First Interstate BancSystem Inc
NASDAQ:FIBK
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Good morning, and welcome to the First Interstate BancSystem Third Quarter 2018 Earnings Conference Call. [Operator Instructions] Please also note, today's event is being recorded.
I would now like to turn the conference over to Lisa Slyter-Bray. Please go ahead, ma'am.
Thanks, Rocco. Good morning. Thank you for joining us for our third quarter earnings conference call. As we begin, it is worth noting that the information provided during this call will contain forward-looking statements.
Actual results or outcomes may differ materially from those expressed by those statements. I'd like to direct all listeners to read the cautionary note regarding forward-looking statements and factors that could affect future results contained in our most recent annual report on Form 10-K filed with the SEC and in our earnings release as well as the risk factors identified in the annual report, and our more recent periodic reports filed with the SEC. Relevant factors that could cause actual results to differ materially from any forward-looking statements are included in the earnings release and in our SEC filings.
The company does not undertake to update any forward-looking statements made today. A copy of our earnings release, which contains non-GAAP financial measures, is available on our website at fibk.com. Information regarding our use of non-GAAP financial measures may be found in the body of the earnings release, and reconciliation to their most directly comparable GAAP financial measures is included at the end of the earnings release for your reference. Joining us from management this morning are Kevin Riley, our Chief Executive Officer; and Marcy Mutch, our Chief Financial Officer; along with other members of our management team.
At this time, I'll turn the call over to Kevin Riley. Kevin?
Thanks, Lisa. Good morning, and thanks again to all of you for joining us on our call today. I'm going to provide an overview of the major highlights of the quarter and discuss the two acquisitions we recently announced, and then Marcy will provide more details on our financials.
We executed well in the third quarter, delivering strong financial results, completing our acquisition of INB and making good progress on integration, which will take place over Veterans Day weekend. I couldn't be more proud of all of our team's accomplishments and believe we are firing on all cylinders, with strong earnings, successful acquisitions and continued efforts to strengthen our company's infrastructure.
We generated $41.4 million in net income in the third quarter or $0.71 per share, which included $3.1 million of INB merger-related expenses. Excluding these expenses, we generated earnings per share of $0.75, which compares to the $0.74 last quarter and a year-over-year of operating earnings per share are up 90% from the same period. The positive trends we are seeing in our net interest margin and the improved efficiency we are getting from our larger scale more than offset the $3.2 million decrease in revenue this quarter from the Durbin Amendment.
Excluding recovered interest and accretion income, our net interest margin increased another four basis points during the third quarter. And over the past year, we've seen our margin expand 24 basis points. This reflects the consistent benefit we are getting from the repricing of our earning assets and a higher loan-to-deposit ratio, combined with the effective management of our deposit cost. As we've talked about for the last year, we are focused on maintaining and growing our solid base of core deposits and believe this is important to our long-term success.
In the third quarter, we had $204 million in organic deposit growth or 8.1% on an annualized basis. We continue to push up our deposit pricing in order to provide our clients with a reasonable yield on their funds, which we believe will deter them from seeking other alternatives. Additionally, it will make it more expensive for some of our local competitors to attract deposits. This is an added benefit of reducing some of the irrational loan pricing we have seen in our markets, especially against other community banks with higher loan-to-deposit ratios.
As a result of this strategy, our total cost of deposits increased six basis points in the quarter to 40 basis points. We are comfortable with this level increase, given that our asset sensitivity enable us to more than offset the higher deposit cost. I want to spend a few minutes talking about our loan growth. Excluding the loans added from INB, our total loans increased $46 million.
As we stated when we purchased Cascade, we intended to run off balances related to their purchased residential real estate and their shared asset credit loans. Total year-to-date runoff of these portfolios has amounted to $71 million. Outside these two non-core portfolios, our organic loan growth is pretty much in line with our expectations, and with the strongest growth coming from our ag portfolio, which is up 8%, our commercial real estate portfolio, which is up 2%, and our consumer portfolio, which is up 1.5%.
