Financial Institutions, Inc.
Q3 2022 Earnings Call Transcript

Published: 28 Oct 2022

[Operator:]

Hello, and welcome to today's Financial Institutions, Inc. Third Quarter 2022 Earnings Call. My name is Elliot, and I'll be coordinating your call today. [Operator Instructions]. I'll now like to hand over to Kate Croft, Director of Investor and External Relations. The floor is yours. Please go ahead.

[Kate Croft:]

Thank you for joining us on today's call. Providing prepared comments will be President and CEO, Marty Birmingham; and CFO, Jack Plants. Community Banking Officer, Justin Bigham; Chief Administrative Officer, Sean Willett; and Director of Financial Planning & Analysis, Mike Grover, will join us for Q&A. Today's prepared comments and Q&A will include forward-looking statements. Actual results may differ materially from forward-looking statements due to a variety of risks, uncertainties, and other factors. We refer you to yesterday's earnings release and investor presentations as well as historical SEC filings available on our Investor Relations website for a Safe Harbor description and a detailed discussion of the Risk Factors relating to forward-looking statements. We'll also discuss certain non-GAAP financial measures intended to supplement and not substitute for comparable GAAP measures. Reconciliations of these measures to GAAP financial measures were provided in the earnings release filed as an Exhibit to Form 8-K. Please note that this call includes information that may only be accurate as of today's date, October 28, 2022. I'll now turn the call over to President and CEO, Marty Birmingham.

[Marty Birmingham:]

Thank you, Kate. Good morning, everyone, and thank you for joining us today. During the third quarter, our company produced solid results, including net income available to common shareholders of $13.5 million or $0.88 per diluted share. These results were impacted by non-recurring enhancement from a company-owned life insurance surrender redeploy strategy that Jack will discuss in his remarks, a $4.3 million provision for credit losses, and $312,000 income and fees associated with the Paycheck Protection Program. Adjusting for these items, pre-tax pre-provision income for the quarter was up $770,000 or 3.9% from the prior year, when we record a $541,000 benefit for credit losses and a $1.4 million of PPP related income and fees. Organic loan growth was certainly a highlight in the third quarter, with loans growing 2.7% from June 30 or 2.9% when excluding Paycheck Protection Program loans. The strength of our commercial lending franchise was the driving force behind this double-digit annualized loan growth. The commercial business portfolio, excluding the impact of PPP loans, grew 4.8% from the end of the second quarter. Commercial mortgage was up 8% as much of our committed backlog at June 30, 2022, successfully closed during the third quarter. Since starting with us in February, our new Mid-Atlantic team has hit the ground running and their contributions are evident in our results. As of September 30, they brought on approximately $69 million in outstandings with around $41 million of that coming on during the most recent quarter. This team, which serves the Baltimore and Washington, D.C. region, is also contributing meaningfully to our current commercial pipeline. As we focus on building the Five Star brand in this market, I'm confident in the strength and experience of the team we've added and the high quality nature of the relationships they're bringing on Board. For example, most of our Mid-Atlantic loans are tied to stabilized and matured mortgages, along with some construction lending with excellent sponsors. The average loan to value ratio for this portfolio is approximately 55%. The vast majority of these loans are for office space in the Washington, D.C. Metro that are primarily located in heavy trafficked areas near hospitals, and have a fair amount of medical leasing with high occupancy levels. The success today of the Mid-Atlantic team, together with our long-term track record of credit-disciplined loan growth, and well defined strategic and risk frameworks, give us confidence in this strategy as we continue to evaluate opportunities for growth. As pleased as we are with our commercial performance, we are aware of and are closely monitoring the challenges that the current economic environment poses to our company and our customers. Like the rest of the industry, we are seeing pricing pressures amid the inflationary environment that require us to be very thoughtful as we evaluate opportunities. The quality of our portfolio remains strong, which we're committed to defending. We remain focused on building deep relationships with high quality sponsors in our markets, including our core Upstate New York geography that performs consistently in periods of both economic expansion and recession. Turning to the consumer side of our business. Our residential portfolio grew 0.7% during the quarter, but was down 1.2% from the third quarter of 2021. Home equity volume continues to rise, helping to balance the software activity we're seeing for purchase mortgages and refinancing requests. Many of the pressures we discussed with you on our last call, including inflation and rising interest rates and tighter housing inventory remain headwinds in the near-term. That said, we are driving continued operational efficiencies to further enhance our underwriting and application process and are pleased with the strength of the talent we've brought on recently who are helping us with these initiatives. Our consumer indirect portfolio stands at $997.4 million as of September 30, down 4% from the linked quarter, but up 6% from the year ago period. In terms of application volume, we are still seeing sufficient demand for vehicles and loans. In addition, there's a good deal of M&A activity within the dealer space, which creates disruption in opportunities that we are well-positioned to capitalize on having a strong reputation in our network of more than 500 franchised new auto dealerships. While we did see an increase in charge-offs on this portfolio in the third quarter, we view this will return to a more normalized level following exceptionally low levels in 2021. Before turning the call over to Jack for additional details on our financial results and an update on guidance, I'd like to spend some time this morning on our Banking-as-a-Service or BaaS operating system, which enables our FinTech partners to offer banking products and services to their end customers. This is a fee-based line of business aligned with our risk appetite and credit discipline focus driven by fees from servicing, interchange, advisory, and other revenue sharing opportunities. Additionally, BaaS provides the potential to generate lower cost deposits and enhanced loan diversification. Our BaaS pipeline is beginning to translate into success, and we anticipate it growing through the remainder of 2022 and into 2023. As we noted in our Investor Presentation, we have several partnerships in various stages of onboarding. Earlier this month, our sponsorship with ATMOS Financial went live. ATMOS is a FinTech aimed at affinity groups focused on climate positive banking. While this partnership is early stage, we are encouraged by the opportunities to enable their mission and success. Additionally, we are exploring expanded opportunities to increase revenue while helping ATMOS fulfill its mission. ATMOS proven ability for customer acquisition gives us confidence as this partnership also allows us to lean into the fast growing green finance segment of the market in a responsible way by partnering with FinTech that exclusively works in that niche. This unique partnership perfectly illustrates our thoughtful and disciplined approach to BaaS, which focuses on partners that are complementary to our risk appetite and values, and which have the potential to contribute to both our income statement and balance sheet. We've also found that our approach to engaging with FinTechs on a one-on-one basis as opposed to using connectors to bring in those relationships is beneficial for both sides. While it creates a somewhat longer process, it allows both parties to more fully understand the challenges and opportunities to mutually drive near and long-term growth and value. Our BaaS model is centered on a measured direct integration and rollout of clients such ATMOS, which helps the bank avoid some of the challenges and regulatory pitfalls affecting some others in the BaaS space. It's now my pleasure to turn the call over to Jack for additional details on our financial results and an update on 2022 guidance.

