with approximately $344 million of originations, most of which was originated for sale. This was largely driven by demand for refinancing, which accounted for 73% of our originations in the second quarter. With the increased volume and improved mortgage sale margins, we saw a significant spike in the profitability of our mortgage operations. We generated $8.3 million in net income on revenue of $10.2 million in the second quarter. Turning to Slide 14 and our expenses. Our net noninterest expense decreased 13.7% from the prior quarter. The decrease was attributed to the deferred loan origination expense that I mentioned earlier. Our second quarter results also include approximately $325,000 in acquisition expenses related to the branch acquisition. With the strong growth we had in revenue, we saw an acceleration in our improvement in efficiency ratio which was 48.1% in the quarter. As Scott mentioned, we are on track for the branch consolidations in August. Following those consolidations, we expect our quarterly run rate for noninterest expense to be in the range of $15.3 million to $15.7 million. Turning to Slide 15. We'll look at our asset quality. Our nonperforming assets increased by $1 million but declined as a percentage of total assets to 67 basis points from 82 basis points at the end of last quarter. Once again, we continue to see a very low level of losses in the portfolio and had minimal charge-offs this quarter. We recorded a $1.1 million mark on the loans added through the branch acquisition as we took larger credit marks against the modified loans that we acquired. Turning to Slide 16. We recorded $2.1 million in provision expense in the second quarter, which primarily reflects the downgrade in the economic forecast we use in our allowance methodology as well as additional reserves from modified loans to reflect the ongoing impact of the COVID-19 pandemic. This increased our allowance to adjusted total loans to 0.93% when PPP loans and acquired loans are excluded. Turning to Slide 17. We have provided a summary of our loan modifications. As of June 30, we had 98 modified loans, representing total loan balances of $177 million, $31 million of which was added through the branch acquisition. The pace of deferral request has slowed considerably with each passing month. And as of the end of June, we were only providing modifications on a very limited exception basis. The modifications are a mixture of adjustments, with the largest component being loans where we have extended the maturity date and provided a payment deferral. Many of the modifications that we made were for 180 days, while the modified loans we acquired were primarily for 90 days. Turning to Slide 18. We have some additional information on our loan modifications. 76% of our loan modifications are commercial loans with the other 24% being consumer loans. In terms of C&I loans, our largest concentrations of modified loans are in real estate and rental and leasing sector and restaurants and bars. In terms of CRE loans, our largest concentrations are in office, retail and strip center properties. The average size of the modified loan is $1.8 million, and where loan-to-value is applicable, they have an average LTV of 48% and an average seasoning of 2.5 years.

All right. Thanks, Julie. Turning to Slide 19, I wanted to provide some comments about our near-term outlook. While the ongoing pandemic creates a great deal of uncertainty, we believe we're well positioned to see a continuation of our strong performance in the second half of the year. Our asset quality remains strong, and we have a healthy loan pipeline that should continue to drive organic loan growth in the next couple of quarters. Mortgage demand remains strong, which should lead to another good quarter of mortgage production and gain on sale income in the third quarter. As Julie mentioned, we expect to see some expansion in our net interest margin, and our AUM is trending higher as the market recovers from the depths of the pandemic. So we should see positive trends in trust and investment management income as well. We are on track to start realizing the final synergies from the branch acquisition, and the combination of all these factors should result in a strong level of earnings in the second half of the year, further increases in our tangible book value per share, and additional value being created for our shareholders. With that, we're happy to take your questions. Katrina, can you open up the call, please?

We do have a question from Brady Gailey of KBW.

So when you look at loan growth, even excluding the Simmons deal and the PPP, it's still a big number for you guys, $66 million. Maybe just expand a little bit on where that came from? And maybe just a little more color on how you're thinking about kind of core loan growth for the balance of the year and then into next year?

Yes, it's interesting, Brady. During the Great Recession about a decade ago, it felt like our clients were hiding away for a couple of years, taking a very cautious approach to navigating the downturn. In contrast, this time we're observing a notable difference where people have merely changed their work locations and continue to be active. Many view this as an opportunity following the prolonged recovery, believing they can and should keep progressing. We've experienced ongoing demand, and in fact, I would say we've seen heightened demand, which has contributed to the positive growth in our balance sheet. Your observation is correct that to understand this financial performance, you need to distinguish between organic growth and the effects of the PPP and the Simmons branch acquisition. The organic growth and the contributions from the Simmons acquisition will obviously persist. However, it's worth noting that the $200 million from PPP may vanish due to forgiveness in the latter half of the year. Nevertheless, we have witnessed numerous new client opportunities stemming from PPP, which I believe will continue to generate organic growth prospects for us in the second half of the year.

