Umb Financial Corp Q2 FY2022 Earnings Call

Good morning, and thank you for joining UMB Financial's Second Quarter 2022 Conference Call. My name is Daniel, and I will be your moderator. I would now like to hand the call over to our host, Kay Gregory, from UMB Investor Relations. You may now proceed.

Good morning and welcome to our second quarter call. Mariner Kemper, President and CEO; and Ram Shankar, CFO will share a few comments about our results. Jim Rine, CEO of UMB Bank and Tom Terry, Chief Credit Officer will also be available for the question-and-answer session. Before we begin, let me remind you that today's presentation contains forward-looking statements, which are subject to assumptions, risks and uncertainties. These risks are included in our SEC filings and are summarized on Slide 43 of our presentation. Actual results may differ from those set forth in forward-looking statements, which speak only as of today. We undertake no obligation to update them, except to the extent required by securities laws. All earnings per share metrics discussed on this call are on a diluted share basis. Our presentation materials and press release are available online at investorrelations.umb.com. Now, I'll turn the call over to Mariner Kemper.

Thank you, Kay, and thanks everyone for joining us today. Our second quarter results included a 23% linked quarter annualized increase in average loans, solid net interest margin expansion, and continued momentum in our fee businesses. Income from bond trading activities and 12b-1 fees were strong while we saw some market-related pressure in trust and securities processing and in the valuation of our equity positions. Additional drivers are included in our slides and Ram will share more detail shortly. Net income for the quarter was $137.6 million or $2.83 per share. Operating pre-tax pre-provision income was $187.1 million or $3.84 per share. Financials for the second quarter included a pre-tax gain of $66.2 million from the sale of our Visa Class B ownership, included in fee income. In conjunction with the gain, we made a one-time contribution of $5 million to our charitable foundation, included in other expenses. Pipeline and sales activity continue to be strong across the company. In private wealth, we brought in nearly $750 million in new assets year-to-date, on track to significantly outpace 2021 full-year sales of $836 million. Our institutional banking teams are continuing to perform well. Year-to-date new business volume has increased 15% in corporate trust and escrow services and 68% in specialty trust and public finance has closed 68 deals so far in 2022 compared to 52 for the same period last year. The team recently closed its largest bond issue to date, a $146 million general obligation bond. As you may have seen in June, we announced the agreement to acquire Old National Bancorp's HSA business. As healthcare services continue to focus on direct-to-employer space, this acquisition provides an extremely strong team along with more than $400 million in deposits that will complement our organic growth efforts. Moving to lending, you'll see the drivers behind the growth this quarter on Slide 24. Top line loan production, as shown on Slide 25, again, was very strong, coming in at $1.3 billion for the quarter. Payoffs and paydowns moderated some and were 3.1% of loans. Given the opportunities we see across the footprint, we expect continued strong growth in the third quarter. We saw phenomenal growth in C&I, with balances increasing nearly 30% on a linked-quarter annualized basis, while line utilization ticked up slightly in the second quarter. Much of the growth is due to consistent sales efforts paying off in new customers as well as our relationships with strong companies needing capital to continue to grow. Average residential mortgage balances have increased 27% over the second quarter of last year. As we've discussed previously, we don't rely heavily on mortgage gain on sale revenue. However, we continue to grow our own portfolio and have seen strong activity through our down payment assistance program of late. The program launched in December of 2021 and is geared towards underserved markets and it had more than 500 new applications year-to-date. On the other side of the balance sheet, average total deposits for the quarter decreased 3% or 12.2% on an annualized basis compared to the first quarter, while average DDA balances increased slightly and comprised 45% of average deposits. While we've seen cycle-to-date beta on interest-bearing deposits of approximately 34%, I think this metric alone gives an incomplete view, as it ignores the benefit of DDA balances which have zero beta and the impact of borrowing levels, which have 100% beta. I'd encourage you to look at our total cost of funds instead, which had a beta of 22% thus far. Additionally, we benefit on the earning asset side with cycle-to-date betas of nearly 54% and a linked quarter beta of 61%. This compares favorably to others we've seen reported so far. Our net interest margin expanded 25 basis points from prior quarter, driven by asset repricing and favorable mix shift in earning assets. I'll note that the deposit pricing we're seeing is so far outperforming our internal expectations. We'll continue to manage these costs as we can while opportunistically funding organic loan growth. As you know, we have a larger commercial institutional customer base relative to many peers. As such, we have some index deposits that tend to move more quickly with the interest rate changes, but we look to the entire relationship and overall profitability of these relationships. For example, many public fund customers bring treasury management, lockbox, card programs and bond issuances opportunities. And in addition to lending relationships, our commercial clients may also have corporate cards for healthcare service products. Similarly, many of our institutional clients have asset servicing or suite product relationships in addition to the lending relationships. Moving to asset quality, our net charge-offs were elevated in the quarter, driven entirely by a $27.7 million write-down related to one single commercial credit. While this quarter's charge-offs were elevated, we expect that our full year loss rate will be consistent with our long-term historical averages of approximately 30 basis points or less. Non-performing loans declined 84% from the prior quarter to 10 basis points of total loans as the overall portfolio continues to perform well. Our reserve coverage ratio is now 0.87% of total loans, in line with post CECL day one implementation levels. I'll close by thanking our associates across the country for their hard work and dedication to our customers and communities. I'm excited to execute on the opportunities we see in the second half of the year and beyond. Now, I will turn it over to Ram for some additional comments.