[Jack Plants:]

Thank you, Marty. Good morning, everyone. For the third quarter of 2022, solid organic loan growth and continued net interest margin expansion in the current rising rate environment, supported net interest income of $43.1 million, up $1.5 million from the linked quarter. Just over $6 million and $23 million of PPP loans were forgiven in the third and second quarters of 2022 respectively with the related fee accretion of $297,000 in the third quarter as compared to $756,000 in the second quarter. In total, we have just $2.8 million of PPP loans remaining as of September 30. NIM on a fully taxable equivalent basis was 328 basis points for the third quarter of 2022, up 9 basis points from the linked quarter and 21 basis points from the third quarter of 2021. Investment securities were down due to the impact of rising interest rates on the market value of the portfolio, as well as the deployment of portfolio cash flow to fund loan originations during the third quarter. Our investment securities portfolio is primarily comprised of agency wrapped mortgage-backed securities with intermediate durations, which provide ongoing cash flow coupled with investment grade municipal bonds that are classified as held-to-maturity. Cash flow from the securities portfolio allows for reinvestment into loans for additional investment securities. Our cost of funds was 58 basis points in the current quarter, up from 28 basis points in the linked quarter due to the impact of higher rates on wholesale borrowings and reciprocal deposits. Non-interest income, which includes revenue from our insurance and wealth management businesses, was $12.7 million for the third quarter, up $1.3 million or 11.4% from the second quarter of 2022. SDN Insurance Agency generated $1.6 million of insurance income for the third quarter while Courier Capital and HNP Capital contributed $2.7 million of investment advisory income. Non-interest revenue categories with the largest changes quarter-over-quarter were as follows

[Marty Birmingham:]

Thank you, Jack. Our company has made excellent progress in recent quarters to ensure all our business lines are well-positioned in the current challenging economic environment. We brought on an exceptional talent, expanded our geographic reach, and significantly enhanced our digital capabilities and offerings. In turn, these actions are enabling us to enhance the efficiency of our team, improve the customer experience, and expand our client base to reach FinTechs and other non-bank financials. We believe this is the right recipe that build long-term value for all our stakeholders, including our shareholders, our customers, and our communities. Thank you. Operator, please open the call for questions.

