Mercantile Bank Corporation
Q4 2020 Earnings Call Transcript

Published: 19 Jan 2021

[Operator:]

Good morning and welcome to the Mercantile Bank Corporation Fourth Quarter 2020 Earnings Results Call and Webcast. All participants will be in listen-only mode. Please note this event is being recorded. I would now like to turn the conference over to Tyler Deur, from Lambert, Mercantile’s Investor Relations firm. Please go ahead.

[Tyler Deur:]

Thanks, Grant. Good morning, everyone and thank you for joining Mercantile Bank Corporation’s conference call and webcast to discuss the company’s financial results for the fourth quarter 2020. I am Tyler Deur with Lambert IR, Mercantile’s Investor Relations firm. And joining me today are members of their management team, including Bob Kaminski, President and Chief Executive Officer; Chuck Christmas, Executive Vice President and Chief Financial Officer; and Ray Reitsma, President of Mercantile Bank, Michigan.

[Bob Kaminski:]

Thanks, Tyler and good morning, everyone. On the call this morning, we will provide you with detailed information on the company’s performance in the fourth quarter and full year amidst an unprecedented and challenging operating environment as well as an update on continued activities specifically related to the pandemic. As we reflect on 2020, it is paramount that I again applaud the incredible efforts of our dedicated Mercantile team for their immense resiliency and adaptability across the board to navigate the many unique challenges presented from the pandemic throughout the year. As we have consistently stated throughout the pandemic, our focus has been on the health and safety of our employees and customers, which has required flexibility from all team members who have transparently adapted to working remotely and in new environments. The efforts of our entire staff helped Mercantile deliver strong results again in the fourth quarter and throughout 2020 while successfully pivoting with our customers as needed to fulfill their banking needs in a variety of ways. This positivity is reflected in Mercantile’s strong financial performance again in the fourth quarter, with per share earnings of $0.87. Our company’s sustained areas of financial strength allowed our Board to increase our regular cash dividend for the first quarter of 2021 to $0.29 per share. We are pleased to provide a consistent and competitive cash return to our shareholders within this often challenging environment. And after electing to pause stock repurchases in March, we have also reinstated our buyback program during the fourth quarter as a result of our structured framework and prudent focus on maintaining strong capital levels. Chuck will provide further updates on the many moving parts of our financial statements for the quarter end and year-to-date 2020.

[Ray Reitsma:]

Thank you, Bob. Our total loan portfolio decreased to $134 million during the quarter, including a reduction of our C&I portfolio of $176 million. Both of these reductions were directly impacted by $189 million of PPP forgiveness experienced within the quarter. Owner occupied CRE decreased $20 million. However, non-owner occupied CRE increased by $51 and the mortgage and retail loan portfolios grew by $10 million during the quarter. In general, our C&I loan funding net of PPP activity remains similar to the pre-pandemic levels as we continue to add targeted new commercial relationships around our PPP activity and by serving existing relationships. Additionally, our construction pipeline remains solid with $99 million of commitments in commercial construction and development loans, which we expect to fund over the next 12 to 18 months. Asset quality remains strong as non-performing assets totaled just $4.1 million or 0.9% of our total assets at December 31, 2020. This breakdown can be found in the financial portion of our presentation on Slides 24 and 25. Additionally, accruing commercial pass-through loans at quarter end are nominal in dollar terms, totaling $1.1 million, representing 8 borrowers. Overall pass-through information can be found on Slides 16 and 17. The following recaps our provisioning activities during the COVID-19 impacted time periods. In the second quarter of 2020, provision expense of $7.6 million was generated entirely through increases to environmental factors. The third quarter of 2020 provision expense of $3.2 million was driven by risk rating adjustments to 159 specific credits, 8 of which moved to the watch list. The fourth quarter provision expense of $2.5 million was driven by a $3.9 million increase in qualitative and environmental factors. These actions bring the allowance for loan losses to total loans to 1.33% net of PPP loans, up 49% from 0.84% at December 31, 2019. Payment deferrals at the peak of the program in mid-July impacted 738 borrowers and represented $719 million in exposure. Presently, as of December 31, extensions are in place beyond that date for 18 borrowers representing $14 million of exposure, as seen in Slide 11. The modest current deferral numbers when combined with our expectations for limited future requests and our strong past due performance are positive indicators. The risk rating process depicts a portfolio with strong characteristics, reflecting strength similar to that of the pre-crisis economy as seen in Slide 15. Maintaining accurate risk ratings will remain a key focus in the upcoming quarters as our borrowers continue to report results impacted by the pandemic. We continue to monitor the financial condition and performance of credits, particularly in the following segments, hotels and lodging, assisted living, restaurants and entertainment. None of these individual segments account for more than 5.1% of commercial loans. The composition of these segments can be seen in Slide 13.