Thank you, Mariner. Our strong loan growth coupled with the benefits of higher short-term and long-term interest rates drove a 6.9% linked quarter increase in net interest income. We amortized $1.6 million of PPP origination fees into income and the overall PPP contribution to second quarter net interest income was $1.7 million compared to $2 million last quarter and $12.4 million in the second quarter of 2021. At quarter end, our PPP balances stood at $26.4 million, down from $77.2 million at March 31, approximately $400,000 in unamortized fees remain. As shown on Slide 21, our Fed account, reverse repo, and cash balances declined to $3.7 billion and now comprised 10.5% of average earning assets, with a blended yield of 83 basis points compared to 30 basis points in the first quarter. The 3% decrease in average deposits from the first quarter was driven by outflows of commercial deposits, including the typical seasonal trends in public funds along the capital markets and corporate trust deposits. The total cost of deposits, including DDAs was 20 basis points, up from 8 basis points last quarter and the cycle-to-date beta is approximately 18%. Net interest spread and net interest margin expanded from the first quarter by 13 basis points and 25 basis points, respectively. Net interest margin benefited 21 basis points from reduced liquidity balances at rate, 16 basis points from loan repricing, and 11 basis points from the benefit of free funds, offset by a negative 26 basis points related to the cost of interest bearing liabilities. The estimated impact in net interest income at various rates scenarios is shown on Slide 30. In a rate ramp scenario of plus 200 basis points on a static balance sheet, net interest income is predicted to rise 3.1% in year 1 and 12.8% in year 2. This is predicated on repricing of our variable rate loans based on underlying changes to LIBOR, SOFR, and other indices as well as deposit betas and mix shifts consistent with the prior cycle. While it's early days, our second quarter beta experience was in line to slightly better than our model assumptions. And as Mariner noted, while the focus on deposit beta is important, we focus primarily on net interest spread management, given that our future funding needs will depend on our continued efforts to fund our organic loan growth engine. As we've done in prior cycles, using cash flows from our high quality securities portfolio is another lever available to us to fund the loan growth opportunities. Our average loan to deposit ratio remains attractive at 58%, below our past highs in the low 70s. Loan yields increased 23 basis points from the first quarter to 3.72%. 58% or about $10.6 billion of average loans are variable rates, with 57% repricing in the next quarter and 64% repricing within the next 12 months. As I noted, these are largely tied to indices at the short end of the curve. Additionally, the securities portfolio is expected to generate $1.2 billion of cash flow in the next 12 months. The yield on those securities rolling off is approximately 1.84%, while purchases this past quarter were made at an average of 2.96%. Those details are shown on Slide 28. We continue to reclassify securities to the held-to-maturity portfolio during the second quarter to help manage tangible capital and reduce the impact of rising rates on our equity. Average HTM balances for the second quarter, excluding the $1.1 billion of revenue bonds that we've long held in that book, were $4.1 billion. The composition of our HTM portfolio is shown on Slide 28. Our regulatory capital ratios remain strong with a total risk based capital at 13%, CET1 at 11.44%, and leverage at 8.17%, respectively. Back to the income statement, total fee income for the quarter, as shown on Slide 22, was $176.3 million, including the gain on the sale of our Visa Class B shares. Fee income compared to the first quarter was impacted by the $66.2 million gain on that sale as well as other market-related valuations, including a reduction of $10.5 million in company-owned life insurance income and a $4.9 million negative change in the security gain or loss line related to other equity positions and a $4.2 million reduction in derivative income from back to back swaps. Additionally, the first quarter of 2022 included a $2.4 million gain on the sale of our factoring business, as well as $3 million of healthcare services convergent fees. Excluding those variances, second quarter fee income compared favorably to the first quarter levels. One of the biggest drivers of the fee income momentum in the second quarter was the $9 million quarter-over-quarter increase in brokerage fees where 12b-1 and money market revenue share fees are included in our income statement. The decline in equity valuations had a modest impact on fees tied to AUA and AUM levels in the trust and securities processing line. Non-interest expense trends are shown on Slide 23. The linked-quarter decrease was driven primarily by a $10.7 million reduction in deferred compensation expense related to the reduced COLI income I had mentioned, along with lower payroll taxes, insurance and 401(k) costs. Offsetting these reductions were the charitable contribution we made during the quarter, $4.4 million in additional legal expenses related to general corporate activities, and $4.5 million of increased incentive costs for company performance. Our effective tax rate was 20.8% for the second quarter and reflected a smaller proportion of income from tax exempt municipal securities. For the full year 2022, we anticipate that the tax rate will be between 19% and 21%. That concludes our prepared remarks. And I'll now turn it back over to the operator to begin the Q&A portion of the call.