[Operator:]

Thank you. [Operator Instructions]. Our first question comes from Damon DelMonte from KBW. Your line is open.

[Damon DelMonte:]

Hey, good morning, everyone. Hope everybody's doing well today. Thanks for taking my question. Just wanted to ask questions about the margin and I appreciate the guidance and the color Jack that you provided and noted that you had said that the -- you looked at the balance sheet as being relatively neutral to rates. So I'm just kind of wondering, once we get through like these next couple hikes or towards the end of the year, kind of how you think the balance sheet will react as you go into 2023. Do you think that the little bit of bump you see here in the fourth quarter is kind of your peak and things kind of level out or do you think there's still opportunity for margin expansion into 2023?

[Jack Plants:]

Thanks, Damon. That's a great question. So as I unpack that a little bit, I look back at our historic deposit betas throughout the year. So year-to-date total deposit betas were around 11% and that was just based upon the amount of lag that we saw during the first half of the year, the year to rate increases. During the third quarter, they pushed up to about 20%, which is in line with expectations for the fourth quarter. So I would anticipate a modest amount of margin expansion through the fourth quarter as we expected and guided to and for that to continue into 2023.

[Damon DelMonte:]

Got it. Okay. That's helpful. Thanks. And then, obviously, credit -- credit on a whole is really strong with you guys and your guidance of historical NCOs of 35 basis points to 40 basis points. When we look at that number and we think about loan growth and we kind of factor in what the outlook looks like for the reserve level, is provision pretty much going to be driven with the 35 basis points to 40 basis point charge-off as one component? Is the provision going to be kind of reflective of what the current reserve level is? I don't know if I asked that correctly. Basically I'm saying is your provision going to fluctuate in order to keep your reserves flat with that level of charge-off?

[Jack Plants:]

Yes, this is Jack. I'll take that question. So our coverage ratio right now is about 114 basis points, and that's in line with our CECL day one adoption level. And just given the current economic outlook, I'm very comfortable with that coverage ratio and just given the credit quality of our portfolio. And you're correct in that expectations would be to provide for about 35 basis points to 40 basis points of NCOs along with loan growth. The one area that's a little hard to forecast is national unemployment is that is our quantitative driver for our model, and that is certainly influences the output there. So we'll continue to focus on providing for a coverage ratio that I think aligns with our expectations of that 114 basis point level.

[Marty Birmingham:]

And Damon, just to emphasize the point that Jack just made, I think in this quarter, Jack, the outlook for unemployment obviously is longer-term is increasing and that's was a driver of our increased provision expense this quarter in addition to what was required to support the commercial loan growth.

[Jack Plants:]

Certainly.

[Damon DelMonte:]

Got it. That's great color. Okay. That's all that I had. Thanks a lot. I appreciate it.

[Marty Birmingham:]

Thanks so much, Damon.

[Operator:]

Our next question comes from Alex Twerdahl from Piper Sandler. Your line is open.

[Alex Twerdahl:]

Hey Jack, you alluded to the cash flows from the securities portfolio. I was wondering if you could just provide us sort of what your expectations are in terms of the cash flows from securities on a monthly or a quarterly basis over the next few quarters.

[Jack Plants:]

Yes, actually we run a projection each quarter for a 12-month view just based upon current rate environment and prepayment expectations. So just principal cash flow off the portfolio right now is models about $150 million over the next 12-month period.

[Alex Twerdahl:]

Okay. And then, if I remember correctly, the indirect auto portfolio also is a pretty short duration throws up a lot of cash on a monthly basis. Do you happen to have the numbers about how much cash come off of the indirect auto book as well?

[Jack Plants:]

Yes. I think that our expectation for that portfolio is right around $30 million a quarter.

[Alex Twerdahl:]

Okay. So almost the same amount. And then, as you think about sort of managing the balance sheet, obviously we've been very focused on seeing loan growth over the last couple of years and it's been great to see. I'm just curious as rates go up and obviously funding pressures amount, and I know the municipal funding has been really competitive in your markets and some of these other things. I'm just curious how you're thinking about managing that liquidity if it -- if most of it you expect to go back into loan growth or if you think maybe there's some opportunities to do some other things and sort of optimize the balance sheet from a funding perspective as well with that -- with that additional cash coming free.

[Jack Plants:]

Yes. We have a pretty healthy pipeline on the commercial side with a committed backlog and then just overall opportunities there. So my expectation would be to use that cash flow to support loan growth.