[Chuck Christmas:]

Thank you, Ray and good morning to everybody. As noted on Slide 16 this morning, we announced net income of $14.1 million, or $0.87 per diluted share for the fourth quarter of 2020 compared with net income of $13.3 million, or $0.81 per diluted share for the fourth quarter of 2019. Net income for the full year 2020 totaled $44.1 million or $2.71 per diluted share compared to $49.5 million or $3.01 per diluted share during the full year 2019. Excluding non-core income and expense transactions, diluted earnings per share increased by $0.10 or about 12% during the fourth quarter of 2020 compared to the fourth quarter of 2019, while diluted earnings per share decreased $0.07 or about 2.5% during 2020 compared to full year 2019. Generally speaking, increased mortgage banking income mitigated a lower level of net interest income and higher loan loss provisions during 2023.

[Bob Kaminski:]

Thank you, Chuck. That now concludes management’s prepared comments and we will now open the call up for the question-and-answer period.

[Operator:]

Our first question today will come from Brendan Nosal with Piper Sandler. Please go ahead.

[Brendan Nosal:]

Hey, good morning, everybody. How are you?

[Bob Kaminski:]

Good morning, Brendan. How are you?

[Brendan Nosal:]

Great, thanks. Just wanted to start off on some of the COVID-impacted industries, just hoping you can kind of take us through the state of the hotel, restaurant, and entertainment books today and just how those customers are faring versus the height of COVID last year?

[Ray Reitsma:]

Yes, this is Ray. I will talk about the hotel industry a bit. They are obviously continuing to be impacted very heavily compared to pre-pandemic levels. They are functioning at a higher level than they did earlier in that pandemic from an occupancy standpoint, focusing a lot on expense reductions and the like. Our portfolio has performed quite well. We have a very strong sponsor group amongst the portfolio, which has helped sustain those particular assets and has the ability to continue to do that. We feel like we have got them well positioned in terms of the structure, the AMs, and the like. We have had a number of the operators bringing additional capital to the table to reduce our loans, which has been well received by us and shows the commitment of those operating groups through those assets. So, the most direct answer to your question is that they are slightly improved over where they were at the depths of the pandemic.

[Brendan Nosal:]

Yes, that’s helpful color. Thank you. And then one more from me, just thinking about kind of reserve coverage as we were at the start of the New Year here, I found it interesting that your CECL reserve hypothetically was actually lower than the incurred loss reserve base today. So, just curious as you kind of look at the outlook for the year, do you see much more of a need to continue building reserves or based on what you know today, do you think you are at a sufficient level?

[Chuck Christmas:]

