First Commonwealth Financial Corporation
Q2 2013 Earnings Call Transcript

Published: 24 Jul 2013

[Operator:]

Good afternoon, and welcome to the First Commonwealth Financial Corporation Second Quarter 2013 Earnings Conference Call. All participants will be in a listen-only mode. (Operator Instructions) After today's presentation, there will be an opportunity to ask questions. (Operator Instructions) Please also note this event is being recorded. I would now like to turn the presentation over to Mr. Rich Stimel, Vice President, Corporate Communications. Please go ahead, Rich.

[Rich Stimel:]

Thank you. As a reminder, a copy of today’s earnings release can be accessed by logging on to fcbanking.com and selecting the Investor Relations link at the top of the page and then selecting News on the left side of the page under News and Market Data. We’ve also included a slide presentation on our Investor Relations page with supplemental financial information that we’ll reference throughout today’s call. With me in the room today are Mike Price, President and CEO of First Commonwealth Financial Corporation; Bob Rout, Executive Vice President and Chief Financial Officer; and Bob Emmerich, Executive Vice President and Chief Credit Officer. After brief comments from management, we’ll open the call to your questions. Before we begin, I would like to caution listeners that, this conference call will contain forward-looking statements about First Commonwealth, its business, strategies and prospects. Please refer to our forward-looking statements disclaimer on page two of the slide presentation for a description of risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements and also if you would experience any sound issues with the call during the course of the call, please let the operator know. And with that, I’d like to turn the call over to Mike Price.

[Mike Price:]

Hey. Thank you, Rich. Good afternoon, everyone, and thanks for joining us on the call today. We genuinely appreciate your diligence and investment of time to understand First Commonwealth. With me today are Bob Rout, our Chief Financial Officer; and Bob Emmerich, our Chief Credit Officer, who will both speak to you in a few minutes. Our second quarter performance is disappointing, particularly in light of some of the transformative initiatives underway and some progress at First Commonwealth over the last year or so. Earnings of $0.06 per share for the quarter and $0.17 for the first half of the year, compared to earnings of $0.22 for the first half of last year are simply behind plan. The culprit is the last of some legacy development credits that were originated in the 2004 to 2007 timeframe. The past two quarters we have written down or disposed of our two largest non-performing loans. In the second quarter, a loan to a real-estate developer that has been with us since 2004 and had a balance of 18.6 million, this loan represented 10.1 million of our $10.8 million provision expense or about 94%. Bob Emmerich will provide more details in a few minutes. In the first quarter if you recall, we sustained a 3.1 million charge with the sale of an Eastern PA development credit that was our second largest non-performer at the time. Disappointingly, these two loans cost us approximately $0.09 per share in the first half of this year. I would share that the level and composition of our non-performing loans and classified assets continue to fall and in fact they are at four to five year lows. Also just 18 months ago, we had nine credits over 5 million that were non-performing. Now that number is only three. A common theme among our best in class competitors is strong credit metrics. We believe that our credit leadership and infrastructure that we have will put us in place and will enable us to have consistently strong credit metrics over time. I’ve shared our strategic themes with this audience in the past, and our first theme is to build a strong independent credit infrastructure that produces competitive advantage over time. Shifting gears, we have now grown loans at six of the last seven quarters despite some unique headwinds that include intensive de-risking of the balance sheet and the lack of a purchase First Money Mortgage offering. We’ve reduced loans over $15 million by nearly 50% over the last few years and we continue to let deals go that don’t align with our community bank positioning. And when I say let deals go, I am not just talking about new opportunities, but credits that have performed and on our balance sheet and do not meet our current risk appetite. Our production in our retail and corporate bank is good and has set records each of the last two years. But as you know, loan structures and pricing are under significant pressure. Just a reminder, we’re still liquidating a substantial First Mortgage portfolio, since we have not been in the purchase Money Mortgage business for seven years. That has created a headwind to loan growth, hurt our non-interest income and even our margins. We’re patiently looking for the right entrée for First Mortgage and have passed on three acquisition opportunities over the last 12 months. We now plan to enter that business via a de-novo effort. During the second quarter, our net interest margin fell 10 basis points and has dropped 28 basis points year-over-year. Bob Rout will discuss but we believe that the NIM compression we are experiencing is moderating. We’ve built a good core franchise in retail and corporate banking and our cross selling in ticking up. We look to capitalize further and we see continued opportunities for non interest income generation via better integration in delivery of our wealth services. The good news is that we have a loyal and satisfied customer base. We’ve shared this before, but our objective measures to include J.D. Power ratings recently are on customer surveys and brand work all point in the same direction. We’ve made good incremental progress on expenses in the conversion of our bank systems and processes represent a transformative opportunity to improve our operating efficiency. It also sets the stage for rethinking our distribution in this digital age. We have been in negotiations with three technology vendors to transform our IT environment and simultaneously reduce our overall cost, improve our integration and upgrade our solutions. We will look to give you more detail either prior to or in conjunction with our third quarter earnings. But obviously this technology conversion represents a catalyst to improve deficiency in financial performance. The nature of our conversion will magnify both the upfront charges as well as the long terms savings. A few other noteworthy items from the second quarter. First, in June, we announced the hiring of Jane Grebenc, as the President of First Commonwealth Bank and Chief Revenue Officer for the corporation. Jane has deep executive experience in retail banking, the mortgage business, business banking wealth in operations at both large and smaller banks and she will be at the forefront of our continued efforts to build our best in classed sales and service culture, enhance it, add new revenue streams and improve efficiency across the organization. Secondly, we’ve opened our loan production office in Cleveland. This is a market we are intimately familiar with and one that offers immediate opportunities. Our business center manager is now in place and we have already begun to book assets and in fact we have a good portfolio there already. Third, we’re closing, we’re close to naming an executive to lead our mortgage efforts as well and ideally we would be in a position to offer our mortgage product in the first half of 2014. So, progress towards strategic objectives continues but not with that challenges while our improved competitiveness has not yet translated in potentially better financial results as of yet. First Commonwealth is executing on a clear path to become the best in class performer that begins with lower long term credit cost, growing revenue, improved efficiency and affectively navigating the environment we find ourselves in. With that, I will turn it over to Bob Rout for a brief financial review.