[Alex Twerdahl:]

Okay. So and but based on the pipeline in the commercial portfolio, maybe the loan growth kind of becomes a little bit more commercial focused. I know that obviously indirect has been a fantastic supplement, but do you think we see that mix shift a little bit towards commercial in the next 12?

[Jack Plants:]

I think that's right, Alex. That's consistent with really what we've been trying to do in general anyway, prior to the pandemic was to moderate the indirect exposure and continue to drive well all other loans.

[Alex Twerdahl:]

Awesome. On the salaries and benefits line, which is up like $1 million over the last quarter, how much of that is due to just normal wage increases versus other things that might be in there like I know, if I remember correctly, you guys self-insure and maybe medical expenses tend to pick up a bit in the third and fourth quarter of the year. I'm just curious how much of that might stick around into early next year versus the component that might be harder to project?

[Jack Plants:]

Yes, about $350,000 of the increase was driven by medical claims, which were up in the third quarter, and then about $450,000 of it was just pure salaries.

[Alex Twerdahl:]

Okay. And are you guys at this point consider yourself to be pretty close to fully staffed, are you still looking to bring on more people?

[Jack Plants:]

We have open requisitions for placements of turnover that we've had throughout the year. But I think that we're appropriately staffed at the stage of the game. And as we look at other additions next year, it'll be viewed under the lens of a business case and essentially looking for folks that pay for themselves.

[Marty Birmingham:]

I just would editorial comment, that's an ongoing and very rigorous conversation that occurs frequently amongst our senior management team in cascading through other managers in the company.

[Alex Twerdahl:]

Okay. That's great. That's all my questions for now. Thank you.

[Marty Birmingham:]

Thank you so much.

[Operator:]

[Operator Instructions]. Our next question comes from Erik Zwick from Hovde Group. Your line is open.

[Erik Zwick:]

I appreciate all the kind of detailed expectations for the fourth quarter and I guess kind of what I'm curious about today thinking about the loan portfolio sounds like it's still strong now, and you've indicated that it's leaning towards more commercial given the environment. And I know it's tough to lookout more than a quarter at this point, given all the uncertainty in the market. But curious, if you're seeing any indications that, that higher interest rates and uncertainty over potential recession in 2023 are having any impact on either bar or sentiment or the pipeline. I'm just curious how that might translate into loan growth in 2023 and whether some of the -- if there are some offsets there whether just the fact that you've added the Mid-Atlantic team, which seems to really be ramping up nicely, could act as an offset. I'm just kind of curious about how that might impact longer-term loan growth.

[Marty Birmingham:]

So I think that definitely sentiment is evolving fast given what's happening in the economy and the outlook for the economy. Some of the offsets that you talk about does relate to the additional team that we have working for us in Mid-Atlantic. We've also been continuing to reinforce and bolster our small business commercial team as well as in general across the commercial business. So the pipeline as it's currently stand today is strong. We've got commitments flowing through over $200 million I think for the fourth quarter that's expected. And generally the pipeline is closer to $800 million as we speak today across the entire line of business. That being said, though, our borrowers are being very careful and thoughtful relative to incremental borrowing and revisiting underlying projects if they haven't funded yet or closed or under consideration in terms of the impact of higher rates, requirement for more equity, contribution or however else the knockdown effect is given what's happened to induced rates.

[Erik Zwick:]

That's helpful. Thank you. And just last one from me, just curious if you could refresh on your thoughts around buying back shares today in today's environment. Certainly bank valuations are depressed versus maybe historical averages, but there's also the uncertainty regarding the economy. Certainly the AOCI impact well, you've clearly illustrated is temporary. But that just may be from an optical standpoint weighing on decisions that also just curious how you think about the opportunity to repurchase shares today.

[Marty Birmingham:]

Well, I think you've listed the key issues that would factor into a decision like that. We do have a program that is currently in place and to the extent that we used it, would use it, we would have to consider everything you just referenced. Historically, when we have bought back shares, we've been very pleased with the return, the capital investment and the return on that investment and the short earned debt period. But at this point in time, there's is so much noise relative to our capital ratios, valuations in the industry, et cetera, that were being very proven.

[Operator:]

This concludes our Q&A. I'll now hand over to Marty Birmingham, CEO, for final remarks.

[Marty Birmingham:]

Thank you, everyone for their participation. We look forward to continuing to build on this conversation at the conclusion of our fourth quarter.

[Operator:]

Today's call is now concluded. We'd like to thank you for your participation. You may now disconnect your lines.