Yes. Brendan, this is Chuck. I will take the first stab at that. And as I mentioned in my prepared remarks, 80% of our provision that we did in 2020 was due to the environmentals. And as you saw from our metrics, we are continuing to have very strong asset quality, and we have been able to build the reserve based on those environmentals not so much so on specific credit deterioration, which, as Ray mentioned, most of that took place with our extended review during the third quarter. As long as those quality numbers stay consistently strong, the ability to grow your reserve continues to primarily rely on the environmentals. So, it seems to us that if we continue in the pattern that we are doing that our provision will certainly be much lower than it was in 2020 and so knock-on wood that we can continue to do that. But again, we continue to have our loan review program, all the communications that we have internally. Clearly, we have very closed eyes on the credits. On all credits, but certainly those that are in the industries that are – have been most heavily impacted, and I don’t think we would be surprised anyone saying we have regular contact with those borrowers. So overall, we feel pretty good. In regard to specifically with CECL, I think we – this is my opinion, we started to see it last week, late last week with the mega banks reporting and talking with other CFOs – bank CFOs, I think one of the common themes that’s out there with the CECL models is that the economic forecasts are starting to improve, and that was one of the – our CECL model throughout 2020 was much closer to our incurred model. The $2.5 million or so that we see at year end 2020 was quite a bit higher than – difference was quite a bit higher than what we are seeing. And most of that was because of the economic forecast improvement. Like most banks, we certainly used a third-party as our primary source, but also have another third-party that we throw into the model as well just a test to make sure that the models we are using are somewhat similar or in consensus with the markets that are out there, and the reserve allocated for the economic factor fell quite dramatically. So, I think that, that might be a trend that we see, we will see over the next couple of weeks. But with – and I think that makes sense from the CECL standpoint is we saw a lot of build taking place earlier in 2020 because of the segregation of economic environment and the forecast, but now with the economic forecasts coming out better with improved results, those using the CECL model or because of the CECL model, it does result in some reserve release. And of course, what you do overall, it depends on all the other factors and calculations that go into it.

[Brendan Nosal:]

Perfect.

[Bob Kaminski:]

Yes, this is Bob. I would say that as we have talked about in past calls, we have years and years of experience with the incurred loss model and we feel very comfortable with the levels of reserve that it requires us to have during all kinds of economic conditions, whether it be challenging times such as we experienced in 2020 or good economic times. And we think that, as Chuck said, that’s the best way for us to have a good solid reserve that reflects the risk in the portfolio and keeps us where we need to be. And just as we have throughout other economic cycles in the past, we will continue to evaluate, we will continue to look at the qualitative factors and obviously look at our credit relationships and making sure as we always do that the risk ratings are accurate and where they need to be as well. And we will do that obviously in conjunction with what we are seeing on the parallel CECL model. Because as Chuck said, there is some interesting dynamics that take place based upon what that model is based on. And – but we will take all that into consideration and continue to make the evaluation of each quarter as to where the reserve needs to be, but we feel really good about where it’s currently at and the process that we have to make sure it stays there.

[Brendan Nosal:]

Excellent. Thank you for taking my questions.

[Bob Kaminski:]

You bet.

[Operator:]

Our next question will come from Damon DelMonte with KBW. Please go ahead.

[Damon DelMonte:]

Good morning, guys. How are you doing today?

[Bob Kaminski:]

Fine, Damon. How are you?

[Damon DelMonte:]

Doing great. Thanks. So, first question, Chuck, just wanted to talk a little bit about the margin, can you – I think you had said how much the PPP loan forgiveness on a dollar basis was. Could you just repeat that and do you know what that was off the top of your head from a basis point standpoint?

[Chuck Christmas:]

Yes. Let me catch up to myself here. The growth was about 2 to 3 – if you compare fourth quarter over third quarter, the increase in the fourth quarter is about $2.3 million or $2.4 million higher than what we did in the third quarter. And a vast, vast majority, if not, all of that was related to the forgiveness payments and the acceleration on the fee income that took place as a result. We got our first forgiveness payment I think it was October 30, whatever the last business day was of October and then they have been since that time pretty regular as far as a pretty wide range, we get somewhere between $2 million to $6 million a day in that and that has continued here into January. On a basis point that $2 million to $3 million – $2.4 million added about 25 basis points to our margin for the quarter. So, we got – the way I look at it, we got a 25 basis point improvement because of that and then as I mentioned about a 40 basis point negative impact to our margin because of the excess liquidity, so not that would put us at about a 3.15% if you will, core margin and that’s pretty similar to what we have talked about on past calls.

