Berkshire Hills Bancorp, Inc.
Q2 2016 Earnings Call Transcript

Published: 25 Oct 2016

[Operator:]

Good day, and welcome to the Berkshire Hills Bancorp Q3 Earnings Release Conference Call. All participants will be in listen-only mode [Operator Instructions]. After today's presentation, there will be an opportunity to ask questions [Operator Instructions]. Please note this event is being recorded. I would now like to turn the conference over to Allison O'Rourke. Please go ahead.

[Allison O'Rourke:]

Good morning, and thank you, for joining this discussion of third quarter results. Our news release is available on the Investor Relations sections of our Web site, berkshirebank.com, and will be furnished to the SEC. None of today's discussion is intended as a proxy solicitation. Our discussion will include forward-looking statements, and actual results could differ materially from those statements. For detail on related factors, please see our earnings release and most recent SEC reports on Forms 10-K and 10-Q. In addition, certain non-GAAP financial measures will be discussed on this conference call. References to non-GAAP measures are only provided to assist you in understanding Berkshire's results and performance trends, and should not be relied upon as financial measures of actual results or future projections. A comparison and reconsolidation to GAAP measures is included in our news release. With that, I'd like to turn the call over to CEO, Mike Daly. Mike?

[Mike Daly:]

Thank you, Ally. Good morning, everyone. Thanks for joining us this morning for our third quarter call. I'll provide an overview of the quarter. Then I'll turn it over to Jamie Moses, our Chief Financial Officer. Jamie has settled right in with his team, and he’ll take you through some of the specifics in our financials. And then I'll wrap it up. So, it was a solid quarter for us. We delivered $0.57 in core EPS. That's a 6% increase quarter-over-quarter, and $0.53 in GAAP EPS. The results reflect the disciplined balance sheet management, significant revenue gains, and continued efficiency improvement. Now the team has executed on our fee income strategies. It made good progress towards our profitability goals, and moved ahead with our preparations for closing the First Choice acquisition later in the quarter. We’d solid loan growth this quarter with commercial landing delivering 6% annualized growth, primarily led by our New York and Connecticut markets. And I'd add, were mindful of commercial real-estate levels, and we've been managing the portfolio to stay below those regulatory thresholds. And the pipeline for C&I loans has also picked up. So, we expect to see further growth there as we go forward. Our overall commercial pipeline does remain solid. But we’re also committed to remaining selective, especially with underwriting and profitability. And taking that into account, total commercial loan growth is again expected to be in the mid single digits in the fourth quarter. And I'll just note that all of the guidance I am giving for the fourth quarter is organic guidance and does not include the impact of First Choice. Their shareholder vote is coming up in few weeks, and we'll let that process take place before addressing more specifics of our closing plan. And we do expect modest growth in consumer and residential lending in the fourth quarter, as we continue sales of these products to balance margin and asset sensitivity goals when market opportunities occur. Overall, fourth quarter organic loan growth is expected to be in the low to mid-single digits. Now turning to deposits. We had a very strong quarter for demand deposits, which grew at a 24% annualized pace. I think we’re doing a better job of mining commercial relationships, which is helping to drive growth in this category. We expect overall organic deposits to grow in the low to mid-single digits, as well in the fourth quarter, so similar to overall loan growth. Our net interest margin for the third quarter was 3.25%, and the margin before loan accretion was 3.13%. Now, this included the impact of the final tranche of forward starting balance sheet swaps, which are now fully baked-in. So, we expect the margin ex-accretion to hold flat in the fourth quarter. Now, turning to fee income. We are delivering on our strategy here, and I am pleased with the results we’re seeing from 44 Business Capital, our Philadelphia based SBA group. Total fee income was up 17% over the second quarter with about $1 million of that attributed to SBA loan sales. We also benefitted from strong demand and favorable market pricing in the mortgage market. For the fourth quarter, we expect most of our fee lines continue at a minimum at these levels, set for course seasonally lower mortgage fees. Now, before I turn it over to Jamie, I want to touch on some expense initiatives. And the team has been doing a good job managing expenses this year. And it's the kind of thing we need to stay focused on, especially in the light of $10 billion thresholds. Now, as many of you know, I’ve been ready to get out ahead of ourselves on cost and plans associated with crossing $10 billion. We wanted to be sure we needed to be sure of our estimates and our regulator views. Well, we’re at that point. So, here is the breakdown of what we’ve absorbed and what we plan to absorb as we thoroughly prepare for that eventuality. Over the last three years, we’ve implemented a full enterprise-wide risk management system. We’ve implemented new compliance systems and software. We’ve implemented a new asset liability management system and these infrastructure investments which are necessity for a bank operating over $10 billion, costs us around $5 million to implement. We’ve also added over 40 people to our compliance and risk departments during this time, accounting for over 3.5 million, plus another 0.5 million in ongoing system expense. So over 4 million right now baked into our current run rate. Also included in this run rate, we spent $750,000 this year and be fast ready. And we expect to spend an additional million dollars in 2017 as we work through our first drive-run with the regulators. And then anticipate the ongoing run rate to be about $1.5 million to $2 million a year. Richard is going to be available during Q&A to give more color on this if needed. But at the end of the day, that accounts for almost 85% of the costs associated with crossing $10 billion, already included in our run rate. The only additional compliance expense we anticipate at this time will be people, which will directly correlate with how quickly we scale the business. And the strategy remains to find the right combination that allow us to get to around $12 billion asset range, absorb the impact of Durbin and continue to improve profitability. We’ve got time to do that. So, in the meantime, it's business as usual. Now, one more time on expenses. As you know, we've been active in evaluating and adjusting our branch network each year. We completed the sale of two branches in August. And at this point, we've identified an additional three branches for consolidation in early 2017. Now that makes 36 branches closed, sold, or consolidated, over the last five years. And we’ve done that while maintaining our organic growth and expanding our customer services and market share. We also announced the opening of our first full service branch on Congress Street in Downtown, Boston. That's scheduled for the first quarter. The new branch will use virtual power technology complemented by whole service by bankers, private bankers, and loan officers. We're excited to enhance our strong lending operations in Boston with branch presence, especially one that uses the latest technology to provide convenience to customers, and of course cost saves to us. Now with that, I am going to turn it over to Jamie. Jamie?

