Mercantile Bank Corp

NASDAQ:MBWM

Earnings Call Analysis

Earnings Call Transcript 2024-Q2

[Operator]

Good morning, and welcome to the Mercantile Bank Corporation 2024 Second Quarter Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded.

I would now like to turn the conference over to Nichole Kladder, First Vice President, Chief Marketing Officer of Mercantile Bank. Please go ahead.

[Nichole Kladder, executive]

Good morning, and thank you for joining us. Today, we will cover the company's financial results for the second quarter of 2024. The team members joining me this morning include Ray Reitsma, President and Chief Executive Officer; as well as Chuck Christmas, Executive Vice President and Chief Financial Officer.

Our agenda will begin with prepared remarks by both Ray and Chuck, and will include references to our presentation covering this quarter's results. You can access a copy of the presentation, as well as the press release sent earlier today, by visiting mercbank.com. After our prepared remarks, we will then open the call to your questions.

Before we begin, it is my responsibility to inform you that this call may involve certain forward-looking statement, such as projections of revenue, earnings and capital structure, as well as statements on the plans and objectives of the company's business.

The company's actual result could differ materially from any forward-looking statement made today due to factors described in the company's latest securities and exchange commission's filings. The company assumes no obligation to update any forward-looking statements made during the call.

That is all I have for you today, I will now turn the meeting over to our President and Chief Executive Officer, Ray Reitsma. Ray?

[Raymond Reitsma, executive]

Thank you, Nichole. My comments will focus on our loan-to-deposit ratio, deposit growth, loan growth, asset quality, and non-interest income.

Over the last 3 years, commercial loan growth and mortgage loan growth has been strong, and while our deposit growth has been solid, it has not kept pace with total loan growth. As a result, the bank's loan-to-deposit ratio increased to 110% at year-end 2023 compared to 85% at year-end 2021 when deposits were elevated because of the PPP program and the resulting excess liquidity in the system. We believe the bank's elevated loan-to-deposit ratio is a contributing factor to our below-peer valuation despite a strong return profile.

The following comments summarize the strategies we believe will contribute to further reductions in our loan-to-deposit ratio. We have undertaken a 3-pronged approach to building our deposit base with the objective of reducing the loan-to-deposit ratio into the mid-90% range over time.

First, we plan to grow the public and municipal realm through strategic personnel additions with existing relationships in this space.

Second, placing additional focus on small business banking through more efficient underwriting and obtaining the full relationship that characterizes this type of business.

Third, growing the retail customer focus based on total balances as opposed to activity hurdles such as transactions and card usage.

These efforts led to an increase in local deposits in the first half of 2024 of approximately $260 million, a 14% annualized growth rate. Local deposits grew $153 million in the second quarter alone.

Mortgage loans on the balance sheet have grown substantially over the past few years as borrowers have opted for ARMs rather than fixed rates in the increasing rate environment. We have successfully executed changes within our portfolio mortgage programs, resulting in a greater portion of our mortgage production being sold rather than placed on our balance sheet.

The positive outcomes include a 76% increase in mortgage banking income during the first 6 months of 2024 compared to the respective 2023 period, and a nominal increase in mortgage loans on our balance sheet of $12 million year-to-date.

Commercial loan growth in the first half of 2024 was $118 million, or 7% annualized. The current pipeline stands near the trend line established over the last 3 quarters including commitments to fund commercial construction loans of $320 million and residential construction loans of $37 million.

Customer reductions and loan balances from excess cash flow or asset sales of $76 million also impacted our commercial loan totals. Taking these factors into account, we do not expect to see a deceleration in commercial loan growth in the immediate future.

Taken together, these strategies produced a loan-to-deposit ratio of 107% as of June 30, 2024, compared to 110% at year-end 2023, as deposit growth was approximately double total loan growth year-to-date. This ratio reduces to 102% when giving effect to our sweep account balances.

During this period, the ratio of wholesale funds to total funds decreased from 13.8% to 12.1%, another demonstration of the strengthening of the funding side of the balance sheet.

Asset quality remains very strong as non-performing assets sold $9.1 million at quarter end or 16 basis points of total assets consisting of 25% residential real estate and 75% non-real estate commercial loans. There is no commercial real estate representation among the nonperforming assets.

Past due loans and dollars represent 14 basis points of total loans and there is no outstanding ORE. Nonowner occupied office exposure is $271 million or 6% of total loans. The borrowers in this asset class have performed well and continue to be monitored closely.

We remain vigilant in our underwriting standards and monitoring to identify any deterioration within our portfolio. Our lenders are the first line of observation and defense to recognize areas of emerging risk.

