Columbia Banking System, Inc.
Q2 2017 Earnings Call Transcript

Published: 28 Jul 2017

[Operator:]

Ladies and gentlemen, thank you for standing by. Welcome to the Columbia Banking System Second Quarter 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instruction will be given at that time. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the call over to your host, Hadley Robbins, President and Chief Executive Officer of Columbia Banking System.

[Hadley Robbins:]

Thank you, Jeanine. Good afternoon, everyone, and thank you for joining us today on our call for our second quarter 2017 results. The release is available via our website, columbiabank.com. First, I want to take this opportunity to say that I'm deeply honored to have the privilege of serving as the next President and CEO of Columbia. During my time at Columbia, and especially through the past five months, I've witnessed the dedication, drive and pride of our employees. Their resilience in the face of great difficulties and persistence in creating positive outcomes is truly inspiring. As we approach the 25th anniversary of our company, it's important to acknowledge that, as in the past, our future is about placing the customer at the center of what we do. I also want to take this opportunity to provide assurance that we'll continue to execute our existing strategy. We'll continue to grow the bank by concentrating on building durable relationships with our customers, making the necessary investments in technology to ensure we have contemporary products and services and selectively look for acquisition partners that have good economic and cultural fit. We'll also continue our ongoing efforts to reduce expenses and increase operating leverage while consistently holding to our credit disciplines across business cycles to best preserve our capacity to generate long-term, sustainable revenue streams. During the second quarter, we achieved record net income for the period of $27 million. Our bankers were successful in generating loan production of $316 million which, along with higher levels of line utilization, resulted in net loan growth of $195 million or about 3.1% for the quarter. We now have received shareholder and state regulatory approvals for the merger of Pacific Continental into Columbia, Federal regulatory approvals are still pending. Upon approval by the Federal Reserve and FDIC, we'll move quickly to close and commence integration and conversion activities. Our system conversion date is now set for mid-November. On the call with me today are Clint Stein, our Chief Financial Officer and recently announced Chief Operating Officer, who will provide details about our earning performance; and Andy McDonald, our Chief Credit Officer, who will review our credit quality information. I will conclude by providing an update, covering our deposit loan activity. Following our prepared comments, we'll be happy to answer your questions. It is important that I remind you that we'll be making forward-looking statements today, which are subject to economic and other factors. For a full discussion of the risks and uncertainties associated with the forward-looking statements, please refer to our securities filings and, in particular, our 2016 SEC Form 10-K. At this point, I'd like to turn the call over to Clint to talk about our financial performance.

[Clint Stein:]

Good afternoon, everyone. As Hadley mentioned, earlier today, we reported record second quarter earnings of $27.1 million, or $0.47 per diluted common share, which is $0.03 higher than the second quarter of last year. Expenses related to the termination of loss-share agreements with the FDIC, and the pending acquisition of Pacific Continental Corporation reduced our reported earnings $2.2 million and lowered EPS by $0.04. We recorded a pretax charge of $2.4 million in the second quarter to write off the remaining loss-sharing asset and relieve the FDIC call-back liability. Acquisition-related expenses of $1 million in the quarter were in the following income statement line items

[Andy McDonald:]

Thanks, Clint. For the quarter ended June 30, the company made a provision for loan losses of $3.2 million. This was primarily driven by the originated portfolio which had a provision of $4.4 million. The discounted portfolios collective released 440 for the second quarter and the purchase credit impaired portfolio enjoyed a release of $738,000. Loan growth, negative migration and net charge-offs drove the provision in the originated portfolio, while a continued contraction had relatively stable credit metrics in the other portfolios allowed the releases. It's important to note that within the originated loan portfolio, we enjoyed over $216 million of loan growth during the quarter. So as of June 30, 2017, our allowances to total loans was 1.14% even with the first quarter and essentially the same when compared to 1.13% as of December 31, 2016. As we have discussed before, the weakness in the portfolio has been most notable in the agricultural sector, which drove both the provision and the increase in nonaccrual loans for the quarter. At quarter-end, we had approximately $466 million in agricultural-related commercial business loans and another $258 million in commercial real estate farmland loans. On a combined basis, the largest sector is hops at $97 million. We have not experienced any credit issues within our hop portfolio. Beef and cattle ranching is next at $96 million. The cattle business showed weakness throughout 2016 but rebounded in the first half of 2017. However, we continue to be diligent in this area as we are seeing increases in the U.S. cattle herd, which could have a negative effect on pricing in the second half of 2017. The next largest sector is wheat at $65 million. Our wheat portfolio has been very stable with over 97% of the credits rated

[Hadley Robbins:]