The first question comes from Jared Shaw of Wells Fargo.

This is Timur Braziler filling in for Jared. Maybe starting off on the deposit side, just as you're thinking about funding this continued strong loan growth, clearly you have plenty of on-balance sheet liquidity with a 60% loan to deposit ratio, you have $400 million of deposits coming on later this year from the ONB deal. I guess, how are you thinking about kind of funding the loan growth over the next couple of quarters? How aggressive will you be in chasing new kind of deposit relationships in the interim here?

This is Mariner. I will take that, and if Ram or Jim or anyone else has anything to add, they can jump in. It's important to pay attention to our balance sheet as it has appeared for a long time. In the first quarter, we typically see our seasonal deposits run off. When you consider this run-off in the first half of the year, it translates to about $500 million, which reflects what has happened in the industry rather than a specific issue with our deposits. The rest of the changes are connected to the usual seasonality of our deposits. So I would emphasize that about $500 million has run off. Some observations on that: first, utilization rates are increasing as borrowers are depleting their cash reserves and starting to borrow. Additionally, energy and inventory costs have gone up in general. This indicates that customers are using their cash rather than money leaving our balance sheet. We've mentioned before that we manage over $14 billion for customers off our balance sheet, and we can bring any of that on at any time while offering competitive rates. Our diverse customer base, including institutions, commercial entities, and large corporations, gives us a lot of flexibility in managing our deposits and our balance sheet as needed. Therefore, I am not concerned about it, and we have faced this situation before.