Our risk rating model is robust with a continued emphasis on current borrower cash flow, providing prompt sensitivity to any emerging challenges within a borrower's finances. That said, our customers continue to report strong results to date and have not begun to experience the impacts of a potential recessionary environment in any systemic fashion.

Total noninterest income grew 40% during the first half of 2024 compared to the first half of 2023, with growth reported in virtually every category. Mortgage banking income grew 76% based on the strategies outlined earlier and the resulting ability to sell a greater portion of the originations on the secondary market.

Income from interest rate swaps grew 18% as we met our customers' desire for fixed rate financing, principally in the CRE market.

Service charges on accounts grew 58%, reflecting higher activity levels and customer growth, and less earnings credit offset to charges based on reduced balances and transaction accounts.

Payroll services grew by 20% as our offerings continued to build traction in the marketplace.

Finally, credit and debit card income grew 4% when adjusted for the receipt of a 1-time payment from Visa, associated with our contract renewal in the second quarter of 2023.

That concludes my comments. I will now turn the call over to Chuck.

[Charles Christmas, executive]

Thanks, Ray. Good morning, everybody. This morning, we announced net income of $18.8 million, or $1.17 per diluted share, for the second quarter of 2024, compared with net income of $20.4 million, or $1.27 per diluted share, for the respective prior year period.

Net income during the first 6 months of 2024 totaled $40.3 million or $2.50 per diluted share compared to $41.3 million or $2.58 per diluted share during the first 6 months of 2023.

While noninterest income increased during both period, net income was negatively impacted by higher provisions for credit losses and increased noninterest expenses. Net interest income was relatively similar.

Interest income on loans increased during the second quarter and first 6 months of 2024 compared to the prior year periods, reflecting the increased interest rate environment and solid growth in commercial and residential mortgage loans.

Our loan yield during the second quarter of 2024 was 45 basis points higher than the second quarter of 2023, with average loans up about 9% over the respective periods. The improved loan yield largely reflects the combined impact of an aggregate 75 basis point increase in the federal funds rate during the period of March through July of 2023, and over 2/3 of our commercial loans have any floating rate.

Interest income on securities also increased during the 2024 periods compared to the prior year periods, reflecting growth in the securities portfolio and the higher interest rate environment.

Interest income on interest earning deposits, a vast majority of which is comprised of funds on deposit with the Federal Reserve Bank of Chicago, also increased during the 2024 periods compared to the prior year periods, reflecting a higher average balance and an increased yield.

In total, interest income was $13 million and $29.2 million higher during the second quarter and first 6 months of 2024, respectively, compared to the prior year periods.

We recorded increased interest expense on deposits in our sweep account product during the second quarter and first 6 months of 2024, compared to the prior year periods, reflecting the increased interest rate environment, money market and time deposit growth, transfers of deposits from no or low-costing deposit products to higher-costing deposit products, and enhanced competition for deposits.

Our cost of deposits during the second quarter of 2024 was 106 basis points higher than the second quarter of 2023, with average deposits up almost 13% over the respective periods.

Interest expense on the Federal Home Loan Bank of Indianapolis advances also increased during the 2024 period compared to the prior year period, generally reflecting the higher interest rate environment, as well as a higher average advanced portfolio balance in the year-to-date comparison.

Interest expense on other borrower funds increased during the 2024 periods compared to the prior year periods, primarily reflecting the higher interest costs of our trust-referred securities.

In total, interest expense was $13.4 million and $30.7 million higher during the second quarter and first 6 months of 2024, respectively, compared to the prior year periods.

Net interest income declined $0.5 million and $1.5 million during the second quarter and first 6 months of 2024, respectively, compared to the prior time periods.

Our net interest margin declined 42 basis points during the second quarter of 2024 compared to the second quarter of 2023. Although our yield on earning assets increased 46 basis points during that time period, our cost of funds was up 88 basis points.

While we experienced rapid growth in earning asset yield during the period of March of '22 through July of '23 when the FOMC raised the federal funds rate by 525 basis points, meaningful increases in our cost of funds did not begin to materialize until the latter part of 2022 when competition for deposit base balances increased deposit rates and depositors began to move funds from no and lower costing deposit types to higher costing deposit products. Our net interest margin peaked during the latter part of 2022 and early stages of 2023.

Impacting our net interest margin more recently is our strategic initiative to lower the loan-to-deposit ratio, which generally entails deposit growth exceeding loan growth and using the additional monies to purchase securities. A large portion of the deposit growth is in the higher costing money market and time deposit products while the purchase securities provide a lower yield than loan products.