This offsets a 3% decline in our C&I portfolio, which was primarily attributed to a payoff of 1 commercial loan by a customer that had a significant amount of cash on hand. From a geographic perspective, we continue to see our strongest growth in the west, which is on track to be in the upper single digits for the year, with the Mount region coming in around the mid-single digits.
As I mentioned earlier, the integration of INB has gone very smoothly, and the system conversion is on schedule for mid-November. We've been able to apply lessons learned from past acquisition to continue to enhance our integration process, and it's become a core competency that we want to continue to leverage. The well-honed process we have developed makes us comfortable with our ability to complete and integrate the two simultaneous acquisitions that we have recently announced.
Since we entered the Idaho market with the Cascade acquisition, we've been looking to increase our presence there by giving -- because of the strong economic growth occurring throughout the state. In 2017, Idaho grew the fastest of any state in the nation. Adding residents at triple the U.S. rate, as people are attracted by the opportunities in the state's developing technology, healthcare and construction sector. Idaho continually ranks number five in the nation for unemployment, registering at 2.8%, and is leading all U.S. states in year-over-year payroll growth.
Idaho has also seen an influx of retirees looking to relocate from the higher cost of living on the west coast. Economic indicators such as personal income, unemployment and home prices continue to show broad-based strength and are testament to the opportunity within the Idaho region.
With the acquisitions of Idaho Independent Bank, and Community 1st Bank, we'll have the sixth-largest market share in Idaho. In Boise, we will become the largest community bank and the number 3 in market share in Ada County. In Coeur d’Alene, which is in Kootenai County, we moved to number 4 in market share, up from number 9. With a larger presence in Idaho, we believe we can increase the overall growth profile of our franchise and improve the ability to generate quality balance sheet and earnings growth into the future.
Both Idaho Independent Bank and Community 1st Bank have outstanding deposit franchises. Idaho Independent Bank, the larger of the 2 banks, has $600 million in deposits, with a cost of deposits of just 9 basis points, while Community First has a cost of deposits of 34 basis points.
The addition of two stable, low-cost deposit bases will further enhance our ability to manage our deposit cost in this raising interest rate environment. Both banks have capitalized on the robust economic activities in their markets to generate significant loan growth. Since 2014, each bank has had a compounded annual growth of greater than 9% in their loan portfolio. And with both portfolios having an average yield of 5.85% to go along with their low cost of funds, they will have a positive impact on our net interest margin.
From a financial perspective, we are expecting these combined transactions to be 3.6% accretive to our earnings per share in 2020 and have a tangible book value dilution earn back of less than two years using the crossover method.
Given this significant overlap of the -- of our existing branches' network in Idaho, there'll be continually opportunities for branch consolidations, which will result in cost savings representing approximately 50% of both banks' expense base. While we don't mind revenue enhancements, we believe there will be good growth opportunities in our broad set of products and services, including wealth management, mortgages, commercial credit cards, indirect and SBA lending.
Additionally, we will be able to better service the existing client base with our larger lending limit. Given the size of these two deals and the proximity to our existing franchise in Idaho, we believe this -- it has relatively low risk and a significant upside potential for us. We believe there is a significant value to growing our presence in Idaho and becoming the sixth-largest bank in the state. Both banks are a great fit for us geographically, strategically, financially and culturally. And we're very excited to add a talented group of bankers that will play a significant role in the continued growth of our franchise. And by taking this over $14 billion in assets, we'll have an even greater ability to leverage the investments we have made over time in our people, our processes and our technology.
So with those comments, I'd like to turn the call over to Marcy, for a little bit more behind the numbers. Go ahead, Marcy.
Thanks, Kevin, and good morning, everyone. As I walk through our financial results, unless otherwise noted, all of the prior period comparisons will be with the second quarter of 2018. I'll begin with our income statement. Our net interest income increased 6% from the prior quarter, primarily due to the partial-quarter contribution of INB and a higher net interest margin.