[Jamie Moses:]

Thanks, Mike, and good morning, everyone. This was a good quarter. We feel good about where we're going. We continue to be focused on profitability and we're demonstrating solid growth and disciplined expense managements, in what remains the challenging environment. As Mike said, core EPS came in at $0.57 and GAAP EPS came in at $0.53 for the third quarter. Our GAAP EPS reflects the impact of non-core charges associated with the recent acquisitions and restructuring. With good balance sheet management and strong fee income growth, net revenue grew 7% this quarter. Average earning assets grew 2%, and are expected to be flat in the fourth quarter, taking into account lower securities balances to end Q3. Purchase loan accretion for the third quarter was $2.2 million. We expect recovery to be bouncy, and scheduled accretions to wind-down. Total purchase loan accretion, including recoveries, is expected to be lower in the fourth quarter. Moving now to expenses, where I believe, we’re demonstrating good disciplines. Revenue growth outpaced expense growth, creating positive operating leverage. The increase in core non-interest expense was primarily driven by compensation tied to our fee income drivers. We expect organic expenses to come back down in the fourth quarter as some loan production costs role-off. Our core tax rate for the third quarter was 30%, including the benefit of some small existing tax credit investments. We still anticipate the full-year core tax rate will be in the 27% range, which means that for the fourth quarter, we see the core tax rate dropping to about 23%, with the corresponding offset of about $3.5 million charge to interest income. The additional impact to the bottom line of the lower tax rate in Q4 is negligible due to the structure of the deals. Taken together, we expect to organically deliver $0.57 in core EPS in the fourth quarter. This was result of a 6% increase year-over-year with stronger revenues offsetting a higher tax rate. Our GAAP earnings will be affected by the acquisition of First Choice. The exact impact of charges on the fourth quarter is to be determined. But we expect to deliver the total deal cost on plan when merger is completed and integrated. We're pleased with our progress this quarter toward our profitability goals. Core return on assets improved to 88 basis-points and core return on tangible equity came in at 13%, moving our metrics in the right direction. Including non-core charges, the ROA was 82 basis-points for the third quarter, and return on equity was 7.3%. At quarter end, our tangible equity was 7.7% of tangible assets. Tangible book value grew 2% quarter-over-quartet to $18.78 per share, and book value per share grew 1% to $29.97. So, there’s good movement on the capital front. Also good results on credit, which remains very strong and we intend to remain selective, taking advantage of our specialty lending platforms and diverse footprints, emphasizing relationships, margin and profitability. We don’t expect any significant changes to our overall credit or charge-off levels in the fourth quarter. And we anticipate our provision will be in line with our Q3 level. We’re happy with our performance this quarter, and our prospects for delivering solid results in Q4 and beyond. While there are headwinds, we see opportunity for profitable growth and we’re making strides on diversifying our income streams. Our financial condition is good, and we expect to make further progress towards our fee income and profitability goals. With that, I’ll turn it back over to Mike.