[Bob Rout:]

Thank you, Mike. And welcome everyone. As Mike just mentioned, the big issue in our performance this quarter is the cleanup of our lingering credit issue. Bob Emmerich will be discussing net credit in his presentation. So I will focus my discussion on the remaining pieces of the income statement. The net interest margin continues to be pressured declining $0.10 basis points on a linked quarter basis. Net interest income actually increased in the same linked quarter comparison about 300,000 due to more days in the quarter and the growth in earning assets. About 5 basis points of that net interest margin change is related to less fees, primarily from our corporate syndication function. We also had a 10 basis point decline in our investment yields. During the quarter, we added approximately $100 million of mortgage related securities growth. The purpose of this strategy was to increase net interest income and to use excess liquidity in interest rate risk flexibility until loan growth becomes more meaningful. The loan growth that we did get this quarter was in the home equity and indirect auto portfolios where competition is starting to pressure those yields. Commercial loan growth this quarter was affected by the aforementioned charge off by not renewing a couple of large commercial real estate loans that were outside of our market as part of the portfolio de-risking that Mike was mentioning earlier and the resolution of some smaller problem credits that Bob Emmerich will discuss in his upcoming presentation. On the positive side with respect to the margin, we pulled down our core deposit rates another couple of basis points and the early redemption of the 33 million of 9.5% fixed rate TruP borrowings should benefit our margin 4 to 5 basis points going forward. Traction in our small and middle market lending activities and the shift in the yield curve will be a major factor in getting the net interest margin trending upward once again. We see some of that now occurring. There was not a lot of unusual activity or variances in the non interest income this quarter. But on the year-over-year comparison, we had some nice gains on some troubled loan sales in 2012 that were not repeatable here in 2013. We did earlier this year get a $900,000 positive adjustment on our commercial loan swaps as a result of better credit quality metrics in that portfolio. One time charge of $1.6 million for early TruP redemption is masking some of the core improvements in non-interest expense. Less OREO and other collection costs as our credit quality improves is especially helpful. I've mentioned previously that our goal is to get this core non-interest expense run rate down below $40 million a quarter. We are essentially there and believe that our planned IT conversion will push that number to even lower levels. That IT conversion is currently in sensitive end stages and negotiations so we are not yet prepared at this time to discuss conversion costs or projected benefits, but because we are currently an in house IT system, the obsolescence charge in conversion cost for abandoned hardware and software will be higher than most organizations or just moving from one outsourced IT vendor to another. These costs are dependent upon vendor selection, thus our hesitancy in disclosing any specifics at this time. We obviously get questions concerning our effective tax rate as it's currently 26% and a $75 million common stock buyback continues to move along. Currently we have approximately $14 million remaining in that authorization. So with that I'll turn the microphone over to Bob Emmerich for an update on credit, thank you.