Included in net interest income this quarter was charged-off interest at $700,000 compared to $1.9 million last quarter. Total accretion income on the acquired portfolios was $3.6 million this quarter, which was $700,000 more than the second quarter. Included in this accretion -- included in this was accretion related to early payoff of $1.5 million this quarter, which was $400,000 more than last quarter.
With the addition of INB, we anticipate that our scheduled accretion will be $2.2 million in the fourth quarter. Looking forward to 2019, we expect scheduled accretion to be approximately $2 million per quarter, excluding the impact from our 2 pending acquisitions. On a reported basis, our net interest margin increased one basis point to 3.88% in the third quarter.
Although as Kevin mentioned, excluding the impact of charged-off interest and loan accretion, our operating net interest margin increased four basis points to 3.73%. The expansion in our operating net interest margin was driven by an increase in our yield on earning assets, which more than offset the six basis point increase in our cost of funds. We continue to see an increase in the yield on our investment portfolio, and with the short duration of this portfolio, which is currently at 2.8 years, we are able to reinvest funds today at around 3.25% without significantly extending the duration.
We're also seeing a lift from the loan portfolio. Approximately half of our portfolio consists of variable or adjustable rate loan, and 51% of the total legacy portfolio is scheduled to reprice in one year or less. We expect that the increase in our yield on earning assets will continue to more than offset the increase in our deposit costs, resulting in further expansion in our operating net interest margin. With the addition of the INB portfolio and the two portfolios we will add next year from Idaho Independent and Community First, we will further increase the percentage of variable rate loans, which we expect will increase the benefit we get from loan repricing.
Moving to noninterest income. We saw a decrease of $1.4 million quarter-over-quarter to $36.2 million. The decline was primarily due to a drop of $2.8 million in our payment services revenue as this was the first quarter that we were impacted by the Durbin Amendment. The Durbin Amendment had a negative impact of $3.2 million on payment services revenue, which was slightly offset by an increase in interchange fees on seasonally higher volumes of transactions, which is consistent with what we typically see in the last half of the year.
Our mortgage banking revenue declined $500,000. The decline continues to be almost entirely attributable to a drop off in refinance activity, as production for purchases has been consistent with our expectations. Construction volume in the west was down significantly this year due to dramatic increases in construction costs across the region, resulting in delays or cancellations of projects.
In the third quarter, loans originated for purchase accounted for 85% of our total productions, up from 80% last quarter. Going into the seasonally slower period for the housing market, we would expect to see mortgage banking revenues slightly down in the fourth quarter. These declines in noninterest income were partially offset by a $1.7 million positive valuation adjustment on our Visa B shares. As there's additional clarity around the Visa litigation, we've seen a more active market for these shares, which has resulted in this adjustment.
Moving to total noninterest expense, we incurred $3.1 million in acquisition-related expenses in this quarter. Excluding these expenses, our noninterest expense increased $2.7 million, with $2.5 million attributable to the partial-quarter impact of INB. Excluding the impact of INB, our noninterest expense was essentially in line with our expectations. Included in noninterest expense this quarter were severance costs of $600,000 and hiring costs of $300,000. And as I mentioned last quarter, we continue to incur costs related to process improvement efforts around our commercial and consumer lending activities, which was about $600,000 this quarter.
We won't see the benefits of the efficiency gains from the INB acquisition until the end of the fourth quarter, when we complete the system conversion.
Headed into 2019, we expect that our INB cost savings will be fully realized, and the additional expense from this acquisition will add between $5 million to $6 million quarterly to our run rate for operating expenses.
Looking at the balance sheet, Kevin has already discussed our loans, so I'll move on to our deposit trends. We had a stronger quarter of deposit gathering and ended the quarter with $10.8 billion in total deposits. We added $696 million in deposits from INB and had organic growth of $204 million. We had a slightly positive mix shift, with our noninterest bearing demand deposits increasing to 30% of our total deposits, which was primarily attributable to the addition of INB's deposit portfolio.
Turning to asset quality. We saw generally positive trends in the quarter. Our nonperforming assets decreased $6.6 million, which was due to the effective execution of workout strategies for problem commercial and commercial real estate loans. Our total volume of criticized loans increased during the quarter due to the INB acquisition, however, within the legacy portfolio, criticized loans decreased $19 million.