[Damon DelMonte:]

Got it, okay. And then you had said that you expect the majority of the remaining forgiveness to occur in the first three quarters, was that accurate?

[Chuck Christmas:]

Yes, I would probably say first two quarters. Hopefully, that’s what I said. I know that’s what I had in my script, first two quarters. The ones under $2 million continue to come in. Of course, we have to wait for the borrowers to put their applications together, we review it then we submit it to the SBA and then of course, wait for the SBA to do what they need to do before they send us to ACH. So, we have a pretty small part, as far as the timing of all that goes. But like I said, it’s been pretty regular, steady on the amount of forgiveness that we have got coming through. So based on what we saw the last 2 months and as well as what we have seen so far here in January through the first 2 weeks, I would expect that most of those will be paid off by the end of the second quarter. Again, I threw that out there, on the $2 million, we’re just not sure what the government is doing with that segment, clearly on, way back in the second quarter. They indicated loans that were over $2 million were going to get additional scrutiny. It certainly appears that way. The application – forgiveness application process and the application itself is much, much more long – is much more longer, much more evolved. We have instances where they’re asking for additional information on some of them. So it’s definitely taken a longer time period than what we see with those loans under $2 million. So it’s a guess that it’s going to be at the end of the second quarter, feel pretty confident about those that are under $2 million and we’re hopeful that the government will start accepting or approving the forgiveness applications and paying off those over $2 million as well. As of year-end, the over $2 million portfolio was about 50% of our outstanding balance. So it’s about $185 million in that segment. So it’s a pretty large segment on the balance sheet. The forgiveness – the net origination fee is about 20% of the, I think, $3.8 million left.

[Damon DelMonte:]

Got it, okay. And then on expenses, obviously you got some good cost savings from those branch closures. What do you feel is a reasonable core run rate that we should actually model from this point forward going into 2021?

[Chuck Christmas:]

Yes, I kind of threw the word core with the word normal just trying to figure out where we’re at. There were some additional – we don’t talk about them, but there were definitely some costs in there related to PPP, stay-at-home, work-from-home costs in there. But I would say, if you get down to the core, I would say that the increase in 2021 from 2020 will be somewhere between 1.5% and 2%.

[Damon DelMonte:]

Okay. And that would be off of like call it $98 million or so $98.5 million or no?

[Chuck Christmas:]

Yes, I don’t have that number in front of me, Damon, but whatever gets down to the core that we threw in there, I think, that’s a pretty good guess.

[Damon DelMonte:]

Okay. And then just one – well, two quick ones here and fee income – the swap fee income that you guys broke out this quarter, is that something that – is that kind of a new focus for you guys where we should start to incorporate a measure of that each quarter or is that more of a one-time?

[Chuck Christmas:]

No, it’s definitely a new program and it’s a back-to-back swap program. Clearly, a lot of banks have been doing this. What it is, it’s a way to manage interest rate risk from, what I would call, our longer term commercial loans. So those are typically 5-year balloons. Occasionally we do 7-year balloons. Historically, we use the FHLB and, to a lesser degree, the broker deposit program to kind of match-fund those. But clearly what we’ve seen – as why we continue to book the 5-year fixed rate balloons and the occasional 7-year, we certainly don’t need to go to the FHLB and get advance money. So what we have found, it started really in 2019, but certainly throughout 2020, is we really didn’t have the ability from an on-balance sheet standpoint to really effectively hedge those longer term fixed rate commercial loans. So we started to explore the opportunity to do swaps with certain customers. It’s not going to be something that we go out there with all customers, but generally are those that are of larger size and of sufficient sophistication. We want to make sure that we treat this program delicately because when you introduce a swap to many borrowers, not all, but many borrowers, it is a new tool for them and we do have a third party – a well-known third party that we’ve hooked up with as an advisor. They not only help us directly, but also has interaction and materials for our borrowers as well. And so what this is, is for identified borrowers, again, there will be larger balanced, more sophisticated borrowers instead of – historically, we offer all of our borrowers a fixed and floating rate. What we’ll do going forward on these particular borrowers is we will only offer them a floating rate. If they want to go fixed rate, they will enter into an interest rate swap with the bank directly to get on the fixed rate. Of course, that gives us what we don’t want, have some fixed rate again. So we immediately, simultaneously, go to a correspondent bank and enter into the opposite swap. So the swap exposure is basically nil, just some remnants of some credit exposure there, which of course we underwrite that with our borrowers, as part of our underwriting loan to – adjusted loan to collateral values. And because of that, we’re able to – because of the difference in rates, we’re able to get some upfront fee income activity. So again, I’m sure this is common with many of your banks. So it’s a program that we rolled out in the fourth quarter. It’s a program we’ll continue to go with. It is going to be a transactional-type activity. So my guess is that some quarters will be larger in fee income and others will be lower in fee income, but I would say somewhere between – our budget, to be honest, is about $50,000 to $70,000 a month is what we have been budgeting there. Again, it’s pretty new for us, of course, but we certainly see the opportunity and quite frankly the need to do this to manage that longer interest rate risk exposure.