And I'm just wondering, in terms of the higher interest-bearing deposit cost, how much of that was due to the mix shift with maybe some of the lower-cost deposits exiting to other vehicles versus either customers calling in and asking for higher rates or just posting higher rates across the board?

We discussed that 29% of our total is tied to a hard index, which means it fluctuates with rate changes. We can manage the rest effectively. It's important to note that 45% of our deposits are non-interest bearing. I want to shift the focus to the whole balance sheet rather than just deposits; we're seeing only a 12 basis point increase on the liability side, while the asset side is up 39 basis points. We've achieved a spread expansion of 13 basis points and a margin expansion of 25 basis points. In the broader context, net income is the key driver here. With spread and margin increases alongside a 7% rise in net interest income, our primary focus is on managing the growth of margin spread and the overall increase in net interest income, which ultimately contributes to a larger bottom line.

Okay. And then switching gears to asset quality, any additional color you can provide on that $27.7 million charge-off, maybe what industry it was in, what's the remaining balance on that credit and how much you had previously reserved against it?

I have limited comments on this matter because the credit is currently in bankruptcy. We discussed this credit in the first quarter, where we identified it and thought we might resolve it positively. However, as the bankruptcy proceedings continued into the second quarter, we identified complexities and changes that indicated a positive resolution was no longer feasible, leading us to take the charge. There’s nothing to comment on that relates to industry issues, vertical issues, or underwriting concerns. Therefore, there’s no trend to discuss. As we’ve mentioned before, this is a one-off situation, which is consistent with our long history of isolated incidents. If you refer to Page 27 of our presentation, you will see the relevant history. Tom Terry, our Chief Credit Officer, Jim Rine, our CEO, and I have been managing credit and non-credit committees together for over two decades, and this situation is not new or different. We anticipate returning in the second half of the year to our historical charge-off levels of 27 to 30 basis points on an annualized basis, consistent with our 15-year track record. Additionally, our non-performing loans have decreased back down to 10 basis points, which, based on all reports I've seen, is the lowest prospective figure among our peer group for non-performing loans.

That's perfect corollary to my last question. I guess, that linked quarter decline in non-performing assets, I mean, what drove that? Was that return to payment, was that just kind of relooking at the underlying credits and moving them back to performing status? I mean, that was a pretty exceptional move there. What drove that?

Largely again because of how we operate. It had peaked, it has jumped because of this credit and now it's declined back down to its normal levels, largely.

The next question comes from Nathan Race of Piper Sandler.

Ram, perhaps a question. If we kind of add back the COLI impact within salaries in terms of the overall operating expense run rate going forward, any thoughts just kind of directionally in terms of kind of how the total run rate trends in the back half of 2022?

I would say, I would use the $214 million that we reported this quarter and as we noted, $10 million of deferred comp expense was a credit to expense this quarter. So if you add $10 million, it's $224 million and then take $5 million away from the charitable account foundation, so we will get to $219 million. I would say, off the $4.5 million of legal expense increase, some of it was tied to some extraneous factors that we don't expect to recur. So we're talking about a run rate of $217 million to $218 million, plus or minus for operating expenses.

Okay, perfect. And then just going back to the charge-offs in the quarter, was the loan that was charged-off here in 2Q, was that the same one that you guys flagged last quarter in terms of expecting some favorable occurrence on?

Yes, I mentioned earlier that as the bankruptcy procedures moved from the first quarter to the second quarter, the situation has changed and evolved.

Okay. Understood. It seems that pipelines are in good condition, and you are still anticipating above-average loan growth going forward. With the reserve now at the CECL day 1 level, how are you considering the need to provide for growth given the current macro uncertainty, assuming charge-offs return to the previously mentioned range of 27 to 30 basis points?