We had $2.6 million of net charge-offs during the quarter or 13 basis points of average loans on an annualized basis. We recorded $2 million in provision expense, which put our allowance for loans losses at 86 basis points of total loans and provided 111% coverage for our nonperforming loans. As you know, the allowance doesn't take acquired loans into consideration, but combining the allowance with the remaining loan discount on the acquired portfolios was 1.34% of total loans.
And then lastly, our capital ratios remain strong, and we saw an increase in our tangible book value per share of 2% to $16.84. With that, I'll turn the call back over to Kevin.
Thanks, Marcy. Nice job as always. I'm going to wrap up with a few comments about our outlook. The 2 acquisitions that we just announced are another example of our balanced approach to capital allocation, to organic growth, accretive acquisitions and returning capital to our shareholders through a strong dividend. We believe we have a successful formula for creating value for our shareholders. And we are optimistic that we have ample opportunities to continue executing on all aspects of the formula in the future.
Heading into the end of the year, we feel good about how we are positioned. Although, the fourth quarter has typically been a softer period for loan growth for the company, we think our increased exposure to higher-growth markets could result in a different outcome this year. The pipeline in the west division market remains quite strong, and they have historically had good loan production in the fourth quarter. So we are optimistic that we can see better overall fourth quarter growth to finish the year and deliver another strong quarter for our shareholders.
When I started off the call, I mentioned how proud I was of the team. And the company has consistently given 2% of its pretax net income back to the communities. On Columbus Day, over half of our employees gave a part of their day-off to volunteer for a not for profit in their community as a way to celebrate the company's 50th-year anniversary. It is incredible to be part of a company whose commitment to the community is more than just words.
Looking into 2019, we feel great about the position of our company. We built a strong team of leaders, not just at the executive level, but throughout the company. We are executing on building a better company with acquisitions that complement our franchise. And we'll be wrapping up our current infrastructure initiatives. We should complete streamlining our consumer and commercial loan processes, upgrading our financial systems and lastly, transforming our core to allow better analytics and the ability to plug and play digital applications to better serve our customers.
So overlaying this on our strong balance sheet and improved financial performance, we feel good about where we are headed. And so with that, I'll open the call up for questions.
[Operator Instructions]
And today's first question comes from Jeff Rulis of D.A. Davidson.
Hi, everyone. It's actually Drake on for Jeff today. I just had a first question on the expense run rate. I know INB, you mentioned that it won't affect the quarter until late in the fourth quarter. But can you just give a little bit more color on where you see that run rate in 4Q and beyond?
The run rate for INB. So to our historical run rate during this year, we expect INB will add $5 million a quarter -- $5 million to $6 million.
And that's on the $85 million before INB.
Okay. So we have maybe flattish expenses next quarter, is that fair? Or do you say, it's picking up a little bit more?
No, outside of acquisitions --
Outside the acquisition costs that are in there, it'd be flattish.
Except for it will have a full month of INB versus just 1.5 month?
Yes. The next quarter, we'll also -- fourth quarter, let's just be clear, we're going to have a normal run rate of about $90 million. But we're going to have acquisition costs as we start having termination of IT contracts and the severance costs and everything else associated with the final acquisition costs related to that acquisition. So we'll have a core run rate of about $90 million, and then we'll have the additional costs on the final acquisition expenses.
Okay, great. And then just another question on your margin going forward. I know you had a little bit less recoveries in the quarter. Do you see deposit costs continuing to pick up going forward? And where do you see your margin going into 2019?
We see our deposit costs continue to increase, but we believe our margin will also continue to increase. So both positive for the market.
Our next question comes from Jared Shaw with Wells Fargo Securities. Please go ahead.
Hi, good morning. Maybe just following up on the deposit question. So it was great to see only 6 basis points of costs increase on the deposit side, as you add these new geographies and you think that the customer base is going to be as price-insensitive as you have in your core markets. And then when you were talking about preemptively or you're continuing to raise pricing, is that something you said that, that start this quarter to retain those customers? Or is that something we expect to see in the next coming quarters?
