First Interstate BancSystem Inc
NASDAQ:FIBK
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Good morning, and welcome to the First Interstate BancSystem Third Quarter 2019 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please 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, please note 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 of the 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 a 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 will turn the call over to Kevin Reilly, Kevin?
Thanks, Lisa. Good morning, and thanks again to all of you for joining us on our call today. I'm going to start off today by providing an overview of the major highlights of the quarter and then I'll turn the call over to Marcy and she'll provide us more details around our financials. Well, we delivered another solid quarter. Despite the difficult environment for generating loan growth, we were able to deliver core earnings growth, which speaks to the strength of our business model, our diverse source of revenue and our improved efficiencies.
On a GAAP basis, we generated $49.1 million in net income in the third quarter or $0.76 per share which included $3.8 million in merger-related expenses, which had a negative impact of about $0.04 per share. On operating basis, the merger-related expenses are excluded from all the periods. Our third quarter earnings per share was up about 7% when compared to both last quarter and the third quarter of 2018. Over the past year, even including the impact from our 2 most recent acquisitions, our tangible book value per share has increased 15% which reflects the consistently strong value we are creating for our shareholders. We had a very good quarter in terms of deposit gathering.
Our total deposits increased 2.7% from the end of the prior quarter with most of the growth coming in our non-interest bearing deposits. This underscores the strength of our deposit franchise that we have been building. Our commitment to relationship banking and superior client service has helped us to continually expand our deposit relationship with existing clients and attract new clients to the bank. 58% of the deposit growth was from existing clients, mainly in the State of Montana and 42% of our growth came from new clients, with the majority of the growth in business demand accounts, which came in Eastern Washington and Idaho.
Our cost of funds declined 5 basis points in the quarter to 51 basis points which was partially attributed to the strong inflows of non-interest bearing deposits but also to our success in lowering rates across all of our deposit categories. We passed through the first Fed rate cut in July to our depositors at a 39% beta for our net interest-bearing deposits, which was frankly a little too short to offset the impact from the rate reduction. So for the second rate cut we adjusted and passed it through at a 55% beta. Marcy will provide a little more color in her remarks but our more significant September cut should help us mitigate margin pressure in the fourth quarter.
As we talked about a number of times is over the past couple of years, we raised our deposit cost during the periods of rising rates even though we weren't under competitive pressure to do so. And as a result we have substantial room to bring down deposit rates with each rate cut and still be new to top of our market in terms of pricing. We will continue to reduce deposit costs should the Fed decide to further cut rates.
As you all know we place a tremendous value on the strength of our deposit base. This quarter our deposit growth was well in excess of our loan growth, which left us with some excess liquidity. Although we invested more than $450 million in our investment portfolio this quarter we still had excess liquidity that was parked in overnight funds. This had a negative impact on our net interest margin of 3 basis points. As we continue to redeploy this excess liquidity in the higher-yielding assets, we should see some benefit to the margin in future quarters.
Our goal is to invest these funds in loans. And while we continue to see healthy loan demand we will not put loans on our books at a price that does not compensate us for the risk we're taking and not generate a reasonable return on our capital. So while we may have a light quarter of loan growth, we believe over the long term, we will generate better returns for our shareholders by being disciplined in our growth. This long-term view has always served us well.
Currently, with the subsequent rebound and long-term interest rates from the August and September lows, we should see more regional pricing that will allow us to add more profitable loan production to our books.
From a geography perspective, we continue to see strong loan growth in our West Division. Oregon and Washington, Idaho regions all had positive loan growth in the quarter with Idaho being the strongest at nearly 4% growth over the prior quarter. Idaho continues to have a very strong economy and our large presence there is definitely helping us to capitalize on the more business development opportunities in that region. We continue to see run-off from both our state portfolio and the purchase residential loans that we acquired from the Bank of the Cascades. These pay downs accounted for about $25 million in declines in loan balances this quarter.
While low interest rates impacted the growth in our retained mortgage portfolio, we were able to have a very strong quarter of mortgage banking activity and our revenue in this business was up 25% over the prior quarter.