[Damon DelMonte:]

Got it. Okay, that’s great. And then if I could squeeze one more quick one in for Bob, any thoughts on the recent TCS sale to Deutsche Bank and possible follow-up from there? I think there might be some branch divestitures coming and maybe your thoughts on that and possibly picking up some – maybe new lenders? Thanks.

[Bob Kaminski:]

Well, as we talked about in the past, wherever there is disruption that may be caused – if there’s a bank M&A type of transaction in any of our markets, it does provide some potential opportunities, and like we have in the past, with this particular one that you referenced, we’ll continue to look and see if there is any way for us to strengthen ourselves because of some of the transitions that are taking place in the marketplace for those banks. So we will continue to take a long look at any opportunities that come down the pike and make the best decisions from a strategic standpoint for Mercantile. And it seems like whenever there is disruptions, customers usually end up experiencing some frustrations and some issues like that as well as some employees as well. So we’ll keep our options open and keep looking to see what the opportunities may avail themselves to us as we all go through the next several quarters.

[Damon DelMonte:]

Great, thank you very much for taking all my questions this morning.

[Bob Kaminski:]

You bet. Thank you, Damon.

[Operator:]

Our next question will come from Bryce Rowe with Hovde. Please go ahead.

[Bryce Rowe:]

Thanks. Good morning.

[Bob Kaminski:]

Good morning, Bryce.

[Chuck Christmas:]

Good morning, Bryce.

[Bryce Rowe:]

I appreciate you taking the questions here this morning. I had a – had one on kind of the mortgage commentary that you offered, sounded like you have got a good outlook in terms of mortgage despite some of the higher 10-year rates that we’ve seen over the last month. So maybe you could help us think about the mortgage market share takeaway relative to what kind of current market volumes might be reflective of higher 10-year rates?

[Chuck Christmas:]

Yes, this is Chuck. I’ll take the first stab at that and let Bob and/or Ray comment on that. I think, trying to forecast mortgage banking is certainly very, very difficult, especially in regards to the refinance activity. I think market data, kind of what we’ve seen from third parties is that, maybe up to a third of mortgage borrowers up there have the opportunity to refinance and of course that’s going to change almost every day as mortgage rates change. But clearly, mortgage rates continue to stay relatively low and there are some opportunities out there. We certainly expect that rates probably won’t go any lower, if any – if anything, maybe a little bit higher as you mentioned, Bryce. So we certainly don’t – are not anticipating that refinance activity in 2021 will be that as it was in 2020. So net and refinancings, we’re expecting less income from that. So this is something we want to focus on all the time, but I think this period of time really focus is on the fact that in a mortgage banking program, you got to make sure that you’ve got the ability to make mortgages on the purchase side. It’s great to make a lot of fee income when rates decline and everybody has the opportunity to – or most of them have the opportunity to refinance. But to keep a strong operation and to keep it going, you really have to have a solid lender base that has the appropriate contacts that can make sure that we get our share, if you will, or the purchase mortgage market. And that is something that we definitely concentrate when we’re talking to potential new lenders coming on board. It’s looking at their experience, their expertise, their history in regards to that purchase market. So as part of the strategic initiatives that I mentioned, I think, Ray mentioned as well, we’re certainly growing that not just new offices like Midland and Cincinnati last year, but also adding new lenders to us in our existing markets as well. So we’re going to continue to look for opportunities. In our current markets, we’re definitely going to continue to look at other markets, adjacent markets or other opportunities that come up to add to the team. So that will help on – we believe will definitely – expectation would be that, that will help us on the purchase side. So, net, where does that fall, it’s really almost impossible the tell, but I think the net overall aspect is, as we expect a decline in refinance to some degree, but we would expect given the current market’s, both economic and interest rate that we’ll see a pickup in purchase activity. So a long answer, but I didn’t give a specific answer too, but that’s how we look at it.