Yes, we do expect loan growth to continue at favorable levels as it has been. In terms of how we reserve against it, the algorithm is much more complex than before. We are relying on Moody's to guide us regarding unemployment data, and if that changes and we enter a recession, there are many unknowns regarding how we will incorporate economic data into our algorithm. From my perspective, we are facing at least slightly unfavorable economic indicators, which would prompt us to reserve a little more. Loan growth should encourage us to reserve, but if our data improves and bad information is replaced with good information in our portfolio, that would lessen the need to reserve. There is a connection between these factors. I believe we will likely reserve a bit more due to the economic conditions and loan growth, which would be the prudent course of action. As for how this relates to 87 basis points, we prefer not to see it decline as a ratio, but we must adhere to our algorithm. I hope that clarifies things. Ram, do you have anything to add?

Super helpful. And if I could just ask one more, just going back to the balance sheet discussion from the earlier question. I just want to make sure I understand kind of the expectations for deposit levels and the earning asset base going forward. It sounds like you're expecting some additional outflows maybe in 3Q and then you have the HSA deposits coming on in 4Q. So just overall, Ram, perhaps how should we kind of be thinking about the earning asset base going forward with those deposit dynamics at play?

I don't think we expect to see further outflows in the third quarter necessarily. So, I would say, stable to maybe grow a little bit based on our ability to bring on. As I talked about earlier, we can bring on as much of the $14 billion we have off balance sheet by paying competitive rates. So I don't see us going backwards, more of a stabilizing approach for the rest of the year and then having the HSA deposits coming on. And then again, remember we can rotate investments into loans which is right. So we have a $13 billion investment portfolio and 58% loan to deposit ratio. So we've got that also working for us.

There'll be some real-time thinking on the portfolio side, Nate, in terms of just whether we reinvest our cash flows from our securities portfolio every month. We talk about it at our asset liability committee, sometimes which is to reinvest, sometimes depending on what the deposit outlook looks and loan growth outlook looks, we might decide not to reinvest.

The next question comes from Chris McGratty of KBW.

This is Nick Moutafakis on behalf of Chris McGratty from KBW. Could you remind me what the monthly cash flow runoff is for your bond book?

Yes. On Page 28, you will see the portfolio statistics, Nick, and for the next 12 months, we expect about $1.2 billion to come from our portfolio.

Okay, that's great. And then just on the cash level, obviously you guys kind of reduced cash, you're down to about 10% of average earning assets. Could we look at this as kind of the floor for the cash levels or could we potentially run that down even further to fund future loan growth?

If you look at the bottom of Slide Page 21, we show the pre-pandemic levels, right. So if you look at the interest-bearing deposits, it's slightly higher than where we were pre-pandemic. So we could expect some additional contraction in those balances. But obviously, as you see on a quarter-over-quarter basis in response to what happened on the deposit side of the equation, we did see some normalization of these balances.

Okay, that's helpful. And then maybe just on the loan growth side, as you look into the back half of 2022, is there any portfolios where we could see some upside surprise and also potential slowdowns as far as different categories?

Well, I think, I mean, from a growth standpoint, we give you a picture into the upcoming quarter as we always do, so third quarter looks strong as it has. I would say, it seems to be coming across the board from all categories and all regions. We don't really get too far beyond one quarter look as far as guidance goes, but just the indicators for growth seem to be good as you look into the whole back half of the year. And as far as upside or downside, we're all kind of dealing with the same fact there as it relates to, we've got the Fed decision today, what happens with the labor markets, what happens with back half of this year. I think, as I said, I think last quarter, companies are doing pretty well, they are sort of sold out from last year on into through this year. So I think the impact of a recession is really a '23 impact. So loan growth feels pretty good for the remainder of this year.

This is Jim Rine. One of the potential downside risks for banks could be the rise in rates and when people might choose not to pursue their next project or if already booked backlogs could be canceled. However, we haven't seen that happen yet, and we're maintaining close communication with our clients, who are already incorporating these rate increases into their forecasts. The payoff may be gradual, which could also be a contributing factor.