In addition to the loan interest rates, that increase the demand for refinancing, we are also benefiting from our larger market footprint. As well as more opportunities being generated from our new digital mortgage application portal that we've introduced this year. This quarter we closed $10 million in origination through digital channel and we have $23 million more in the pipeline. Another key to our strong results this quarter was our success in controlling expense levels. Excluding merger-related expenses, our total non-interest expense declined by $3.1 million from the prior quarter. We've done a outstanding job in creating the 2 most recent acquisitions, Idaho Independent and Community First Bank. And we're ahead of the schedule in terms of recognizing the cost savings that we projected. So with those comments, I'm going to turn the call over to Marcy for a little more detail behind the numbers. Go ahead, Marcy.
Thanks, Kevin and good morning everyone. As I walk through our financials unless otherwise noted, all of the prior period comparisons will be with the second quarter of 2019 and I'll begin with our income statement.
Our net interest income was essentially flat with the prior quarter, primarily as a result of a $1.1 million decline in recoveries of previously charged off interest and a $1.2 million decline in accretion income this quarter. On a reported basis, our net interest margin decreased 15 basis points to 3.93% in the third quarter. Excluding the impact of interest recoveries and loan accretion our operating net interest margin decreased 6 basis points this quarter to 3.8%.
The impact of the excess liquidity, we had an overnight funding in the quarter with 3 basis points dilutive to our net interest margin. The remaining 3 basis point decline was primarily due to the Fed rate cut. As a result of the cuts, we saw a 5 basis point decline in our operating loan yields, which exclude the impact of interest recoveries and accretion, which was partially offset by lower funding costs.
Our total cost of funds declined 5 basis points in the quarter to 51 basis points. As we passed through the Fed rate cuts to our depositors, we saw a steady decline in our cost of interest-bearing liabilities throughout the third quarter. Our total cost of interest-bearing liabilities was 75 basis points in July, decreasing to 71 basis points in August and down to 67 basis points in September. Since we need the largest rate adjustment in mid-September, we should continue to see the benefit from this heading into the fourth quarter. And with a focus on reinvesting our excess liquidity and higher-yielding investments or loan, pressure on our operating net interest margin should be mitigated. Moving to non-interest income. We saw an increase of $1.4 million quarter-over-quarter to $48.8 million to $40.8 million. The increase was almost entirely due to higher mortgage banking revenue as our other major fee-generating areas were relatively consistent with the prior quarter. Mortgage banking revenue increased $2.1 million or 25% from the prior quarter. In addition to the factors that Kevin discussed, we're seeing increased refinance activity due to lower interest rates. Refinancing increased to 34% of our total production in the third quarter, up from approximately 19% in the second quarter. The increase in our fee-generating areas was partially offset by decline in other income of $1.1 million, which was due to normal fluctuations that we see in this line item.
Moving to total non-interest expense. We incurred $3.8 million in acquisition-related expenses this quarter. Excluding acquisition-related expense, our total non-interest expense came in at $95.5 million or $3.1 million lower than the prior quarter. The primary driver of the decline with lower employee benefits expenses due to lower payroll tax expense, lower health insurance costs and lower Directors stock compensation expense.
We also recognized a $1.3 million credit from the FDIC that reduced our assessment expense this quarter. Heading into 2019, we were fairly confident we'd see this benefit sometime in the second half of this year. We expect to have another $1.5 million in credit to be recognized but the timing will be determined by the FDIC. So when this will occur is still uncertain at this point.
We were able to keep our other major expense areas relatively consistent with the prior quarter as the continued investments we're making in the business were offset by the savings we've seen from our two recent acquisitions. As Kevin indicated we're ahead of schedule in realizing most of these cost savings so there won't be any meaningful decline in expenses in the fourth quarter. Excluding acquisition related expenses, which should be behind us, we expect operating expenses in the fourth quarter to be right around $96 million.