Jared, that's the position we've been taking since the day they started raising fed funds. We've been always proactive to raising our deposit costs to preempt the other banks out there. We remain one of the highest deposit-paying banks currently in our markets. And we're going to continue because of asset sensitivity to increase our deposits in order to hopefully gather deposits from the other institutions that are reluctant to pay because they can't. So we're going to continue increasing our deposit costs, and we're going continue to increase our net interest margin.
Okay. But so the rate of that increase isn't necessarily really going to change? It's just going to be doing more of what you've been doing as we've been moving through it.
Exactly. Yes, we are totally controlling the market, so nobody is forcing. We're not being pressured to increase at a higher rate. Quite frankly, we are -- the market is moving when we move it. So we are not going to be pressured to increase that philosophy.
Okay. And then looking at the loan growth, it was great to see the growth in Ag this quarter. But on the C&I side, why -- is that a little weaker than you had expected? I know you said that there was a large payout in there. And as we look out, as you grow more into Idaho and the faster-growing markets, should the C&I loan group start growing faster than the rest of the portfolio?
Yes, I'm going to have Bill Gottwals answer that question, since he's head of our banking group.
Yes. I think, Jared, we have been obviously increasing our exposure in the C&I space. This quarter in particular though, we did have 1 large credit, as Marcy indicated, that had a significant impact on that. But more specifically, we have several large C&I credits now that we brought on last year that are incredibly seasonal, and we saw pay downs from them. So this quarter really wasn't impact of pay down of 1 credit and then the seasonal pay down, so actually what drove that. We would expect only to see more rapid growth in that C&I space.
Okay. And then finally for me. Kevin, you talked about the systems investments that you've made and the increased capacity there. As you look at the -- all these system investments that you've made, how big of a company, how big of a bank do you have capacity to run now with these improvements?
I think once we finish everything up by the end of '19, I don't know, probably until I retire. So it depends how big we get before I retire. But I have a feeling that these investments will take us well over $20 billion into the future. So I'm not -- we won't have to address it probably within my tenure here.
And our next question today comes from Jackie Bohlen of KBW.
I wanted to start off with a conceptual question. In terms of the net interest margin, just looking into the future. As you continue to develop the western part of the franchise, all else equal and ex the impact of higher margin M&A, will we see that trend up because of the types of loan growth you're able to get and the added loan growth you're able to get?
I wouldn't want to it to continue to trend up because of the additional aspect. I think it could trend up, but I think the nature of our business is -- kind of gives us the ability to have a higher net interest margin of banks out there. So I can see it hanging here to up to maybe at the most 4%. But I think once you start getting over 4%, that's going to be a tough environment to play in.
Okay, that's fair. And then as your initiatives wind down, and it sounds like they'll continue into 2019, but as those are winding down, do you expect to see efficiency improvements outside of just additional revenue generation?
Yes.
Okay. Any general quantification on that?
We're still in the midst of -- I think the biggest savings probably would be in our loan processes improvements that we're doing. And we're still in the process of coming to what that might be. It's bigger than bread box, but I'm not saying. I'm not sure exactly how big it is.
Okay, fair enough. And then just one last one. With the addition of the two pending acquisitions and then the 1 recently closed, does that impact your forward tax guidance at all? I know in the past, we've talked about -- oh no, I can't find my notes. But in the past, we've talked about a similar tax rate. Will it start to trend up at all?
It shouldn't.
Today's next question comes from Andrew Liesch of Sandler O'Neill. Please go ahead.
Hi, everyone. So just some clarification around the noninterest income here. My sense is that as you alluded to that gain on sales is probably going to dip here from seasonality. What other seasonal trends should we expect to see here going into the fourth quarter?
Well, first of all, I think card income actually is going to go up on seasonal bases. Net interest income should go up. I think mortgages should be flat to down slightly. But the rest of the stuff, I think that mortgage is probably the only seasonal thing. Hopefully, this year's loan growth and total loan growth is going to be better than we've seen in the past, up slightly. So I don't think there's anything more seasonal. Probably the only thing would be really that we have some card revenue going up and mortgages softening a little bit. The rest should --.