Thanks, Andy. Total deposits at June 30, 2017, were $8.1 billion relatively unchanged from the prior quarter. Core deposits were $7.7 billion and are holding steady at 96% of total deposits. The average rate on total deposits remained low at 5 basis points. Loans were $6.4 billion at June 30, 2017, a net increase of $195 million or 3.1% over March 31. The second quarter increase was largely driven by loan production as mentioned previously, of $316 million. Line utilization also increased from 49% at March 31, to 51.7% at June 3rd. Line activity in our C&I portfolio typically rises in the second quarter, which reflects seasonal borrowing patterns of a few industries in our portfolio, most notably agriculture. Assuming historical patterns hold, we're likely to see line utilization continue to increase in the third quarter. New production for the second quarter was mostly centered in C&I and commercial real estate and construction loans. Term loans accounted for roughly $190 million of total new production, while new lines represented about $126 million. The mix of new production remained granular in terms of size, 19% of new production was over $5 million, 28% was in the range of $1 million to $5 million, 53% was under $1 million. In terms of geography, 57% of the new production was generated in Washington, 33% in Oregon and 10% in Idaho and a few other states. C&I loans ended the quarter at $2.7 billion, up about $145 million from the previous quarter or 5.7%. Industry segments with the highest net loan growth in the quarter included agriculture, finance and insurance and manufacturing. Commercial real estate and construction loans ended the quarter at $3 billion, up $27 million from the prior quarter. The mix of asset types associated with new production was broadly diversified. The largest net increases occurred in multifamily and healthcare construction loans. The quarterly average tax adjusted coupon rate for new production of 4.58% exceeded the portfolio rate of 4.52%. There was a modest uptick in coupon rates during production this quarter, primarily due to re-pricing in commercial loans following the December and March changes in the Fed funds rate. The Feds funds move in June was too late in the quarter to have a material impact on our loan yields. We continue to believe that the Northwest will grow faster than the national economy during the rest of 2017. The growth rate is likely to be less than last year as labor supply tightens. The tighter labor supply is developing in a number of industries accompanied by upward pressure on wages. Farmers and contractors, in particular, have found it progressively more difficult to find workers. The region does benefit from population growth at a rate that exceeds the national average. However, the availability and cost of housing may slow future growth rates. Overall, business confidence continues to be optimistic, yet business owners are hesitant about committing resources or taking on additional debt to fund significant expansion plans. Most continue to look from our continue to look from our certainty regarding Trump administration and policy changes before committing to action. The banks pipeline at the end of the second quarter is below levels seen at the same time last year. However, deal flows remain steady. New loans coupled with seasonal line utilization, should help create positive net loan growth in the third quarter. In closing, our quarterly dividend of $0.22 per common share will be paid on August 23, 2017 to shareholders of record as of the close of business on August 9. This dividend constitutes a payout ratio of 47% for the quarter and a dividend yield of 2.22% based on the closing price of our stock on July 26. This concludes our prepared comments this afternoon. As a reminder, Clint and Andy are here with me to answer your questions. And now, Jeanine, we'll open the call for questions.

[Unidentified Company Representative:]

Thank you. [Operator Instructions] And operator do we have any questions on the telephone?

[Operator:]

Yes, we have the questions over the phone. First one is from Jeff Rulis [D.A. Davidson]. Your line is open.

[Jeff Rulis:]

Thanks, good afternoon.

[Hadley Robbins:]

Good afternoon, Jeff.

[Jeff Rulis:]

I guess to start with maybe a question for Clint. Given the kind of updated timeline on the PCBK close, could you sort of reengage the cost saving assumptions? Assuming a kind of a mid-Q3 closing with conversion in mid-Q4, if you could just broadly kind of roll through that again?

[Clint Stein:]

Sure. I believe that we had originally stated – we didn't really tie it to a specific quarter, if you will, because of the uncertainty around when we would close. I think it's reasonable that we'll have 50% of the cost savings realized in the first year, 85% in the second year and then 100% thereafter. And in terms of why I say 85% realized in the second year is that there's always a bit of a trail. It could be month 10 after close that we have all the cost saves in place, it could extend on just a few of them until month 13 or something like that. But even if it's later in that first year, the realization rate goes down. And so I would think that – I mean, we've got pretty much everything tracking towards the model still, feel really good about that. I don't think that sliding the conversion really changes the economics of what we put out in the slide deck in January because I think that our time from close to conversion is still going to be about what we've always anticipated it to be.

[Jeff Rulis:]

Okay, so that – just to confirm, you're saying one year from, call it, early August or early to mid-, you get half the cost saves in by August of 2018 and then 85% by August of 2019.