Moving to the balance sheet. Our total loans increased $42 million from the end of the prior quarter with the strongest growth coming in the commercial construction portfolio. This was offset by a $44 million decline in our commercial portfolio, which was partially attributable to $20 million of early payoff in the syndicated national credit portfolio. Our total deposits increased $310 million or 2.7% from the end of the prior quarter.
All of the growth came in non-interest bearing and savings deposits, which more than offset a decline in time deposits. As a result, we had even stronger growth in total core deposits, which were up 3% in the quarter. Looking at asset quality, we saw a small bump in non-performing assets of $1.3 million. This was due to an increase in non-accrual loans, driven by the addition of two commercial loans. This was partially offset by the disposition of other real estate property.
As a percentage of total assets, our non-performing assets were unchanged at 51 basis points. Outside of the nonperforming asset category we saw stability in the rest of the portfolio. Our criticized loans increased $2.1 million but remained consistent at 4.6% of total loans at the end of the quarter. We had a $1.8 million, we had $1.8 million of net charge-offs during the quarter or 8 basis points of average loans on an annualized basis, which was down 1 basis point from last quarter.
We recorded $2.6 million in provision expense, which more than covered our net charge-offs. A portion of our provision expense continues to be related to the acquired portfolios that refinance and migrate over to our originated portfolio. The reserves against these loans accounted for approximately $1.3 million of the provision expense this quarter.
Our allowance for loan losses was unchanged from the end of the prior quarter at 82 basis points of total loans while our coverage of non-performing loans was 131%. As you know, the allowance does not take expired ones into consideration but the combination of the allowance with the remaining loan discount on the acquired portfolios represents 1.25% of total loans. And with that, I'll turn the call back over to Kevin. Kevin?
Thanks, Marcy. Nice. I'm going to wrap up with a few comments about our outlook. We are expecting to deliver another strong quarter to finish out 2019. As I mentioned earlier, we believe we should see more positive trends in loan production as fears of the recession abate and we are hopeful that our commercial clients will feel more positive about making investments in their company as they gain more confidence in the outlook for the economy. This could result in increased credit line usage, which would be an additional catalyst for our loan growth going forward.
We expect another strong quarter of mortgage banking activity. We have seen a steady increase in production over the past months and October is trending well. We would typically see seasonality in November to December due to weather and holiday that impact origination home purchases, but with a higher demand for refinancing, we may have a better chance than usual of offsetting some of this seasonality this year. I talked earlier about the positive results we have seen in the launch of our digital mortgage application portal.
Within the next month, we're launching a new digital credit card application portal and by the end of the year, a small business lending application portal. By offering clients an easier and more convenient way to interface with First Interstate, we believe we will see higher volumes of applications that will positively impact our credit card growth in our small business lending in the future. All 3 of these new portals are part of the significant technology investments that we've been making over the past couple of years. And as we've talked about the number of times these investments in technology are designed to enhance our infrastructure, improve our ability to offer clients new products, services and features and improve our efficiencies.
As a result of these investments, we have improved our business development capabilities and also to build an infrastructure that will be able to support the continued growth of our franchise. At least for the foreseeable future as we make additional acquisitions, we will not need to ramp up our spending on technology to support a larger bank. As I wrap up, I want to make a few comments about our recent conducted employee engagement survey. We are very pleased with the results and response that our employees gave us across the company. Whatever you do acquisitions is always a concern about how the cultures will mesh. And if you'll be able to maintain the employees that you acquire.
The survey showed that employee satisfaction in our West Division was high, which indicates that we've done a great job of identifying compatible merger partners and effectively integrating their operation and making sure that our new employees feel valued and appreciated throughout their transition into First Interstate. The expansion of our footprint in the West division has been a critical step in our plan to enhance the value of our franchise. And we could not be happier to know that our new team members have found their experience with First Interstate to be very rewarding, satisfying and beneficial to the advancement of their career in banking.
So with that, I'd like to open the call up for questions.
Thank you. We will now begin the question-and-answer session. [Operator Instructions] Today's first question comes from Jackie Bohlen of KBW. Please go ahead.