Okay. Great. Next I'd like to ask about the provision. I mean, it ticked up here in the second quarter. The reserves now on an adjusted basis, 93 basis points. How do you think about how the provision will trend from here? I mean, I know with you guys not being a CECL adopter yet, it's different than most. But should we expect the provision to continue to remain elevated in the back half of the year similar to what we saw in 2Q?

Well, Julie, let me take a stab at that, and then you can provide some more color, please. We haven't seen really any signs of credit deterioration, both when you look at across the portfolio or at the micro level. And this is in spite of increased monitoring and tighter interaction between the lenders and our clients. So we haven't had a reason to put more into the reserve other than our general concern that Julie mentioned in her comments about the deteriorated economic conditions. So we increased for that, and then we put in a significant reserve related to the COVID modifications. Again, not because we see a concern, but just to be conservative on that. I would think that we're going to look to continue to build the reserve in the second half of the year. But we really have to wait and see how the credit trends, the economic trends and the COVID deferral trends unfold.

I think you've covered most of it. We're just very closely monitoring the economic trends in all of our major markets. We're doing deep dives that Scott mentioned in his remarks on the credit portfolio and in specifics at COVID mods and/or the higher-impact areas from COVID-19, so that's all going to be driving our future allowance levels, and we'll kind of assess that as things change and/or as we get more information in that area.

My next question is regarding capital. Given the growth from the acquisition and from PPP, your TCE ratio is a bit low at 6.3%. What are your thoughts on your capital base? Would you consider raising some form of noncommon capital at this time?

Do you want to speak to this one, Julie?

With the branch acquisition, we expected a decrease in capital levels. We added more assets related to that closure as well as the growth in the balance sheet that you've mentioned. We're also anticipating that the earnings from this acquisition, in addition to the bank's strong earnings, will help build our capital levels in the second half of the year. We raised $8 million in subordinated debt in the first quarter, which we invested into the bank in connection with the branch acquisition. We've consistently stated that we believed we had sufficient capital to navigate through 2020. If the balance sheet continues to grow at current levels, and considering the impact of the recession and other uncertainties, we still hold this belief. Is there anything else you would like to add?

When we assess the capital ratios, we're excluding the PPP loans because we don't need to hold capital for them. We funded all of them through the PPP liquidity facility. For balance sheet purposes, that does not add to the leverage we need to manage.

All right. And then finally from me. I saw the SEC settlement for $200,000. Anything to be concerned about there or any other impact there outside of the financial impact?

We don't think so. This was an issue that we discovered in 2017. We assessed the client impact and determined there wasn't any net client impact on the accounts. And then subsequent to that, we've replaced the leadership and the compliance team that was there at the time. The SEC did a routine examination in late 2019 and saw that and raised it as an issue, and it was concluded with the settlement here a couple of weeks ago.

Next question, we have Gordon McGuire from Stephens.

Congratulations on the quarter. Julie, I may have missed your comment. Did you give spot deposit rates for end of June?

It did not give spot deposit rates, but I can. The spot deposit rate was 30 basis points or 32 basis points, excluding PPP deposits. So if you're trying to compare that to what our March spot deposit rate was, it was at 0.48%, 48 basis points.

And can you help us think about the cadence of the deposit costs? I guess, beyond the third quarter, how far do you think you can bring them lower?

Well, I think from a current balance sheet perspective, again, excluding PPP deposits that our June spot rate is a pretty good indicator, but that was still trending down, as you can see from the numbers I just gave you from the beginning of the quarter. So I think we should still see a slight decline in our cost of deposits in the third quarter just as that levels out quarter-over-quarter.

Okay. And do you have what yield the acquired loan portfolio came over? I'm curious if there's any kind of benefit or yield differential that I need to think about for the next quarter?

In the second quarter, our core loan yields, excluding purchased loans, were approximately 3.38%. The loans we acquired had an average rate of 4.09%, which is slightly higher than our core portfolio. Excluding PPP loans, the yield was 4.45%. This should provide a slight boost to our loan yields.

And then did I get it right, $15.3 million to $15.7 million expenses post consolidation?

Yes, you did.

What does that assume for mortgage and commission levels?

Well, our mortgage commissions are held within our revenue line of net gain on mortgage sales that comes out of there. And it does have a little bit of growth in the mortgage area for operations, salaried individuals, but not significant.

Next question, we have Ross Haberman from RLH Investments.

Could you talk about the margin on the sale of loans? What are you seeing there? Any trends? Is it coming down what it was compared to, say, 3 or 6 months ago and change?