[Clint Stein:]

Yes, and I think that’s a fairly realistic but biased – a little bit biased towards the conservative estimate.

[Jeff Rulis:]

Got it, okay. And then another question for Andy on the potato and onion deterioration. I guess – and I hadn't heard much on that front, if you could just itemize what in that industry is causing pressure? Is it pricing? And then, I guess, thoughts on any kind of recovery or resolution down the road? Thanks.

[Andy McDonald:]

Yeah, so potatoes have been in a slump, price wise, for, gosh, almost four years now. So it's been long in the cycle. The surprising thing is, the most current pricing on potatoes has – actually it has shown fairly strong improvement. But most of the folks that are in potatoes are also in onions, so the onion market really just fell out, and prices now are half of what they were a year ago, and that's obviously a significant impact relative to just – you're looking at $14, then it drifted down and now you're looking at $6, so a significant change in the economics for onions. So it's really been driven by price and, obviously, the price is a function of supply.

[Jeff Rulis:]

And I guess is it triggers through your – where that goes into nonaccrual it's just been a – is it that onion piece that pulled the whole kind of group down to get to this stage?

[Andy McDonald:]

Yeah, I mean, what we do is, we forecast out. We're monitoring these credits on a budget, on a monthly basis. And there's always carryover from 2016 because the farmers never sell 100% of what they grow in any given year in the year they grow it. And so we are now looking at farmers who will have a difficult time paying off their 2016 crops, so there'll be a carryover from that. And then, when we look at what their costs are going into 2017, at the current pricing for both potatoes and onions, it's unlikely that they will make any money. So given the period of time in which the potato industry has been down, those guys were kind of somewhat benefiting from a little bit better of an onion market. That's gone away, so there's really no support for them, and thus, we've placed them on nonaccrual.

[Jeff Rulis:]

Got it, okay. Thank you.

[Operator:]

Next question comes from the line of Matthew Clark [Piper Jaffray]. Your line is open.

[Matthew Clark:]

Good afternoon.

[Hadley Robbins:]

Good afternoon, Matt.

[Matthew Clark:]

Just to speak to Clint, the core margin outlook from here. Your deposit betas are very muted. Just curious, if you think that will remain – it can remain that way for the balance of the year? And just thinking through the latest rate increase and how we might see that manifest into the higher loan yields from here?

[Clint Stein:]

Yeah, we’re seeing the repricing in the loan portfolio has been really favorable for the margin. If you take the investment portfolio and the premium amortization out, we would have seen a nice expansion in the operating margin for the quarter. We're seeing new stuff come on at higher-than-portfolio rates. We didn't really get any benefit off of the last rate increase in the quarter, so we'll see that flow through in the quarter, so we'll see that flow through in the third quarter. I think that – also, we typically – we've had, just like we do in the loan book, we have some seasonality with our deposits and it's not uncommon for us to have stronger deposit growth in the second half of the year than the first year. So I feel really good about the margin. I'm as optimistic as I've ever been that it'll continue to expand from here. On a side note, we just missed it for the quarter, we now roundup to 5 basis points for our cost of funds. We were rounding down, but I think if you carry it out a few decimal places, it's just a touch over 4.5 basis points for our funding cost. And that's a product of the – as I mentioned in my prepared remarks, we had some additional interest expense with the increase in overnight borrowings, but we also saw, during the quarter, just some funds with about a little $50 million increase that went into our commercial money market sweep product and the combination of – that's really what drove that increase and the cost of deposits to go up ever so slightly.

[Matthew Clark:]

Okay. And then, the merchant business that you guys decided to sell, just curious, again, in terms of the revenue expense impact. I think I may have missed it in your prepared remarks, I heard the pretax amount but I just missed that – the related revenue and expenses on annualized basis.

[Clint Stein:]

On an annualized basis, the revenue is about $23 million. The expense components are right at $20 million. So it's – there's variability from quarter-to-quarter, but as you're adjusting your model, if you use those amounts and break them into quarterly increments, you'll be pretty close. We think that it's going to drop, as I said, to about $1.5 million the first year, net contribution. From here on out, it'll all flow through non-interest income, there won't be the non-interest expense component. And we see that building back to the level that we're currently at with a net contribution at $3 million level. We see it building in the 24 to 36 month horizon, and then from there, we really think that we're going to be able to leverage the expertise of this third party and the technology they bring to the table and increase it further from there than what we could do on our own.

[Matthew Clark:]

Okay, great. And then just a follow on around credit for Andy. I love the color by the way. Can you just talk to the resolution of the $10 million? What your plan is to resolve that $10 million exposure? And what you've set aside, I guess, so far?