I wanted to touch on the shift in your loan book for 3Q versus 4Q. I just understanding that you're more optimistic that you were in the third quarter. Is that more driven by movements in rates or is it more driven by a shift in customer confidence in the economy?
I would say it's a little of both. I think the rates got so low during the third quarter. Some of the pricing got so ridiculous that we stepped away. I think the pricing has come back, so we won't be stepping away from these many deals. And also we believe that the economy could make our customers feel a bit better about the future so they might invest more.
And is there anything specific that happened within local economies that's improving customer confidence?
No, I just think, you know, we're just hoping that some of this tariff stuff would be resolved, and I think there's a lot of concern out there, what's really happening in the world, and I think if we can just get some of these things behind us, they'll feel more positive about the future. I think people are sitting waiting to see some alternative but the economies in our markets are strong, but people are just hesitant to invest into it.
Okay, fair enough. And you had mentioned that the strength that you had in the West Division particularly in Idaho, how did the Mountain Division fare?
Well, not so well because we saw the overall growth in loans. I would say that Wyoming declined, Montana was pretty flat to slightly down, and I would say that the Rapid City South Dakota was slightly up, so really, most of the growth came from the West and then there was a detractor in the legacy markets.
Okay, and I would guess that your comment surrounding on confidence had more to do with the West market than with the Mountain market, is that a fair assessment?
Yes.
Okay and then just one last one and I'll step back. In terms of the refi demands, I understand the effect that it has on mortgage banking but how do you see that playing out within the loan portfolio and potential impacts to prepayments understanding that they are near impossible to predict?
I would say the customers are pushing at us on rate reductions, it's a never-ever-ending story, so it's mainly the larger customers that are coming in for rate reductions, the small customers don't really push us that hard, but it's the larger customers, and the good news is that our average loan is it like around $300,000 or 90% are under $1 million. So there is a handful of customers that are putting pressure on us with regards to rate reduction but majority of our portfolio, we're not seeing that pressure.
Okay, great, thank you. That's helpful I will step back.
Thank you.
And our next question today comes from Jared Shaw of Wells Fargo Securities. Please go ahead.
Hi good morning.
Good morning, Jared.
If you could spend just a little bit of time on the margin, great color on the trend in betas on the deposit side. If we see an October cut, do you think that that deposit beta can go higher or is 55%, sort of fully locked in there with the right environment?
Well, first of all, it was 35% on individual one and 55% and the second one individually. So we, to be honest we undershot a little bit on the first one, we had room, but we thought the 39% beta cut would have kept our margin flat, we were a little shy. I think, we think the 55% might be a little aggressive and my pushes the other way. So we're prepared to meet the next cut with the same type of activity.
And then on the lending side, how, especially on the commercial side, were you able to put in floors, or I guess, as we look at it, we're continuing at a low rate environment, anything you can do on the loan side to protect against continued lower rates?
Marcy is going to go over that, details on floors.
Yeah. So we are trying to put in floors on our loans as we go forward. Right now we have about $729 million that would still re-price in a down interest rate environment.
Okay. And then apart from that, though, you have some protection on the other parts of the loan book.
Yes.
Okay. And then on the mortgage banking side, great quarter for that. As you look going into fourth quarter with the likely slow down on the purchase side, do you think that the refi could it stay stable from what we saw in the third quarter overall, or do you actually think that maybe you see a little bit of growth from here or how should we size that going into the end of the year?
I would say that October is probably going to be strong and you're going to tail off in November-December.
That's because we're normally seasonal during that time of year and so even with refinance activity, I think we'll see a little bit of a pullback.
Okay. And then finally just for me on the securities portfolio, can you give a little color on what that 450 million was? And then as we look at this cash is that the excess liquidity is that all going to go into loans or would there be some potential continued expansion on the security side?
Some are going to security, but Marcy's going to give you some color, but the interesting thing is, as you would see refinancing in a mortgage business, so that's mortgage-backed securities paid out, so that's part of the reason why we've been trying to invest a lot, because just the cash flow is coming in but, go ahead, Marcy.