Yes, it's a benefit, right? We've seen it from first quarter to second quarter, we are already seeing that moderate because of higher rate. So we went from mid-4s to 3.1 on payoffs, paydowns. You also have utilization rates up marginally. And I think both of those things will buoy based on the current book, also about 60% of our new business in the second quarter was from new customers. So that also we should see sort of buoy things for the back half of the year. We've talked to construction companies about their backlogs, Jim talks about that, they'll all say they are still very strong. And the only thing they see, the developers, there is a bit of softening in the forward-looking pipeline for developers, but that's being made up for larger projects, public, private and kind of large data farms and distribution facilities and multifamily and areas where there is still a lot of need, kind of making up for logistics and things like that are making up for some of that more expensive borrowing and land costs. Let's not forget also that rates are still at historically low levels, right? Talking heads talk about all the crazy stuff going on with rates, we are still at historically low levels. So that I think bears saying.

The next question comes from John Rodis of Janney.

Ram, on the margin, obviously nice expansion. Can you talk about maybe just give a little more detail? Do you have what the margin was maybe in June and how we should think about the margin going forward?

I don't think we get specific into, just because of deposit inflows and outflows, it's hard to just use any month data. But I would say, obviously with the 25 basis points that we got in the second quarter, those are probably a little faster than probably for the industry and for us as well, but we continue to expect modest margin expansion going forward based on where we see loan pricing. We're going to be fairly disciplined on the deposit side and managing that. As you heard Mariner talk about, we're going to manage to net interest spread and make sure that, that translates to margins being maintained or expanding from here. But a more moderate pace than the second quarter.

Okay, that makes sense. Ram, I have one more question about the brokerage fees. I understand the increase in the 12b-1 fees, but I was a bit surprised by the jump from the first to the second quarter. In previous quarters, you've mentioned looking back to 2019, when brokerage fees for the entire year were $31 million. Can you share what the net number was this quarter and what you anticipate for the brokerage line item going forward?

Yes. I think, it was a pleasant surprise for all of us. Obviously, with the Fed raising rates by 75 basis points and the back end of these investments being really short term in nature and where the treasury curve is, it was a nice surprise for us. So what we said relative to the $31 million back in 2019 was that book of off-balance sheet deposits where we get revenue share and 12b-1 fees has doubled. So clearly, we see some opportunities as interest rates stay elevated, to be able to mimic the $12 million, $12.5 million run rate you saw in the second quarter.

Ultimately, we want to make the process quicker. Ram mentioned that the short end of the yield curve has impacted how quickly we can move. The yield curve has significantly influenced the pace at which money markets can invest and generate returns on shorter-term notes, allowing us to benefit sooner.

So, Ram, Mariner, just to clarify, though, again, so it should stay at this level if we get no further rate increases or even with further rate increases, just given where the forward curve is, I guess?

Yes, it could slightly increase depending on what happens with our off-balance sheet deposits. You heard Mariner discuss the deposit question, mentioning that we can tap into some of these off-balance sheet deposits, which might lead to a decrease in balances. Conversely, if our aviation and corporate trust businesses grow faster than anticipated, we could see an increase in off-balance sheet deposits as well as more volume-driven increases in this area. However, like my earlier question about margin, I believe that any ongoing increases will be modest compared to second quarter levels.

Yes, there is the size of the off-balance sheet book and then there's a rate pay rate. On the rate pay side, that's going to moderate. So, it really depends on what happens with the short end of the yield curve. It's likely to moderate, but I still expect some increase with rates continuing to rise, which ties to the size of the book. I expect it to continue to grow, largely due to what's happening with municipal underwriting on a national level and also in aviation, including the buying, selling, and movement of planes. So, I still expect that to grow a bit.

Okay. Makes sense. There are currently no further questions registered at this time. I will pass the conference back over to the management team for closing remarks.

Thank you and thanks for joining us today and for your interest in UMB. As always, if you have follow-up questions, you can reach us at 816-860-7106. Thank you.

That concludes the conference call. Thank you for your participation.