[Mike Daly:]

Thank you, Jamie. That was solid. So, as Jamie said, we expect to deliver another solid quarter in Q4 on an organic basis, and that would mean a 6% increase in core EPS in 2016; a double-digit increase in net revenue; and steady improvements toward our profitability and fee income goals, so a pretty good year. And on the meantime, I want to touch on some high level 2017 guidance. Assuming a December close for First Choice, we expect the combined organization to grow loans at mid-single digit pace with deposit growth to match. We’re looking at one, maybe two, bps of organic margin compression each quarter, assuming a flat rate environment. And I’d note, we expect to see more pronounced seasonality tied to the mortgage business with stronger quarters of course in the middle of the year. Now, lastly, an additional comment on taxes. We do continue to pursue the historic tax credit strategy with our local customers. The guidance from the IRS over the summer actually provided some clarity on the value of these deals. And that, combined with our current pipeline, means our annual tax rate will remain in the 25% to 30% range for the next two years. This equates to about a penny a quarter in EPS benefit once you take into account all the offsets. So all-in, we’re targeting EPS growth in the 5% to 7% range for 2017 with marked improvement toward our goal of 1% ROA. Now there continue to challenges facing the banking industries. But as we look ahead, I am optimistic about our ability to take advantage of the franchise we’ve built. Our near-term focus will be on closing and integrating the First Choice acquisition, and getting to know our new market there. Our strong integration history gives me confidence that we’ll hit the ground running, and continue to build on our expanded platforms. I feel good about the franchise’s diverse footprint and expanded customer base, the bank’s culture and brand. I feel like we’re setup to grow more profitably and we’ve been disciplined on pricing and underwriting. And that the team had a great vision in spending the time, money, and resources, to prepare this Company to operate at a new level of regulatory oversights, well ahead of schedule. So our outlook remains positive and we look forward to further delivering on the power of this franchise to all of our constituencies. And with that, I’m going to open it up to any questions.

[Operator:]

We will now begin the question-and-answer session [Operator Instructions]. Our first question comes from Casey Haire of Jefferies. Please go ahead.

[Casey Haire:]

I wanted to talk about -- I appreciate the guidance on 2017. I was wondering, it sounds like you guys have a little bit of work to do on getting ready for the $10 billion asset threshold. If I heard you correctly, it's $1.5 million to $2 million. Is that -- but on the revenue side, sounds like you obviously have some momentum there. I am just wondering -- does that investment spend, is that take positive operating leverage off the table for 2017?

[Mike Daly:]

No, let me just be clear. We spent $750,000 this year and be passed readiness, so $1 million baked into our forecast next year. And then beyond the $10 billion level, we anticipate somewhere between $1.5 million to $2 million in the run rates.

[Casey Haire:]

So the $1.5 million to $2 million is once you cross $10 billion?

[Mike Daly:]

That's correct.

[Casey Haire:]

So switching to the NIM outlook. You guys have done a pretty good job of protecting the name by running down that lower yielding securities book, sounds like that's going to continue in the fourth quarter here. How much more room do you have with the loans, with the securities books, at 16.5%? Is there, I mean, how much lower can that go as a percent of earning assets?

[Jamie Moses:]

Casey, it's Jamie. I think we're pretty comfortable with where the securities portfolio is at the moment. Obviously, we will always take a look at where we are with regard to interest rate risk and things like that. But I think from NIM perspective, we expect to be flat in Q4. And then we'll also take a look at how our securities portfolio looks in the context of the First Choice, as well.

[Casey Haire:]

And on the First Choice, one. So, that the liquidity profile at First Choice will -- is pretty strong, and actually not, if my math is right, take you guys below 100% loan to deposit. I know the guide is mid single digits for loans and deposits next year. But, I mean, would you guys -- I know being above 100% has slowdown other banks in terms of loan growth with that. Would you guys be a little bit more, I don’t know what the word is, may be aggressive given that you have a stronger liquidity profile below 100%?

[Mike Daly:]

We'll probably finish up the First Choice deal at may be a little below 100%, but may be right around to 100%. And I think we’re going to remain comfortable in that 100% to 105% range, if that answers the question Casey?

[Casey Haire:]

Yes. It does. Thank you.

[Mike Daly:]

You're welcome.

[Casey Haire:]

And just last one on the First Choice. The national mortgage origination platform that they have is going to be a very nice addition to your fee income stream. It's also going to be pretty volatile if I am looking at historical correctly, it's been as high as 24, as low as 10. Is there any clear line of sight in terms of what fee contribution we can expect with First Choice on-board next year?