A good portion of that went back into mortgage-backed securities and then a little bit in government and a little bit amenities and a little bit in cooperative, but a good deal that went in back into mortgage-backed securities.
In terms of yield and duration?
Currently, I don't have that with me, the duration of our whole investment portfolio extended slightly, it's now at 2.2 years. I don't have it broken out by what we put on this quarter with me right now, Jared, but I could get back with you on that.
Okay, great. Thank you.
We didn't put really long dated stuff, Jared, so I would say it's a duration of right around five years or less.
And our next question today comes from Andrew Liesch of Sandler O'Neill. Please go ahead.
I appreciate the guidance on expenses here in the fourth quarter, but looking into next year, recognizing there could be some seasonality in the first quarter, is this $96 million, a good run rate to build off of in 2020?
As a build off, you can use that but I think the thing is that we see expenses kind of net going up somewhere around 1.5% to 2% year-over-year.
You know, most of our expenses, I mean, the bulk of it's in salaries and so just normal salary increases will drive that up a little bit.
So okay and then on the loan growth, here it's mentioned there's difficult rate environment, how much was it driven just by competition offering rates in terms that you guys were not just not comfortable playing with or was it really just driven by what the yield curve is doing or what rates we're doing?
Mostly by what some of the rates have been offered by competition, I mean, one of our, one of our large customers was actually offered 85 basis points over cost of funds. We just can't compete with that and we won't compete with that, so good for them. And so, I mean there are still customers on the deposit side, but if they can get the lend to your borrowing meets net but met by somebody else at that level, we're not going there.
Got it. That's very helpful. You've covered all my other questions.
And our next question today comes from Jeff Rulis of D.A. Davidson. Mr. Rulis your line is open. Are you on mute perhaps?
I was, I apologize. It's actually on for Jeff. How is everyone doing?
Good. How are you?
Good, good. I'm just kind of trying to get a better sense for the run rate on the core NIM, can you break out the impact between the charge-off or rather the recovery that got accreted back into the yield.
The impact to that the NIM was 1 basis point from interest recoveries 4 basis points from early payoffs and 8 basis points from regular accretion to get us down to the core NIM of 380.
Awesome. Thank you. And then can you remind us how many cuts are you kind of baking into your assumptions right now?
We're really hoping for one more at the most because we believe the economy is strong. I think to take in a pause at some rate cuts here, but the economy is not requiring to continue to cut rates, so we're looking at maybe one more at the most.
And then maybe lastly just on M&A, it has opportunities, talks, is that increasing, decreasing since your last couple of announcements?
I would say it's increasing a little, we're out talking to people but I would not say it's robust. We have passed on a couple of smaller deals that we just didn't believe would add any value to our franchise [indiscernible] good price, but they just didn't look like they're going to be meaningful for us, so we passed on them. So there are some deals out there, but we're being very selective about the deals that we're going to do.
And our next question today comes from Gordon McGuire of Stephens.
Kevin, I appreciate the commentary on feeling a little bit better about production in the fourth quarter, but if I recall, the fourth quarter is usually seasonally weaker from a utilization standpoint. With the stronger feelings about the production, would you expect a little bit stronger growth or is it just still going to be, you're still going to see the seasonal impacts and it's more flattish?
Well you've been following us for a while, so you understand the seasonal impact because mainly we have pay downs on agricultural lines in the fourth quarter. So there are some seasonal headwinds out there, but we believe that the production could offset that. And so we're looking at loan growth for the fourth quarter to be somewhere around 0.5% to 1%. So not really flat to down like we normally see in the fourth quarter but slightly up in the fourth quarter.
Got it. And then anything in your crystal ball for what we can think about for maybe going forward 2020 if some of these headwinds that you saw this past quarter are alleviated?
Who knows? I mean there's so much stuff going on. I, we're hoping to continue to grow at low to mid single-digits in loan growth next year. But every day you open a newspaper or turn on the news something else is out there. So I, my crystal ball is pretty cloudy.