[Andy McDonald:]

Yeah, so hat we’re doing to mitigate our loss content within that portfolio is, we're working with the farmers and we're either taking the farm ground as collateral to bolster our position from a collateral standpoint, so that we're not reliant on the commodities that they're going but rather the farm ground itself, or we're working with the farmers who are getting loans from primarily government-sponsored agencies in which they're then able to inject additional cash proceeds, essentially allowing us to pay our loans down and give us a better margin between where our loan value is versus what the current market value of the collateral would be. So in both cases, real estate is the avenue of resolution. We do have certain specific allocations within the allowance, that's a little over $3 million. I have not broken out the number specific to the other credits and what they're drawing, but I would say that, in aggregate, we're probably somewhere between $5 million to $5.5 million in allowance. So it's fairly well covered.

[Matthew Clark:]

Got it. Thank you.

[Operator:]

The next question comes from the line of Aaron Deer [Sandler O'Neill] Your line is open.

[Aaron Deer:]

Hey, good afternoon everyone.

[Hadley Robbins:]

Hi, Aaron.

[Aaron Deer:]

I just wanted follow up again with Clint on the merchant card items. Just is the – is there going to be any timing differential between the drop-offs of the revenues or expenses? Is that fully hit here in the, I guess, with the third quarter?

[Clint Stein:]

That’s a good point of clarification. It is a transition that we're working through in the third quarter. So we executed the agreement early in the quarter. We've sold the portfolio but we're servicing the existing portfolio and transitioning to that new platform, really, throughout the majority of this third quarter. So I think that you're probably not going to see – there's going to be some noise in terms of – we'll still have some expense associated with that in our financials in the third quarter. By the fourth quarter, we should be pretty clean with what the new go-forward run rate is going to look like in terms of not having the non-interest expense but then also having the lower non-interest income.

[Aaron Deer:]

Okay, that’s helpful. And I guess the decision behind this, sounds like part of it is just related to the technology and the opportunity of working with this third party. But it did – did Durbin Amendment thoughts come into this at all? Was that part of the decision making?

[Clint Stein:]

Not directly, but certainly it's related. We've looked at the merchant program that we had over the years and came to the conclusion that with this arrangement and the ability to essentially double our dedicated sales force, get an improved products at, remove some of the operating risk that we have and be able to redirect capital that we were going to deploy that into the other areas of the bank, on the whole, provided a better net contribution to the bank.

[Aaron Deer:]

Okay. And then just one last question on that point and then I'll jump back. The – on the revenue side, it looks – Mike like this is going to come entirely out of the Merchant Service field and – but then, it looks like some additional comes out of maybe another line items. Is that out of deposit service charges? Or is that in the other line? Or where might we find the rest of those revenues coming out?

[Clint Stein:]

I have to follow-up with you on – off-line on exactly which line items. I don't have that committed to memory, sorry.

[Aaron Deer:]

Okay, no, that’s right. All right. I appreciate it guys. Thanks for taking my questions.

[Hadley Robbins:]

You bet.

[Operator:]

The next question comes from the line of Jon Arfstrom [RBC Capital Markets].

[Jon Arfstrom:]

Hey, thanks. Good afternoon.

[Hadley Robbins:]

Good afternoon.

[Jon Arfstrom:]

A few follow-ups. On deposit costs that's – they're exceptionally low, but just curious, how long do you think you can hold this level of pricing? And when you might start to see pressure?

[Andy McDonald:]

So I'll give you kind of a backlog and then ask Clint to weigh in. We – routinely, we look at where our market place is. And we're keen, in part, of the changes in our competitors, but we believe that we've been able to lag our deposit costs, at least historically, understanding, of course, it's been a long time using technologies out. So we've been able to lag our deposit costs fairly substantially on a historical basis, as I indicated. And so, it's a process that we're going to follow. We have a number of strategies on the shelf that we can pull off in the case that we see the market start to move. And the idea behind those strategies is to contain the range of increases to where we think that we have the most competitive pressure with few product types. Clint?

[Clint Stein:]

Yes, I think that also gets into the – some of the things that drove deposit growth, or a slight decrease in deposits during the quarter is that we're really looking at – and particular with some of our public fund customers, where we have operating accounts and we have their excess funds, and we've worked with a lot of them to send funds back to the local government pool because it's just too expensive and, quite honestly, we could fund it in other ways. And so just – we really take, I guess, a holistic view of the deposit base. We try to be rationale and smart about pricing and I do think rates are becoming – starting to become meaningful. And so that will create some upward pressure, right? I think that's a little bit of what we saw with the money markets going into that reciprocal sweep product we have. It's that people are looking at it and thinking now it's worth their effort to look at other alternatives. So I do think there will be some pressure, but I – consistent with my earlier comments about the margin, I think that we're seeing in terms of pricing and the new production and repricing in the existing parts of the loan portfolio, I still think that it bodes well for the margin and net interest income.