This is a great question. We previously discussed the disconnect that occurred from mid-March to early April between the pricing in the secondary mortgage market and the mortgage-backed market used for hedging. Our loan positions in mortgages from March became disconnected from the hedge positions we were short, which was impacted by the emergency rate cut of 150 basis points made by the Fed in mid-March and significant purchases by the Fed. As a result, we incurred a $4 million loss in Q1 related to mortgages, of which we believe we've recovered about $2 million in Q2. The pricing dynamics are complex, but it seems we managed to recover roughly half of the initial loss. If the disconnect hadn't happened at the end of March, our pre-tax earnings in Q1 would have been $4 million higher, while Q2 could have seen a reduction of about $2 million. Nonetheless, we have observed our margins recovering to normal levels and, in fact, improving. We've been able to enhance our margins on mortgages sold in Q2.

And just are you keeping any of those loans? Or are you selling all of them basically?

We've been consistently working to keep mortgages that are a good fit for us from a client standpoint, and then we'll sell the great majority of them. Do you have the data, Julie, in Q2?

In quarter 2, we originated for sale $344 million and $37 million for the portfolio.

And just one final question. That West Coast money management business that you were going to sell a quarter or 2 ago, what's the status of that today and going forward?

Yes. So that's the fixed income portion of First Western Capital management, and we have not completed that transaction yet. We are looking to find a better home for them, and we'll continue to work on that.

Next question, we have Kevin Swanson from Hovde Group.

Within the acquired portfolio, do you anticipate any runoff there or derisking of that portfolio?

So from May 15 to June 30, we actually saw some growth in both the loan and deposit side of that acquisition. So initial runoff hasn't really been a problem so far. The next challenge will be when we close 2 of the 3 branches. We have been able to retain the key client service people from the legacy Simmons team and, in fact, put them into positions where we think they're going to be really productive for First Western. So I would say on the loan side, we expect to have really good retention and, in fact, good growth from that team going forward. On the deposit side, I think there's likely to be some runoff of small deposits because of Simmons, they had more of a retail deposit composition than what First Western has. And I think just moving the locations, there'll be some breakage there, but I don't expect it to be material in terms of overall numbers or profitability.

Great. Across the industry, mortgage performance has been strong, but your results this quarter stand out. Can you share any specific factors that contributed to such success this quarter? Or was it more of a combination of various elements? I'm interested in your perspective on how that business performed and what you identify as its strengths.

When we acquired that company 2.5 years ago, we identified an opportunity to enhance their infrastructure to increase their capacity for handling more volume. We made significant efforts in that area, and those efforts have clearly paid off in the first half of this year. However, I believe it's somewhat misleading due to discrepancies in our hedging. The first quarter showed strong performance, but a $4 million loss was included in the gains, which masked the results. Similarly, the second quarter appears inflated due to a $2 million recovery that isn’t typical in a normal environment. Our mortgage team had previously noted that this is an unprecedented disruption in the market, something they had never encountered before. Moving forward, I expect a return to more typical performance levels. While volumes may not remain at the current high levels, particularly due to refinancing, we have strong teams in place and are continuously adding talented mortgage loan originators. Therefore, I believe our core business focused on new money purchases will continue to thrive. I was talking to our Jackson Hole team this morning for a periodic review I do with them. And they're talking in these resort markets about all the folks moving to town out of the big urban markets, and we see that in each of our resort markets, we see it here in Denver, and we see it in our other front range in Arizona markets. All that feeds into the mortgage business as well as supporting the underlying organic growth of the company.

This concludes our question-and-answer session. I would now like to turn the call back to management for any closing remarks.

Okay. Well, thank you, everybody, for dialing in. As I said at the beginning of the call today, we had, in our initial public offering, said that we thought there was a real earnings inflection coming, and it's great to see that playing out here into 2020. We've made a number of investments over the past 12 months. We just talked about the mortgage one. The PPP cross-sales opportunity is going to be very strong in the second half of the year. We've added several new offices that are expenses for us that are just maturing now into being contributors. That includes the new Broomfield office, the new Loan Tree office, Vail, Aspen and now our new RiNo, River North, Denver office. I think that with all that, we continue to see opportunity to upgrade our products and services and the skills of our team. We're launching a big First Western Way Sales Training next week to retrain all of our people in a specific sales methodology that we use here. We just got, earlier this week, our new Net Promoter Score from our clients, which continues to be in the mid-80s, which is an extraordinary score for a financial institution, and we've launched a new Trust Where You Bank campaign highlighting the difference between a community-oriented bank like First Western and some of our giant competitors that we compete with day in and day out. So we're optimistic that we can continue with strong results like we posted this quarter and year-to-date. And I sure appreciate the interest and support of all of you. Thanks, and have a great day.

Ladies and gentlemen, this concludes today's conference. Thank you for your participation, and have a wonderful day. You may all disconnect.