Financial Institutions Inc

NASDAQ:FISI

Earnings Call Transcript 2024-Q3

[Operator]

Thank you for standing by ladies and gentlemen. Welcome to Financial Institutions, Inc. Third Quarter 2024 Earnings Call. My name is Candice, and I will be your event coordinator today. [Operator Instructions]

I would like to turn the conference call over to Kate Croft, Head of Investor Relations. Please go ahead.

[Kate Croft, executive]

Thank you for joining us for today's call. Providing prepared comments will be President and CEO, Marty Birmingham and CFO, Jack Plants. He will be joined by additional members of the company's leadership team during the question-and-answer session. Today's prepared comments and Q&A will include forward-looking statements.

Actual results may differ materially from forward-looking statements due to a variety of risks, uncertainties and other factors. We refer you to yesterday's earnings release and investor presentation as well as historical SEC filings, which are available on our Investor Relations website, for our safe harbor description and a detailed discussion of the risk factors relating to forward-looking statements.

We'll also discuss certain non-GAAP financial measures intended to supplement and not substitute for comparable GAAP measures. Reconciliations of these measures to GAAP financial measures were provided in the earnings release filed with an exhibit to Form 8-K or in our latest investor presentation available on our IR website, www.fisi-investor.com.

Please note that this call includes information that may only be accurate as of today's date, October 25, 2024. I'll now turn the call over to President and CEO, Marty Birmingham.

[Martin Birmingham, executive]

Thank you, Kate. Good morning, everyone, and thank you for joining us today. Our third quarter results were highlighted by strong deposit growth, incremental net interest margin expansion, solid expense management and continued build in our regulatory and tangible capital ratios.

Third quarter 2024 income available to common shareholders was $13.1 million, or $0.84 per diluted share compared to $25.3 million or $1.62 per diluted share in the linked quarter, which benefited from a $13.5 million pretax gain on the sale of our insurance business.

Third quarter return on average assets was 89 base points, and our efficiency ratio was 55%. Year-to-date, ROAA of 90 basis points and efficiency ratio of 72% were impacted by our previously disclosed [ product ] event and the sale of our insurance subsidiary.

Excluding these items, adjusted ROAA through the first 9 months of the year was 100 basis points and efficiency ratio was 65%, reflecting the strength of our core business. Before discussing our third quarter results in greater detail, I would like to provide an update on the wind down of our Banking as a Service offering announced last month after careful review undertaken in conjunction with our annual strategic planning process.

And considering balance-sheet allocation, only about 2% of the bank's total deposits are BaaS-related and they're primarily associated with 4 live partnerships. These deposits amounted to $103 million on September 30, and they averaged $109 million in the third quarter with a cost of 3.84%.

Our initial BaaS partner engagement focused on core funding capabilities, a modest amount of credit extension and transaction-related fees. As we continue to evaluate the financial results associated with this offering, management determined that the business unit economics were not contributing to the company's franchise value as anticipated.

Furthermore, it was added that an exit from the line of business would not have a material impact on the company's future financial performance. Since launching our BaaS offering in 2021, our investments have largely been focused on building a scalable technological interface to engage with our BaaS partners.

This interface also enables smooth integration with other software and tools we rely on, including our customer relationship management solution that supports all business lines. We intend to redeploy our investments of time and talent including headcount to support the significant opportunities we have in Five Star Bank's community banking franchise.

As we work with our customers to wind down their respective relationships, we intend to take the same measured approach that we have since our entry in the past in order to support orderly transitions for our partner firms and their customers.

We're having productive and regular discussions with buy partners about orderly wines and completion remains targeted for some time in 2025. We currently expect to see the outflow of BaaS deposits begin more notably in the first quarter. In our core community banking business, we see good opportunities for deposit gathering among our existing markets and within our consumer, commercial and municipal customer bases as experienced in the third quarter.

Third quarter balance sheet results were highlighted by total deposit growth of $173.3 million or 3.4% from June 30 as public and nonpublic deposit increases more than offset a decrease in reciprocal balance. In addition to seasonality, typical of our public deposits, this portfolio maintained higher comp balances during typical outflow cycles while also growing deposits with new and existing municipalities.

This was complemented by solid growth in nonpublic loss during the quarter. Total deposits were relatively flat year-over-year as both public and nonpublic deposit growth enabled us to reduce reliance on broker deposits, which were down just over $313 million from September 30, 2023.

Total loans were down slightly from June 30, 2024, as increases in commercial mortgage and stability in residential loans declines were offset by declines in commercial business and consumer indirect loans.