[Bob Emmerich:]

Thank you, Bob. In the second quarter 13.1 million of our 15.6 million total charge offs and as Mike said 10.1 million of our 10.8 million of total provision expense were from one loan. I'm sure you'll have keen interest in that and that will be the focus of my remarks. The bank's largest non performing asset at 3/31 was the $18.6 million remaining balance on an original $46 million unsecured loan to a Pittsburg bill state developer. You may recall in December of 2010, the bank entered into a forbearance agreement with this borrower and with other banks that had loans made under similar terms to the same developer. At that time the borrower refinanced his properties and was able to take cash out and pay the banks down. Our share of that pay down at the time was $8 million, the banks agreed to accept interest only for 42 months after which time the assets would be sold or refinancing the bank would receive further proceeds. In the fourth quarter 2010 First Commonwealth charged the loan down by 15.4 million. So what the expected net proceeds would be from the sale or refinance of the borrower's assets. The bank also assessed a reserve on part of that remaining balance and we have adjusted the reserve balance each quarter subsequently. Analysis to support the reserve assessment has usually been based on the net operating income of the properties and current cap rates. We're now getting close to the end of our forbearance period and have been meeting with the borrower to develop a liquidation plan that will be acceptable to the bank group. There are seven principal assets that would be the source of our proceeds, five of the assets have held up in value to what the bank's expectations have been, two of the assets have declined sharply in value. Since the source of our proceeds is the borrower's net equity in the assets, this valuation decline has had a significant impact on our expected proceeds. Given that we do not see anything in the market that's going to improve the situation, the bank has decided to charge the loan down to the low end of the revised range of expected proceeds. The bank has also placed a reserve on that remaining balance so that our net exposure is less than $3 million. We are obviously very disappointed and frustrated that this asset has continued to drag down our results. In the second quarter our non performing loans were down $5.2 million to $73.1 million or 1.73% of total loans. The major reductions were these, first, the aforementioned $13.1 million charge off on the $46 million exposure discussed above. Second, the bank sold the share of the notes for our resort project in Orlando, Florida that has been previously disclosed. The book balance on this note was 3.5 million and we received 3.8 million and showed a gain on sale of just under $300,000. Third, the bank restored to a cool status $2.5 million in loans to a contracting company whose operations and cash flow have improved. Inflows of new non accruals during the quarter were $16 million. There were three larger accounts that made up most of that total, first was a $7.7 million commercial mortgage on a warehouse in Pittsburg. The note matured in February. The borrower was not able to refinance this loan, nor was he willing to accept the bank's terms for extension. So the bank is pursuing foreclosure. We have a new appraise on the property and no reserve assessment was required. Second, $3.3 million in loans to a Western Pennsylvania metal servicing operation. This borrower has filed bankruptcy. There is a small reserve assessment on this loan. Then third, a 3.1 million in loans to a Western Pennsylvania manufacturer. The borrower’s major customers were military contractors and their sales have declined sharply. There is no reserve assessment for this borrower. The nature and size of the nonaccrual inflow has greatly improved over what the bank experienced in 2009 to 2011 time period, with generally lower provision expensive tabs to these assets. The balance of our other real estate owned was up $4.7 million. All of this increase can be attributed to an agreement with a Pittsburgh developer to accept deeds in lieu on four properties to satisfy three of its notes that had a principal balance of $5.7 million. Charge-offs totaling 900,000 were taking on these notes at the time properties were taken in OREO. Given the increase in OREO, total nonperforming assets were only down 700,000 to 89.3 million or 1.45% of total assets even though there was not much improvement in nonperforming assets during the quarter we did see improvement in our classified loans which declined $33 million to a $112 million. [ALLL at] [ph] quarter end was 57.5 million or 1.36% of total loans down from 1.48% at March 31st. Although the reserve is lower than prior quarters, we believe it is at an acceptable level reflective of lower specific reserves on our impaired assets, improvements in delinquency, loss history and the level of classified assets that concludes my remarks on credit and I will now turn back to Mike Price.

[Mike Price:]

Yes, operator, we’d now like to open the line for questions.

[Operator:]

(Operator Instructions) The first question comes from Bob Ramsey of FBR. Please go ahead.