[Bryce Rowe:]

Okay, go ahead.

[Ray Reitsma:]

A bit of additional color would be that since the turning of the calendar to 2021, our pipeline has gone up about 20%, which would not be seasonally expected and it’s maintained its proportions as it relates to refinance and purchase. So, both forces are still in effect and very strong both seasonally and in absolute terms. So, whatever the correct number of people is out there or proportion of people that can benefit from refinance that pool still exists and they are still actively pursuing that. And we have definitely seen that on a rather consistent basis from the first of the year till now.

[Bryce Rowe:]

Okay, that’s helpful, Ray. I appreciate it. I wanted to ask, I guess, a question, I got two more questions, one around PPP any indication from borrowers on this latest round of the PPP in terms of how much interest there might be here in 2021?

[Bob Kaminski:]

Yes, it’s interesting. In the first go round, we had over 2,000 loans for $550 million during the course of that program. We are just getting started. We already have 300 applications that we have received to the tune of about $75 million. So, the interest out of the gate was pretty strong. It’s toned down a bit already. And so how the past will be going forward from a trajectory of applications and apps approved remains to be seen. Our sense is that it will be somewhat less and to what degree, it’s way too early to tell, but that’s the current as of yesterday morning data.

[Bryce Rowe:]

Okay. That’s helpful. And interesting commentary around forgiveness of these loans with $2 million or more in balances, guys, I am curious, what’s the reaction from those borrowers with maybe more scrutiny being placed on the forgiveness process. I mean, I don’t know how much involvement you have had with those particular customers, but if you have any kind of anecdotal commentary that would be interesting?

[Bob Kaminski:]

Honestly, I have had very limited conversations about that. They are just anticipating what’s coming next, reading everything that they can find and trying to offer information that will support the activity that they undertook in the program, which they all to a person believe was appropriate. And they are just looking forward to the opportunity to lay out whatever information needs to be provided to make that case.

[Bryce Rowe:]

Okay. That’s helpful. And then maybe last one for me here, lot of talk about loan yields and the impact from the PPP and forgiveness as well as some commentary around the excess liquidity. I was wondering with, I guess, the economic outlook possibly having gotten a bit better here as we move into ‘21, what are competitors doing from a – maybe a loan pricing perspective now relative to what it look like in the heat of the pandemic. I am just kind of trying to understand if there is pricing pressure coming down the pike in ‘21 relative to what we might have seen last year? Thanks.

[Bob Kaminski:]

I have not really witnessed or experienced or felt any additional pricing pressure that has happened in the time periods that you referenced. I would say there is pricing pressure, but it hasn’t really changed.

[Bryce Rowe:]

Okay, that’s very helpful. Thank you all.

[Bob Kaminski:]

Thank you, Bryce.

[Operator:]

This will conclude our question-and-answer session. I would like to turn the conference back over to Bob Kaminski for any closing remarks.

[Bob Kaminski:]

Thank you, Grant and thank you all very much for your interest in Mercantile Bank Corporation. We hope that you and your family stay healthy and safe. And we look forward to speaking with you again at the conclusion of the first quarter in April. This call is now concluded.

[Operator:]

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