Competition for capable commercial operators and high-quality CRE sponsors continues to be very high, and we, like many other banks are seeing business owners utilize excess cash rather than credit and the higher interest rate environment. That said, we continue to see excellent opportunities in our geographic markets to drive credit disciplined loan growth.

Our commercial pipelines are in a rebuilding phase, and we would expect demand to pick up with additional rate cuts. Overall, we remain confident in the health of our portfolios While we did see an increase in nonperforming loans in the third quarter as a result of a $15.5 million commercial relationship that was moved to nonaccrual, we were pleased to report zero commercial net charge-offs begin in the third quarter.

The $31.4 million in nonperforming commercial loans at September 30, 2024, largely relates to 2 separate commercial relationships in upstate New York, which are experiencing issues that are specific to these particular borrowers. We believe we are appropriately reserved each and are working closely with all parties involved toward resolution.

Given the nature of the projects, we do expect that this will take some time. Credit quality remained strong within our Mid-Atlantic portfolio, where our clients operate largely in suburban communities outside Baltimore and Washington, D.C.

Our Mid-Atlantic team as intended, has brought relationships with very strong and experienced developers and provides us with geographic and asset class diversity. Loans in this market totaled $138 million at September 30, 2024. We're also seeing intense competition in the residential lending space as housing inventory remains low in our upstate New York market.

As a result, residential loans in line were relatively flat on a linked-quarter basis at $724.4 million. Credit metrics remained favorable, and we reported zero basis points of residential net charge-offs in the third quarter and a stable level of nonperformers.

Consumer indirect loans totaled $874.7 million at September 30, 2024, down $19.9 million or 2.2% from June 30. While indirect net charge-offs increased from the linked quarter, they remain about half the level we experienced in the first and fourth quarters. We've intentionally reduced our indirect portfolio over time, being thoughtful and considering its percentage of our overall loan portfolio and refocusing on our core upstate New York markets by exiting the Pennsylvania auto market.

At the same time, we've improved the profitability of this line of business and continued to see healthy spreads and favorable credit mix and new production. Indirect lending remains a core lending competency and is a useful balance sheet management tool, given the short duration, associated cash flow and higher yields.

We will continue to maintain this portfolio given the demand and practicality in our core markets where public transportation is fairly limited. For the last 20 years, positive and negative economic cycle, this low category has performed consistently in a narrow range of acceptable credit metrics and risk-adjusted returns.

Our balance sheet remains healthy overall, and we look forward to continuing to build relationships with depositors and borrowers throughout our upstate New York and Mid-Atlantic markets. I'd now like to turn the call over to Jack for additional details on financial results and our 2024 guidance.

[Jack Plants, executive]

Thank you, Marty. Good morning, everyone. We reported net interest margin on a fully taxable equivalent basis of 289 basis points from the third quarter of 2024, up 2 basis points from the linked second quarter. NIM was negatively impacted by the commercial relationship placed on nonaccrual during the quarter that Marty discussed, which reduced margin by 3 basis points.

Net interest income of $40.7 million was down $512,000 from the linked quarter, with the majority of that variance attributable to the reversal of interest income for the single commercial relationship. Interest-earning asset yields increased 3 basis points, modestly outpacing our overall cost of funds, which increased 2 basis points.

While the average yield on interest-bearing liabilities increased from the second quarter as a result of growth in higher cost time deposits, we were pleased to see a slowing of disintermediation from noninterest-bearing accounts for average balances of about $1 billion were stable quarter-over-quarter.

Average total deposits were down about 2% on a linked-quarter basis, largely due to the timing of seasonal public deposit inflows in addition to a decrease in reciprocal deposits which offset an increase in average nonpublic deposits. We continue to be proactive in managing funding costs for CAM and further reduced short-term borrowings in the third quarter.

Since year-end 2023, we've reduced total borrowings and broker deposits by about $307 million or 54%. And looking at our total deposit portfolio, relative to the magnitude of FOMC rate increases that occurred in 2022 and 2023 and the recent 50 basis point decrease, we experienced a cycle-to-date beta of 53%.

Excluding the cost of time deposits, the nonmaturity deposit portfolio had a beta of 32%. Year-to-date NIM of 2.85% at the low end of the 2.85% to 2.95% range we guided in January. At this time, we're narrowing our expected range for full year 2024 NIM to 2.85% to 2.9%.

As a reminder, this guidance was and continues to be based on a spot rate forecast that does not factor in potential future rate cuts. Given quarter-end balances and the continued lending competition that Marty discussed, we now expect 2024 annual loan growth to come in at the low end of our guided range of 1% to 3%.