[Sean Gray:]

You're right on with your mix. We modelled it at the lower level. So we feel comfortable that the deal worked at the lower levels with higher seasonality obviously in the mid quarters, Q2 and Q3.

[Operator:]

Our next question comes from Mark Fitzgibbon of Sandler O’Neill Partners. Please go ahead.

[Mark Fitzgibbon:]

Jamie just wanted to clarify one question you had on the tax rate. I think you said you expected it to be 23% rate in the fourth quarter. How much is the offset in other income, where you expect that to be?

[Jamie Moses:]

Yes, it's $3.5 million, Mark.

[Mark Fitzgibbon:]

$3.5 million, okay. And then secondly I noticed you had I think $717,000 of restructuring expenses in the second quarter. What exactly was that for?

[Jamie Moses:]

That’s tied of executive severance.

[Mark Fitzgibbon:]

And then lastly I wondered if you could share with us what the commercial pipeline looks like right now and the complexity.

[Sean Gray:]

Sure Mark, Sean here. Pipelines remains strong, approximately $150 million, and we’re encouraged that we’re seeing a mix of about 50% C&I in that pipeline.

[Operator:]

Our next question comes from David Bishop of FIG Partners. Please go ahead.

[David Bishop:]

In terms of the outlook next year as you budgeted out, you noted the Congress Street branch opening. Are you gearing up, or are you budgeting much in terms of loan growth next year? Or do you think it's going to take several quarters to ramp up? I am just curious, if you’ve sort of already laying the seeds there to jump-start some of the growth upon the opening of that branch?

[Mike Daly:]

Are you talking about loan growth across the enterprise space?

[David Bishop:]

More of just from that Boston market...

[Sean Gray:]

David, Sean here. We feel really good. We feel the branch has a natural progression, because we’ve already committed to substantial loan growth in that market. As you know, we have a middle market team in the Boston area. We have an ABL team that sits in that Boston area. And obviously from a mortgage perspective, we’re doing a good job of originating residential mortgages in that area. So, the hope that the branch is more so to leverage those relationships, gather deposits, and enhance the overall depth of wallet in the Boston area.

[David Bishop:]

And then as it relates to 44 Business Capital, just curious in terms of how you view that shaping up coming into the fourth quarter as well?

[Sean Gray:]

They are doing great. There is a tremendous amount of synergy within our other divisions. So we believe we can continue at that $1 million pace, and really look to $1 million to $1.5 million on a go forward with 44 Business Capital, from an SBA fee generation perspective.

[David Bishop:]

And then one final question, loan growth little bit muted from last quarter. Just curious what impact payoffs or maybe some seasonality played in restarting some of the end of period loan growth?

[Mike Daly:]

There were some. But I don’t think it was material. I mean we were where we expected to be.

[Jamie Moses:]

That’s right David. This is Jamie. There was some seasonality in our specialty lending groups. And so, there is also some seasoned loan sales that we had in there as well. So that’s why you’re seeing the number you see.

[David Bishop:]

Any sense or magnitude in terms of the loan sales dollar amount?

[Sean Gray:]

So forwards paper.

[David Bishop:]

I am sorry...

[Sean Gray:]

Are you talking about going forward or this past quarter?

[David Bishop:]

This past quarter, in terms of the impact...

[Sean Gray:]

From a seasoned loan perspective, we sold approximately $100 million in residential mortgages.

[Operator:]

Our next question comes from Collyn Gilbert of KBW. Please go ahead.

[Collyn Gilbert:]

Just to start with the NIM discussion, it sounds the 1 to 2 basis-points on a quarterly basis of compression you guys are looking for is a little bit better perhaps, I think, may be than you were suggesting coming out of the second quarter. Just trying to understand what's driving that?

[Mike Daly:]

Well, remember, we’ve had the third quarter we had the final tranche of the forward rate swaps in there. So that had the biggest impact on the margin coming into the third quarter. So, now we're talking about, basically just pure margin compression based on yields.

[Collyn Gilbert:]

Okay...

[Jamie Moses:]

That’s right. Collyn, its Jamie. In Q3, we also did some portfolio remix that help to support the margin in a little bit in Q3. We expect that to be supportive in Q4, as well. We expect a flat margin in Q4. But we also are getting closer and closer to the other roll-on roll-off being close in line together.

[Collyn Gilbert:]

And that kind of feeds into my next question. Just, Sean, as you talked about 50% of the pipeline being in C&I side. Where are you seeing that demand, seeing that demand? And how are you seeing the pricing on some of the loans moving to the pipeline?