We recorded a provision expense of $3.5 million and $4.8 million during the second quarter and first 6 months of 2024 respectively.

The second quarter 2024 provision expense primarily reflects a specific allocation for a nonperforming non-real estate related commercial loan relationship and allocations necessitated by net loan growth.

The first 6 months expense also includes a specific allocation recorded during the first quarter of 2024 for a different nonperforming non-real estate related commercial loan relationship.

Noninterest expenses were $1.9 million and $3.3 million higher during the second quarter and first 6 months of 2024, respectively, compared to the prior year time periods. The increases largely reflect higher salary and benefit costs, including annual merit pay increases, market adjustments, higher residential mortgage lender commissions, lower residential mortgage loan deferred salary costs, and increased medical insurance costs.

Higher data processing costs also comprise a notable portion of the increased noninterest expense level primarily reflecting higher transaction volumes and software support costs, along with the introduction of new cash management products and services.

We remain in a strong and well-capitalized regulatory capital position. Our bank's total risk-based capital ratio was 13.9% at the end of the second quarter, slightly over $200 million above the minimum threshold to be categorized as well-capitalized.

We did not repurchase shares during the second quarter of 2024. We have $6.8 million available in our current repurchase plan.

While net unrealized gains and losses in our investment portfolio are excluded from regulatory capital calculations, we do regularly compute our regulatory capital ratios assuming the calculations did include that adjustment. While our regulatory capital ratios were negatively impacted by the pro forma calculations, our capital position remained strong.

As of June 30, our Tier 1 leverage capital ratio declines from 12.2% to 11.3%, and our total risk-based capital ratio declines from 13.9% to 12.9%.

Our excess capital, as measured by the total risk-based capital ratio, is also negatively impacted. However, it's still a strong $150 million over the minimum regulatory amount to be categorized as well-capitalized.

On Slide 22 of the presentation, we share our latest assumptions on the interest rate environment and key performance metrics for the remainder of 2024, with the caveat that market conditions remain volatile, making forecasting difficult.

This forecast is predicated on the federal funds rate being lowered by 25 basis points, effective October 1. We continue to project loan growth in the range of 4% to 6%. We are forecasting our net interest margin to be in a range of 3.50% to 3.60% during both the third and fourth quarters.

We expect increased interest costs from continued growth and higher costing money market and time deposits and the renewal of maturing time deposits open in lower interest rate environments to be generally mitigated by the renewal replacement of maturing fixed rate commercial loans and investments that were made and obtained in considerably lower interest rate environments.

We expect noninterest income and noninterest expense to be relatively stable during the remainder of 2024.

In closing, we are very pleased with our 2024 operating results and financial condition and believe we remain well positioned to continue to successfully navigate through the myriad of challenges faced by all financial institutions.

Those are my prepared remarks. I'll now turn the call back over to Ray.

[Raymond Reitsma, executive]

Thank you, Chuck. That concludes the prepared remarks from management. We will now move into the Q&A portion of the call.

[Operator]

[Operator Instructions] The first question comes from Brendan Nosal with Hovde Group.

[Brendan Nosal, analyst]

Maybe just starting off on deposit competition and what you folks are seeing there. I mean, it feels like the mix shift out of noninterest bearing has slowed pretty materially, and the pace of increase in deposit pricing has as well. So I'm just kind of curious where the competitive environment stands, and how much further bleed in funding costs you might see as the year progresses.

[Charles Christmas, executive]

Yes, Brendan, that's a good question. This is Chuck. I would agree with your comment that transfers from the no or low-costing deposit products has definitely slowed from -- certainly from where it was in the back half of last year and the beginning of this year. We still see some of that, but certainly not just what we had before.

One of the things that we haven't seen that we typically do, it kind of goes back to in January of each year, we lose quite a bit of noninterest bearing deposits as our commercial customers pay bonuses, taxes, and partnership distributions. And then we generally see that ramp back up and kind of go through the same cycle again. We're not seeing the growth in noninterest bearing accounts that we typically would, but what we are seeing is those businesses growing their money market and in some cases, time deposits. So I think with the rates being higher than obviously what they have been over the last few years, I think our commercial customers are being more savvy and paying more attention to cash management. And so I think we -- so our margin or net interest income is impacted by them putting money into those higher money market accounts versus the noninterest bearing accounts.

I would say that interest deposit rates in our markets have remained relatively stable for the last few months, which obviously is a good thing. I think, we're still feeling that the rates are relatively high in total, but we're not seeing them increase anymore.

[Brendan Nosal, analyst]

Maybe one more for me before I step back. Just on that goal to get the loan-to-deposit ratio into the mid-90s over time, I know that there's a lot of factors environmentally that can kind of help or hurt that, but just kind of curious how you think about a time frame to get towards that target?