Our year-to-date cash flows have been lighter than originally modeled at the outset of the year, we do expect that anticipated rate cuts will be accompanied by increased demand for commercial borrowers. We're currently projecting more than $1.1 billion in total cash flow over the next 12 months off the loan and securities portfolios combined.

Noninterest income totaled $9.4 million in the third quarter compared to $24 million in the second quarter when we recorded $13.5 million in pretax gains on the sale of our insurance business. We had a small additional gain of $138,000 related to this transaction in the third quarter of 2024. Also contributing to the linked quarter variance, the net loss of $170,000 on tax credit investments in the third quarter.

This compares to a net gain of $406,000 in the second quarter related to a historic tax credit investment with the New York state of refundable component placed into service in that period. Limited partnership income of $400,000 in the recent quarter with about half the level we recorded in the second quarter and swap fee income was down $165,000 due to a lower level of back-to-back spot activity in the third quarter as compared to the linked quarter.

Recurring noninterest income, which we typically provide guidance on of $9.1 million was down modestly from $9.3 million in the linked quarter. This excludes gains and losses on investment securities, investment tax credits and other assets as well as limited partnership and insurance income.

Investment advisory income, which comes primarily from Career Capital, totaled $2.8 million, relatively flat with the second quarter. Our wealth management subsidiary had $3.2 billion in assets under management as of September 30, 2024, with year-to-date AUM growth of approximately $319 million or 10%, coming from a combination of market appreciation and positive net inflows of $44 million as a result of business development efforts.

Noninterest expense was $32.5 million in the third quarter of 2024, down modestly from $33 million in the second quarter. This was primarily due to a lower FDIC assessment in part due to improvement in our leverage ratio and lower other expenses, including other bank charges and timing of director compensation and donations.

We recorded a provision for credit losses of $3.1 million in the third quarter of 2024 compared to $2 million in the second quarter. Third quarter 2024 provision was driven by a combination of factors, including a slight increase in the natural unemployment forecast and higher qualitative factors overall, partially offset by lower loan balances.

Income tax expense was $1.1 million in the quarter, represented an effective tax rate of 7.4%. Our year-to-date effective tax rate is 12.6% and within our guided range for the full year of 11% to 13%. Our accumulated other comprehensive loss was $102 million at September 30, 2024, an improvement of $23.7 million from June 30.

We reported a TCE ratio at September 30 of 6.93%, intangible common book value per share of $27.28. Excluding the AOCI impact, the TCE ratio and tangible common book value per share would have been 8.38% and $33.02 respectively. We continue to expect these metrics to return to more normalized levels over time given the high credit quality and cash flow nature of our investment portfolio.

Our core financial performance through the first 9 months of the year has been strong and generally in line with our expectations. As mentioned, we've lowered the expected high end range of full year margin to 2.9% and expect 2024 full year loan growth to come in at the low end of our guided range of 1% to 3%.

Additionally, we now expect full year net charge-offs to fall within a range of between 20 to 30 basis points of average loans down from the 30 to 40 basis points we originally guided. There are no other changes to our previously published guidance, which you'll find outlined in our latest investor presentation. That concludes my prepared remarks. I'll now turn the call back to Marty.

[Martin Birmingham, executive]

Thanks, Jack. Amid a continued challenging operating environment, our companies remain intently focused on liquidity, capital and earnings. The actions we've taken over the course of this year have allowed us to expand capital ratios meaningfully, including a common equity Tier 1 ratio of 10.28% up 85 basis points from 9.43% at year-end 2023.

Many of the strategic actions we've taken from the sale of our insurance business to adjustments within our indirect business, to our decision to wind down our Banking as a Service offering have also been focused around supporting our core community banking franchise in our existing footprint.

We remain very focused on driving sustainable growth across each of our retail banking, commercial banking and wealth management business lines and by extension, driving value into the company for the benefit of our shareholders, customers, associates and communities. That concludes our prepared remarks. Operator, please open the call for questions.

[Operator]

[Operator Instructions] Our first question comes from Damon DelMonte from KBW.

[Damon Del Monte, analyst]

Just wanted to start off with a question on margin. I appreciate the updated guidance here for the fourth quarter. Jack, I just kind of want to get your thoughts, though, if we have a couple more rate cuts in '24, and we have a more steady flow of 25 basis point cuts in '25, can you just give us a little perspective on how you're thinking about the margin kind of given the cash flow expectations and what you're seeing for loan growth?

[Jack Plants, executive]

Sure. So I'll just reconfirm that a little over 30% of our loan portfolio is priced off of SOFR prime. And on the commercial side, that adjusts with -- on the prime side with rate cuts and then SOFR adjusts monthly, on the consumer side, the prime adjustments generally adjust on a monthly basis.