[Jon Arfstrom:]

Okay, that’s helpful. Just a couple more follow-ups as well. So Hadley, you mentioned in your prepared comments that the pipelines were good but they were below where they were a year ago. What do you think drives that? Or what is driving that?

[Hadley Robbins:]

It’s probably a number of things, and I'll kind of highlight a few that I think about. First of all, comparing to last year, that was the peak of production during the second quarter, and we are, collectively, year-to-date, a bit below where our production was last year and our pipelines are moving in the same way. The things that we're seeing out in the marketplace a bit are that the pricing and the structure is more competitive, and it seems to be a bit more each quarter. And as a consequence, we adhere to our disciplines, and that's disciplines both on pricing and credit structure, and have made decisions that we can compete to a point but not to the point where we're going to compromise. So that has an impact. We're also managing the exposure levels in our portfolio and that changes from quarter-to-quarter and that also has an impact as compared to where we were last year. Things to think about going into the third quarter are the payoffs and prepayment activity that was pretty high going into the second quarter and in the third quarter last year. We don't have that visibility that we did last year into that kind of activity but our expectations is that we may see less of payoff or prepayment activity. We also had some undrawn construction lines that have the ability to help us in the third quarter as well. So although that pipelines may be less than it was last year for some of the competitive reasons, the activity that drives net loan growth may be adequate to keep us pointed in the direction that would be consistent with prior year.

[Jon Arfstrom:]

Okay, thanks. And then just one final one for you, Andy. You could probably go back and add it up, but you may have it, of the $40 million in – $41 million in nonperforming assets, what percentage of that is ag related?

[Andy McDonald:]

About a little over 25%.

[Jon Arfstrom:]

Okay, 25 is ag and the rest…

[Andy McDonald:]

Yeah, we still have some leftovers from the great recession in the real estate area. We got a couple of contractors, the other stuff is pretty spread out across the portfolio.

[Jon Arfstrom:]

Okay, okay, thank you.

[Hadley Robbins:]

Thank you.

[Operator:]

The next question comes from the line of Jackie Bohlen [KBW]. Your line is open.

[Jackie Bohlen:]

Hey, good afternoon everyone.

[Hadley Robbins:]

Good afternoon.

[Jackie Bohlen:]

I was just looking at the fee line items, I know there's always a little bit seasonality in the second quarter after the first quarter, but items were just particularly strong this quarter. Is there anything that was a major driver of that?

[Clint Stein:]

Well, I think that part of it is, is the seasonality. Obviously the growth in the loan portfolio, our – we had a lot of great activity in our lending teams and we had, I think, a good quarter when it came to swap activity and swap fees, obviously those helped. But in general, I think it's just a product of first quarter is typically our toughest quarter and then it builds through middle part of the year.

[Jackie Bohlen:]

Was 1Q perhaps seasonally lower than usual given the leather?

[Clint Stein:]

You know as well as we do that the Portland metro area was shut down for most of January with snow and ice. And then, just in terms of line utilizations and some of those things, people were slower getting – going into spring in our ag book. And so intuitively, we believe that there was some impact there. If you ask us to put a number to it, I don't know that we can do that, but we just know that it did slow things down and activity was slow, especially during the winter storm times.

[Jackie Bohlen:]

Okay. Everything else I have has already asked. So, thank you.

[Hadley Robbins:]

Thank you, Jackie.

[Operator:]

There are no further questions over the phone. You may continue.

[Clint Stein:]

I want to follow-up on Aaron's question regarding the geography of the income and expense items for Merchant Services. So I was a little bit off when I was speaking of expense. In our financial statements, we actually net the processing expense associated with the merchant program out of that merchant processing revenue line item that you see in non-interest income. If we look back over the last four or five quarters, that number is anywhere from $3.6 million to $4 million a quarter. So on an annual basis, roughly about $15 million, $16 million of that $20 million of non-interest expense or expense impact, I guess, is going to come out of that non-interest income line item, that net merchant revenue service. The remainder is primarily going to come out of comp and benefits for the most part.

[Hadley Robbins:]

Well, if there are no further questions, thank you for attending. Bye-bye.

[Operator:]

And again, thank you all for joining us today. This concludes our program and you may now disconnect.