[Raymond Reitsma, executive]

Because of the way you opened your question, we don't think about it with a time frame. You're correct. There are so many variables and our goal in general is to continue to grow the loan portfolio at a pace that our markets and customers demand of us and outgrow that with deposits at the same time. And to do that without going above market for our deposit rates. So those are the factors that will determine how quickly we can bring it down. And for the first 6 months of the year, we've been able to grow our loan book at about 7%, deposit book at about twice that at 14%. And so that's an indication of what the last 6 months environment yielded. We don't expect that to change materially. But as we've seen in financial markets, things do change, and they will. So we'll have to adjust as that happens.

[Operator]

The next question comes from Daniel Tamayo with Raymond James.

[Daniel Tamayo, analyst]

Maybe just digging into credit a little bit. It's obviously been a strength for you guys and remains so. But just curious if you're able to give us any information on the commercial relationship that drove the increase in reserves in the quarter.

[Raymond Reitsma, executive]

Well, it was an outlier. It was non-real estate related. A C&I business that basically ran into management issues, and that caused the credit issue. Doesn't look like it relates to anything systemic in the marketplace, the economy, or our portfolio.

[Daniel Tamayo, analyst]

And what was taken in terms of reserves on that loan? And where does that stand in terms of loan due? I'm sorry, in terms of coverage.

[Raymond Reitsma, executive]

Yes, we reserved it aggressively and fully, so I wouldn't expect to have further reserve related to that credit.

[Daniel Tamayo, analyst]

And then I guess, the classified and criticized trends, anything noteworthy may not be fully up to speed on those yet, but just curious from what you guys know now, like what you can expect when the reg data comes out?

[Raymond Reitsma, executive]

Well, the mix of classified versus not is pretty stable. Qualitatively, within the more risky end of that spectrum, we have a number of exit credits that are working out as anticipated. The rehab credits in that group are healing as anticipated. So from where we sit, we don't expect surprises within that group.

[Daniel Tamayo, analyst]

And then just lastly on credit, the provision and net charge-offs, is there anything different that we should think about in terms of forecasting that loss provision number going forward or outside of the unusual number in the second quarter? Do you still feel like that's relatively stable?

[Charles Christmas, executive]

Yes, [ Dan ]. This is Chuck. I think, we generally don't give guidance on provision. All the firms have their own different thoughts on the economy, and certainly we can see, especially as a commercial lender with some sizable credits, occasionally we do have some one-offs, which hopefully will go the other way as we continue our collection efforts namely on the 2 credits that I mentioned in my prepared remarks. So I would say if you look at a combination of the first and second quarter, kind of average them out is in general what our expectations would be as we sit here today.

[Operator]

The next question comes from Nathan Race with Piper Sandler.

[Nathan Race, analyst]

Just going back to Chuck's comments previously in terms of the deposit and pricing environment being relatively stable of late, just curious kind of how the trend in the margin unfolded over the course of second quarter. Was it relatively stable or kind of steady compression each month between April and June?

[Charles Christmas, executive]

Yes, I would say it was a downward trend throughout the quarter. I think, what we're seeing is that our deposits are repricing a little bit faster than what our assets are repricing as we kind of get to that equilibrium state as we've gone through the timing events that I mentioned. So I -- but I think that we're getting close to the point here, and you can see that in my guidance, is we're getting close to a point of equilibrium. The CD is repricing today while they're repricing, they're not repricing to the magnitude that they were certainly 12 months ago, even 6 months ago. And then, again, we continue to have the repricing on the asset side as well.

So we think on an overall basis with, it looks like the Fed's going to start lowering rates on a measured basis. We feel good about our balance sheet in that environment. So taking all that together, we think when we get here into the third and fourth quarter, is that our margin will be relatively stable at the levels that we projected.

[Nathan Race, analyst]

And then just speaking of repricing, on the right side of the balance sheet, Chuck, can you remind us just in terms of what amount of non-maturity deposits can reprice kind of commensurate with each cut?

[Charles Christmas, executive]

Yes. I think you're kind of touching on something that is going to be a very interesting. I think when we're all looking at trying to forecast our net interest margins as they call them, the deposit betas are, of course, the biggest objective number that we put into our models, we put into our forecasts. And I think now that will get -- it'll become very interesting if the Fed does, in fact, start lowering interest rates. As we see how the competition reacts, clearly, you've heard from our comments today, the loan-to-deposit ratio strategy is very important to us. So that's going to come into the mix as well. I think we definitely have seen some increases in time deposits, but the biggest level of increases by far are the money market rates. Those are the ones that have been priced most aggressively, not just by us, but in the marketplace as well. So it's our expectation, it's I guess our hope, that when the Fed does start lowering interest rates is that we'll see some meaningful declines and the rates being offered on that product within the marketplace as well.