[Sean Gray:]

Sure. The good news is the demand is diverse across the franchise. Most recently, the Albany market has done a tremendous job. And I think that's one of the advantages of having such a wide geography. From a pricing perspective, we’re seeing the roll-on coming in the mid 3s, and we think we can continue at that pace. And of course we’re looking for full relationship cash management fees in the full bundle with those clients.

[Collyn Gilbert:]

And then just recognizing that there is going to be volatility here on some of the fee lines kind of commission driven. How are you guys structuring, or how should we think about the incentive comp part of the puzzle as we look out and model for some of this incremental growth that’s coming on?

[Mike Daly:]

I think you're going to see some seasonal uptick in expenses. But those are definitely tied to income that we're getting from those expenses. So, you’ll see some things pick-up, but it's all tied to good stuff that we're doing.

[Collyn Gilbert:]

So the incentive cost will come-in in conjunction with the increased volumes. So it's not like it's an accrual situation, which will change throughout the year. It will come when the volumes come?

[Mike Daly:]

You got it.

[Collyn Gilbert:]

Okay, okay...

[Sean Gray:]

And Collyn, I mentioned this prior, the mortgage company, the top five executives are based on a net income compensation structure. So that should remove any additional volatility that could come from just loan production.

[Collyn Gilbert:]

And then finally Mike you had mentioned may be a December close for First Choice. I know I am placing here is a little bit here. But are they going to be beginning of December, end of December, I know it's hard to tell when you enhance with the regulators. But just trying to figure out what kind of maybe the better way to model this is?

[Mike Daly:]

Well, I mean, I would love to see it close in the first part of December. But I think as you eloquently put, there is certainly not up thoughts. So, our hope is that the earliest in December as we can would be our -- that’d be our hope. And we’ll see we can get it done.

[Collyn Gilbert:]

All right I'll leave it here. Thanks guys. Oh, one final question, sorry. Just on the tax guidance that you gave for next year. What should we assume that the offset to be? Does it go back to the $1.5 million a quarter or...

[Jamie Moses:]

Collyn, it's Jamie. That goes to $3 million a quarter at those levels.

[Collyn Gilbert:]

So, in '17, $3 million a quarter.

[Jamie Moses:]

Yes.

[Operator:]

Our next question comes from Matthew Breese of Piper Jaffray. Please go ahead.

[Matthew Breese:]

Just on the tax rate, you guys provided some pretty good guidance. I am just curious about the nuts and bolts of that. And behind the scenes on your-end, what are the drivers of the volatility, and how does it works?

[Jamie Moses:]

Well, so the drivers of the volatility are basically when the deals close. So, what we’re looking at for next year and for ’18 as well is you can expect 25% to 30% tax rate for full year guidance. There will be some lumpiness, depending on when those deals close, Matt. And that’s tied to the offset. At those levels, again, it's $3 million a quarter in offset. But again big picture is this is about a penny a quarter for the tax stuff.

[Ally O'Rourke:]

Matt, this is Ally. Just to add to that. If a deal didn’t close in one quarter, so there was more lumpiness like you saw this quarter, 30%, we’re guiding to 22% next quarter. The impact to the bottom line is very minimal.

[Matthew Breese:]

And then how comfortable you feel with the pipeline of future deals that you can invest in?

[Jamie Moses:]

We feel really good. We spend a lot of time making sure that that pipeline is there, cultivating those relationships. And again as Mike said, these are relationships with our customers that we have, that we feel good about, helping out in the communities as well. So, we feel pretty good about that guidance Matt.

[Matthew Breese:]

And then can you talk about how much swap fee income there was this quarter, and the outlook for that line of business in fourth quarter and 2017?

[Jamie Moses:]

Yes, sure Matt. So it's Jamie again. So $1.5 million was swap income here in Q3. And we feel pretty good in that $1 million to $1.5 million range going forward.

[Matthew Breese:]

And then can you remind us if there is a fed funds hike in December. What kind of impact would that have on the margins?

[Jamie Moses:]

So, it's going to have a positive impact. It's not a huge amount. Again, we’re slightly asset sensitive at this point. Maybe a couple of hundred thousand, or something like that, it’s not a big number, Matt.

[Operator:]

This concludes our question-and-answer session. I would like to turn the conference back over to Michael Daly for any closing remarks.

[Mike Daly:]

Okay. Well, thank you everybody for joining us. We certainly look forward to speaking with you again in January to discuss our year-end results, and so off and running. Thank you very much.

[Operator:]

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