And when we provided our margin guidance at the beginning of the year, it was based upon a flat environment. We did some modeling around the impact to NII for rate cuts. And we modeled out that we were fairly neutral for the first 50 basis points of cuts. The expectation on that side was that there was going to be a longer lag for deposit repricing.

We've actually seen our competitors be a little bit more aggressive in adjusting their rates on a posted basis. And as such, we've reacted a little bit more faster than we would have anticipated. So we've already started to price down segments of the consumer, commercial, municipal and reciprocal portfolios. And our expectation is that we continue that with additional rate cuts. So we'll provide full year guidance on our fourth quarter earnings call for 2025. And my expectation is that we kind of remain in that neutral band in the near term.

[Damon Del Monte, analyst]

Got you. Okay. That's helpful. And then with regards to the outlook for loan growth, I think Marty, you made a comment that the commercial pipeline seems to be -- to rebuilding right now. So does that give you better confidence for kind of maybe mid-single-digit growth as we go through 2025?

[Martin Birmingham, executive]

It does, Damon. Thanks for the question and participating this morning. It certainly does. As I also commented last 18 months, we've been focused on liquidity, capital earnings and in light of the operating environment, in light of commentary around concerns over credit, et cetera.

So we've been selective during this period. And we have been signaling to our lending teams and to our customers of our interest to start to rebuild both pipeline and to build momentum in support of growth in the range you just talked about for 2025.

[Damon Del Monte, analyst]

Got it. Okay. That's great. And then maybe just one more quick one here for Jack on expenses, came in lower than what we were looking for this quarter and down a little bit from last quarter. I guess, how do you think about when you kind of reset the button and going into '25, do you think you can kind of maintain a modest like low single-digit type growth outlook here? Or do you have any anticipated expenditures that you're aware or you can disclose?

[Jack Plants, executive]

We're certainly focused on reinvesting in our core lines of businesses for future growth payments. But our mindset over the past couple of years has been certainly focused on expense management and prudent expense management in that regard. So as far as full year expense guidance is concerned for 2025, again, we'll provide that update with the fourth quarter call.

But I would point to our exit from BaaS and the fact that there were 14 FTEs associated with supporting that line of business, they are going to be redirected towards our more mature lines of business. And in my mind, that's cost avoidance where we would have had to have gone out and hired to support growth in future periods.

[Operator]

Our next question comes from David [indiscernible] from Stephens.

[Unknown Analyst]

This is David [indiscernible]. I'm from [indiscernible]. I think I kind of talked about the betas that you kind of saw on the way up. And I would love to hear your thoughts on kind of expectations around the loan and deposit betas on the way down through 2025. And if you kind of expect those figures to be fairly similar to what they were on the up cycle?

[Jack Plants, executive]

Yes, this is Jack. I'll take that question. So as I mentioned earlier, when we were remodeling at the beginning of the year and considering future rate cuts, we had expected to be a bit slower on the downward repricing at least for the first couple of rate cuts in our deposit betas. So a longer lag than we have experienced previously.

What we have seen is that we shortened that lag more than anticipated. The betas again are in line with what we would have anticipated. So from my perspective, in the near term, the impact to margin would be neutral. But as we continue to see the Fed act with additional rate cuts, I see betas catching up to where they would have been historically over time.

[Unknown Analyst]

Okay. Great. And then just on Slide 23 of the presentation, it looks like in most segments, loans are rolling off at a higher rate than the current rate. I don't think those loans are longer duration and we'd see some yield pickup there. So I was just wondering if you could provide some commentary around that?

[Jack Plants, executive]

Yes. So that's been the story as far as our ability to expand margin throughout 2024 with that roll-off yield on the loan portfolio are being reinvested at higher rates. And we've been pretty selective as far as our pricing requirements for deals that we've approved this year on the commercial side in order to preserve and expand margin.

That philosophy hasn't changed, which is why we've seen a lower level of loan growth maybe than some of our peers as we've been selective in that regard. That story continues, and we continue to be focused on spread maintenance and driving towards expansion on the earning asset side.

[Unknown Analyst]

And the last one for me is -- I'm sorry if I missed this. Just in terms of the best wind down, do you expect any onetime costs associated with that?

[Martin Birmingham, executive]

No material one-time costs.

[Operator]

And we currently have no further questions in the queue. I will turn the call back over to Marty Birmingham for closing remarks.

[Martin Birmingham, executive]

Thanks very much for your help this morning, operator. Thanks to all who have participated in our call. We look forward to reporting on our results with you in January.

[Operator]

Thank you, everyone, for your participation. You may now disconnect from the call. Have a nice day.

RECONNECT RECONNECT RECONNECT