[Nathan Race, analyst]

And then if I could just ask one more on kind of expenses and hiring efforts. Just curious if the updated expense guide for the fourth quarter contemplates any hires that you guys are planning to make to maybe accelerate some progress on the deposit gathering front?

[Charles Christmas, executive]

Yes. Our forecast definitely reflects our expectations in our workforce whether we are hiring additional people or trying to fill existing spots right now. We're always looking for people on all facets of our company on the sales side, whether it be commercial lenders and or primarily deposit gatherers. I would say that we've done some very meaningful hires in the past 12 months to 18 months on the deposit side, and we would definitely like to add to that. And that is somewhat budgeted and put into our forecast. But we are a growing company. We continue to expect to grow, and that will be -- will require increases in our workforce.

But one thing that we definitely have seen over the last couple of years is improvements in our efficiencies, especially with our data analytics team. While we have grown as a company over the last couple of years, if you look at our FTEs, except for our summer intern program that we have that throws those numbers off a little bit from time and again. You can see that our FTEs have been very stable, and that really is a reflection of us becoming more efficient internally. We're taking a look at all of our processes. We're getting smarter about what we're doing, but also the data analytics, the function has also had a nice impact on us helping our efficiency there as well.

[Operator]

[Operator Instructions] The next question comes from Damon DelMonte with KBW.

[Damon Del Monte, analyst]

First one, just wanted to touch a little bit on loan growth. It sounds like the outlook remains pretty solid for you guys. Can you just talk a little bit about what areas of your footprint are providing the best opportunities, and kind of within those opportunities, what segments of the economy are providing good credits for you guys?

[Raymond Reitsma, executive]

Yes, Damon. This is Ray. The loan opportunities have been pretty well dispersed and not concentrated in any particular part of our geography. Of course, we have some concentration here in Grand Rapids because of the concentration of existing assets that we have here. But in terms of new opportunities, they're spread around the state. And our search as we grow our commercial book, we're looking for good companies and good management teams. And what industry they're in is less important to us. We just absolutely want to find good management teams that will continue to uphold our credit quality. So we haven't focused in any particular areas of the economy. It's more company-specific driven.

[Damon Del Monte, analyst]

And then kind of switching to the loan yields, Chuck, I think they were kind of flat this quarter, quarter-over-quarter. Is that a function of what you're seeing for new pricing opportunities in the market? Or is that more of a function of the majority of the portfolio has kind of been reset to current rates?

[Charles Christmas, executive]

Yes, I think it's a combination of both. Clearly, we're at the -- as at the end of the quarter, we're up to 70% of our commercial loans are floating rate. So clearly, those going up seems to be done from market expectations on the Fed's next move. We definitely have on an ongoing basis, we have fixed rate loans that were made in much lower rate environments coming up for maturity, and those are either leaving or paying off. But what happens most of the time is they're refinanced. They're ballooning, so they're refinanced at existing rates.

And I would say that in the current pricing marketplace is we're getting yields that are a little bit higher than our overall yield for sure, but the dollar amounts involved are not as significant.

[Damon Del Monte, analyst]

And then I guess lastly on capital, stocks had a very nice run lately, so I guess any updated thoughts on the buyback, probably not at current levels? Is that fair?

[Charles Christmas, executive]

No, we're obviously very pleased with the stock performance over the last week or so, and actually last month or so. I would say our thoughts on capital is that we want to preserve it as much as we can. Clearly, again, we're a growing company. As everybody knows, there's different ratios that we and regulators look at when it comes to comparing that to capital levels. We want to make sure that we're in good stead there. Clearly, we want to have some dry powder, whether it's taking advantage of opportunities. You never know about the economy. So we're pretty comfortable kind of staying on the sidelines with the buyback program. Clearly, the price is probably the biggest driver there. So at these levels, certainly would not expect to initiate any of that. As you saw, we increased the dividend again, as we typically do in the first and the third quarters. So increasing the cash return to our investors at a percent of earnings that we think makes sense for us. Again, making sure that we have capital for the items that I spoke of.

[Operator]

This concludes our question-and-answer session. I would like to turn the conference back over to Ray Reitsma for any closing remarks.

[Raymond Reitsma, executive]

Thank you for your participation in today's call and for your interest in Mercantile Bank. We appreciate it, and that concludes today's call.

[Operator]

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.