[Bob Ramsey:]

First question, I was hoping you could talk a little bit more about net interest margin. The compression was a little more than the 5 to 7 basis points, I think you sort of expected coming into the quarter. I am curious, you know what changed and how you are thinking about margin, the margin outlook from here?

[Bob Rout:]

Bob, it’s Bob Rout. Two issues, we added more to our security’s portfolio because the loan growth was not quite what we had expected. We also talked a little about our fee revenues from our syndication desk was not as high as it has been running typically. And we are not giving you a forward-looking information on the margin but we think it’s moderating at this time. Certainly with the most recent rise and interest rates on the long term anyway, that’s starting to have a very beneficial effect to the reinvestments of our maturing securities.

[Bob Ramsey:]

Okay, that’s good to know. Where are you actually purchasing securities and where are you reinvesting the securities book?

[Bob Rout:]

Primarily mortgage-backed securities, CMOs with the duration probably slightly under 4 years. And this helps offset some of the runoff that we’ve been experiencing in our first mortgage portfolio which is typically running $50 million to $60 million a year. And quite obviously, the runoff that we’re getting in mortgage loans replace them with mortgage securities is yield certainly [at a stretch] [ph].

[Bob Ramsey:]

And I guess I was curious, what you’ve actually been reinvesting at in terms of yield on the securities book?

[Bob Rout:]

We have our treasurer here, Mark (inaudible). Mark can you give them just the…

[Unknown Company Representative:]

Sure. With the back up in interest rates mortgage backed securities right now 15 year you’re probably close to over 2.5%. We’re also looking a 10 year [AM] [ph] paper which right now is about 2% even. CMOs are probably in that 2.25 to 2.35 range.

[Bob Ramsey:]

Okay, that’s helpful, and then maybe if you could just talk a little bit about the plans on the resi mortgage origination business and I’ll hop back out of the queue but I’m just curious, you know, how quickly you’re thinking about getting this business up and running if you’ve got any sort of goals or what origination volumes could look like in 2014 and how much of the resi runoff you think this business will be able to offset?

[Mike Price:]

It’s just a couple comments, you know when you began the journey and got out of the mortgage business 7 years ago, we had about a $650 million to $700 million portfolio. So we’ve had that headwind running against us. You know, as a side note I think that also is why our margin has had more downward compression because we haven’t had a good slug of three quarters of the billion dollars sitting there at a longer rate to make our mortgage more buoyant or I mean our NIM more buoyant. As far as the entrée to the mortgage, we’ve looked at a couple of acquisitions. Quite frankly everybody wanted to sell it five times high earnings when we wanted to average three or four years of earnings, so we didn’t want to overpay. We are kind of at a place now particularly with Jane Grebenc joining us, she knows mortgage very well that we can get a seasoned executive and really go into it on a de novo basis, we hope to have an executive in house here in the second half of the year. And ideally, in the first half of next year, begin to be making mortgages. I would also share that the figuring up the volume is not that hard. I am not going to give you a number but it’s basically just taking the number of branches, our branches do a pretty good job of selling consumer loans, our customer base is very loyal and we have high market share in these communities outside of Pittsburgh in particular and we are a natural fit there and you just do the math that one and half to two and half mortgages and times x mortgage amount and it’s a good business.

[Operator:]

(Operator instructions). The next question comes from Collyn Gilbert of KBW. Please go ahead.

[Collyn Gilbert:]

Bob, just a follow up on the securities discussion, so what is your plan in terms of outstanding if you want to keep that flat? Do you want to grow it? I mean I know you commented obviously on the yield change going on there, but what about just the overall size of the portfolio?

[Bob Rout:]

We plan to stay where we are at Collyn. We think internally generated funds will take care of any mortgage growth or any loan growth that we have coming up. However if we would start to experience greater growth than we have so far this year then we have the capacity to redirect those funds into the lending business rather than the portfolio.

[Collyn Gilbert:]

Okay, and if you have said and I missed that I apologize but the yield that you are seeing on your new loan originations and I am sure obviously it varies over the buckets, but what is that on average?

[Mike Price:]

On the commercial side, we are still on average for the portfolio in the high 2s to the low 3s. The compression has been more on consumer and the indirect side with the margin.

[Collyn Gilbert:]

And when you say high 2s low 3s, is that over LIBOR?

[Mike Price:]

Yes, that spread.

[Collyn Gilbert:]

Okay.

[Mike Price:]

[Subtract] [ph] that with the recent month and then at 12 month average and look at that every month.