Yes. Wealth management service charges, other fees should stay pretty constant.
And our next question today comes from Matthew Clark of Piper Jaffray. Please go ahead.
Hi, good morning. Just on the noninterest expense run rate, $90 million core excluding merger charges. I think you've got about just under $8 million of cost saves coming from this latest acquisition that closed. I mean, should we think about that kind of getting back down to $88 million and growing from there? Or is there some additional efficiencies you think you can achieve to reduce that further, excluding the pending acquisitions?
In the future as we get some of these initiatives behind us that there would be some additional cost saves, as we've been talking about. But the thing is as we get cost saves, and then the cost of doing business goes up a little bit. So I'd say all in all, I don't see expenses growing that much during the year, as we have cost saves bring it in. So I would say that $90 million, right around there is probably a good run rate quarter-by-quarter next year.
Okay. And how much of the cost saves have you gotten out of this latest deal, INB deal.
Out of INB, very little. Most is coming in the -- after conversion.
Okay, great. And then just on the special mention bucket, it looked like a little uptick. Just wondered if that was acquisition-related or whether or not there was something else going on there.
That was acquisition-related.
And our next question comes from Bryce Rowe of Baird. Please go ahead.
Hi, good morning. I wanted to ask about the balance sheet mix. Saw that cash and liquidity on the balance sheet ticked up here in the third quarter, and you guys called out the current reinvestment rate around 325 basis points for the bond portfolios. So curious if you guys are thinking about maybe adding to the bond portfolio, if you can put some of that cash to work. Or is there another way to think about the excess cash on the balance sheet? Thanks.
Yes, it means, if that sticks and we don't get the loan production, we will put that to work. We do like to have, as you've seen in the past, a good amount of cash, but we are exceeding our normal cash level. So if -- we probably will have deposits continue to pick up, put more and more of that cash to work in the investment portfolio.
Excellent, that's -- it's good color, Kevin. And I wanted to ask a question about deposits. I think one of the comments you guys made at the Investor Day was consistent with what you said this morning that you want to maintain a dominant market share position in those markets where you have dominant market share. You also talked about a possible strategy to go into some markets where you maybe don't have as much of a dominant market share. I'm curious if you've kind of thought more about how you might approach those markets to take market share in some of those less dominant markets. Thanks.
We still are -- that's still in progress, and we're still looking at that. But we have not gone out with a huge marketing campaign, as we're actually waiting for our deposit pricing to get up to a certain level and believe that there's an inflection point before we attack the market. And then at that point, we think that we could make a bigger impact with our marketing dollars. You know the interesting thing; I just want to kind of go off the script here a little bit, are we having a pretty strong deposit base here. In the sense where you see some of these bigger banks are losing large deposits.
And interesting thing is our customers are small businesses, small middle market customers, and they don't have cash managers on staff to manage excess cash balances. So a lot of these larger banks because of the interest rates and the other alternatives out there, a lot of their larger and larger customers are moving cash into these other alternatives to seek higher yields. Ours mom and pop customers, they rely on us to give them a decent yield, as they can't pay for high-cost cash managers because they don't have that much deposit. So if we can continue giving them a reasonable rate, they're going to continue depositing all their excess cash with us and not look for alternatives.
And that's kind of what we're doing. And so we don't believe that we're going to have large runoff of deposits because we don't have large customers with large amounts they're going to move somewhere else. So we believe if we continue with the formula that we have, that we will maintain a strong deposit base going forward.
And ladies and gentlemen, this concludes the question-and-answer session. I'd like to turn the conference back over to the management team for any final remarks.
Thank you for your questions. As always, we welcome calls from our investors and analysts. Please reach out to us if you have any follow-up questions. Thanks for tuning in today. Have a great day.
Goodbye, everybody.
Thanks everyone. Today's conference has now concluded. And we thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful day.