And then maybe just trying to size up the balance sheet size, I mean the deposit growth was really, really strong this quarter. Do you feel like any of that might have been transitory and could fall out or do you feel pretty good about the stickiness of the balance sheet size heading into the fourth quarter?
Well, we think it's sticky. The thing is normally if you look at our past history, deposits kind of are flat to down a first quarter and significantly down in the second quarter, they start rebuilding in the third quarter strong, and then they continue to build throughout the fourth quarter. So we believe that that trend, nothing tells us that that trend should be any different this year. Actually we had a little bit stronger year in total on deposit growth. But again most of, almost 50% deposit, as I mentioned in my remarks, were from new clients.
So we feel that this could be sticky and also we're feeling good that we're booking that may new deposit clients, mainly in the corporate side, that that could lend also to is a loan growth development as we move forward. So I think it's sticky and I think it's following the trends of the past, but actually this year is a little stronger than the prior few years with regards to deposit growth.
And our next question today comes from Garrett Holland of Baird. Please go ahead.
Good morning. Hi, Kevin. Hi, Marcy. Thanks for taking the questions. Just one more follow-up on the margin in the fourth quarter. Do you feel good about defending that 380 core NIM level as that drag from excess liquidity reverses a bit?
I'll say it one more time: we feel good. We had a little bit of a miss in the third quarter when we did 39% beta, but we're swinging harder and faster to make sure that we protect that margin from going anywhere down.
That's helpful. And then on the purchase accounting run rate, should that continue to grind a bit lower from here, is a fair assumption?
It will be the accretion, the scheduled accretion, Garrett. Should be about $2.8 million, so similar to this quarter, it was about $2.8 million. And then it will go a little bit down in 2020 to about $2.3 million average per quarter.
Really appreciate that detail and then maybe one follow-up on capital. Very strong metrics increased nicely, obviously some of that is going to get put to work with funding loan growth. But if loan growth remained muted, can you review the capital deployment priorities and your thoughts on dividends and buyback here?
Well, if you pull out our investor deck you have kind of the capital priorities. First we want to deploy capital through organic loan growth and then through strategic acquisitions that will grow the thing. Then through…
Share repurchase.
Share repurchase, but right now our shares are price is too high so that's really not an opportunity because the payback's more than five years, even though we have a share repurchase program in place. Next was dividends, which we provide right now, some between 35% and 45% dividend payout ratio, and I think we're near the higher end of that payout ratio right now. And then lastly, if we can't do anything effective on the first four, then we would look at doing a special dividend to reduce total equity.
I appreciate that. So that doesn't sound like any meaningful change and steady as it goes on organic growth and hopefully some M&A.
Yes.
And our next question today comes from Matthew Clark of Piper Jaffray. Please go ahead.
Hi, good morning. First one for me. Can you just quantify the production and payoffs in the third quarter and maybe the second quarter as well just to have the comparison?
Production payoff.
Yes, Matt, can we get back with you? We don't have that at our fingertips.
Yes, no worries. And then just commentary on the pipeline in terms of its size, maybe just relative to a year ago or from last quarter?
I'm going to have Renee Newman take that. She is our Chief Banking Officer.
We continue to see strong activity. So our pipeline is over $600 million. It's trending along the same lines as previous quarter.
Okay. Great. And then just any updated thoughts on the efficiency ratio outlook? I know the margin obviously is part of that equation which makes a little more difficult, but maybe you could also speak to the expense to average asset ratio just taking the margin out of the equation as we look into next year.
So Matt, our goal and that is to eventually get down to 2.65% expense ratio to average assets. We won't get there probably next year, but we'll get much closer. I think we can get between 56% and 57% efficiency ratio, probably on the lower end of that next year, even if you look at this quarter and you back out the acquisition expenses, we were 56.5%ish on a -- without the acquisition expenses. So we're continuing to work toward that 55% bogey.
Okay, great. Thank you.
And ladies and gentlemen, this concludes our 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 today. Goodbye.
Thank you, sir. 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.