[Collyn Gilbert:]

Okay, I guess, Bob just trying to reconcile the NIM stabilizing here and is it the fact because it still seems like the new origination both on the security side and the loan side is still coming on lower than the portfolio yields of your earning asset buckets. So is it, I am just trying to understand why the NIM would stabilize versus compress a little bit here further?

[Bob Rout:]

Well, Mike was talking to you about spread which is LIBOR based and we have probably most of our loan portfolio is LIBOR based and the fact that we could get with the longer rates moving up that’s going to provide a better yield on those new loans coming in that are not LIBOR based. Our interest rate forecast is not indicating any rise in the short term rates for at least another year. So that’s something that we are going to have to live with. So, yes, we will be seeing some price rise, yield increases within our loans and we have already seen increased yields on reinvestment rates for securities and as you know the securities market reacts quicker than what does the loan pricing environment.

[Collyn Gilbert:]

Okay, that’s helpful and then Bob, just tying in all of your comments that you have made on credit and watch list, everything you have got going on, do you have a general sense of what do you think the net charge off ratio will be for the second half of the year?

[Bob Rout:]

That’s not a projection we are willing to give, Collyn.

[Operator:]

(Operator instructions). We have a question from Matthew Breese of Sterne Agee. Please go ahead.

[Matthew Breese:]

I just wanted to be clear on the mortgage origination business. That’s a for balance sheet business not a gain on sale business, correct?

[Mike Price:]

It will be both.

[Matthew Breese:]

It will be both. So I am assuming you guys would be selling the conventional paper and keeping some of the shorter duration stuff?

[Mike Price:]

You got it.

[Matthew Breese:]

And as far as the timing goes, when do you guys expect that?

[Mike Price:]

Probably latter part of the first half, second and third quarter of next year.

[Matthew Breese:]

Okay and then maybe you guys can talk about the provisioning expense, going forward from here extra large one time charge off this quarter. Is there a way we should be thinking about it as to how to model it?

[Bob Rout:]

This is Bob Rout here. It's probably the same response I gave Collins not something we're looking to project. But I would look to the improvements within our classified and criticized assets, for indicators that we're feeling very good about. We're also feeling very good about the size of the non-performing loans and the collateral valuations that we currently have in that portfolio. It's certainly a refreshing change over what we've experienced the last four years. So we're positive but also very cautious at this point.

[Mike Price:]

Matt this is Mike. It was only two or three years ago, when we looked at our infamous ten non-performers. They were out there. Now we have three over 5 million which I think is more in line with what you would expect from a bank of our size. So that will take some pressure off.

[Matthew Breese:]

Okay.

[Bob Rout:]

The other thing Matt that I wanted to mention is the benefit that we're getting from OREO and inflection cost and non-interest expense has been significant. And especially with this last piece of property in Florida that we sold, that was just a tremendous expense drain for a number of years and we’re glad to see it gone.

[Matthew Breese:]

Maybe tying that into the overall IT conversion, without giving too much guidance on the expense front, what kind of efficiency ratio are you guys eying over the next year or so? I know you have mentioned in the past you wanted to be in the top performing kind of quartile banks. So maybe you could give some color around that again?

[Mike Price:]

It's just; I would share this we're not barking on this IT conversion for a couple of million bucks. So I will leave it at that. And we'll have perhaps more color commentary there shortly, once we get beyond the negotiation phase. And we're looking to get sub 60 into the 50s in the next couple of years.

[Matthew Breese:]

And as far as the system conversion goes I mean, the negotiation process and there is the actual conversion, when is that expected to happen?

[Mike Price:]

Great question, typically nine to 12 months after you set up a conversion with the vendor.

[Matthew Breese:]

So it's really more of a back half 2014 event?

[Mike Price:]

Yes.

[Matthew Breese:]

That's all I had Thank you guys.

[Operator:]

(Operator Instructions) This concludes our question and answer session. I would like to turn the conference back over to Mike Price for any closing remarks.

[Mike Price:]

Thank you again for your attention and your interest in First Commonwealth, I know we'll be on the road with a number of you over the course of the next quarter. So sincerely look forward to that. The keys for us are very simple. Lower long term credit costs, growing revenue. We will add more legs to the revenue stool so to speak. Improved efficiency and we feel like we have built a couple of good engines in our core retail and corporate banking franchise, and really look forward. The businesses are a lot of fun, to really willing those in the market place and winning and extending our franchise. So thank you and look forward to being with you shortly.

[Operator:]

The conference is now concluded. Thank you for attending today's presentation, you may now disconnect your lines.