Midwestone Financial Group Inc (IOWA)

NASDAQ:MOFG

Good morning, and welcome to the Mercantile Bank Corporation 2024 Fourth 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.

Happy New Year, everyone, and thank you for joining us. Today, we will cover the company's financial results for the fourth 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 statements, 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 results could differ materially from any forward-looking statements 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.

Let's begin, Ray.

Thank you, Nichole. My comments will focus on the changes that have been made to the funding side of our balance sheet and the resulting impacts on the income statement as well as our strong loan growth, excellent asset quality and growing noninterest income. Taken together, these performance traits have allowed us to compile attractive compounded annual growth rates for the benefit of our shareholders.

From the year-end 2021 to year-end 2023, commercial and mortgage loan growth was strong, and while deposit growth was solid, it did not keep pace with loan growth. The outflow of deposits from the banking system post-COVID contributed to this trend. As a result, the bank's loan-to-deposit ratio increased from a 110 -- increased to 110% at year-end 2023.

In 2024, we focused on reducing this ratio with the goal of -- to strengthen our on-balance sheet liquidity and overall financial profile. As described in previous calls, we undertook 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.

To reiterate, first, we broadened our focus on business deposits, including entities that have limited or no borrowings. Second, we plan to grow in the governmental and public realm through strategic personnel additions with existing relationships in this space. And third, we are growing the retail customer focus based on total balances as opposed to activity hurdles such as transactions or card usage. These efforts led to an increase in local deposits in 2024 of $816 million, a growth rate of more than 20%.

Local deposits grew $216 million during the fourth quarter alone. The growth in local deposits not only funded our strong loan growth but also allowed reduction in wholesale funding sources for the year, including an $81 million reduction in FHLB advances and a $19 million reduction in broker deposits.

Commercial loan growth for the fiscal year-end was $292 million, or 8.5% over the prior year-end, and was $59 million for the fourth quarter. Customer reductions in loan balances from excess cash flow or sale of assets of $88 million during the fourth quarter impacted our commercial loan totals. The pipeline stands at $296 million and commitments to fund commercial construction loans totaled $245 million, which has slightly increased from the prior quarter end. Taking these factors into account, we expect commercial loan growth in the immediate future to approximate the pace of the recent past.

Mortgage loans on the balance sheet have grown substantially in the increasing rate environment experienced over the past few years as borrowers have opted for ARMs, which reside on our balance sheet rather than fixed rate loans, which are sold in the secondary market. 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 62% increase in mortgage banking income during fiscal 2024 compared to fiscal 2023 and a nominal decrease in mortgage loans on our balance sheet.

Our mortgage team continues to build market share despite a challenging rate environment, allowing results that diverge from average in the market. While mortgage banking is certainly rate-dependent, the level of earnings from this activity that can be considered core or somewhat independent of the rate environment is increasing.

The 22% growth in local deposits coupled with the 7% growth in the loan portfolio drove our loan-to-deposit ratio from 110% at year-end 2023 to 98% at year-end 2024 and contributed to a reduction in our reliance on wholesale funding from 14% at fiscal year-end 2023 to 10% at fiscal year-end 2024.

Asset quality remains very strong as nonperforming assets sold $5.7 million at year-end or 9 basis points of total assets, consisting primarily of residential real estate and non-real estate commercial loans. There is only $42,000 in commercial real estate representation among nonperforming assets.

Past due loans in dollars represent 16 basis points of total loans and there is no outstanding ORE. 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 impacts of a potential recessionary environment in any systematic way.

Total noninterest income grew 26% during 2024 compared to 2023 with growth reported in several categories. Mortgage banking income grew 62% based upon the strategies outlined earlier and the resulting ability to sell a greater portion of originations on the secondary market. Service charges on accounts grew 38% reflecting higher activity levels and customer growth and less earnings credit offset to charges based on reduced balances and transaction accounts. Payroll services grew 22% as our offerings continue to build traction in the marketplace.

Finally, credit and debit card income grew 2% when adjusted for the receipt of a onetime payment from Visa associated with our contract renewal in the second quarter of 2023. Income from interest rate swaps declined 18% as demand by borrowers for interest rate protection shifted with borrowers' future rate expectations.

The results for 2024 described above contribute to a solid 5 year track record of compounded annual growth rates across key metrics, including total loans of 10%, total deposits of 11.8%, earnings per share of 10.1%, and tangible book value per share of 8.4%.

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

Thanks, Ray, and good morning to everybody. This morning we announced net income of $19.6 million, or $1.22 per diluted share for the fourth quarter of 2024 compared with net income of $20.0 million, or $1.25 per diluted share for the respective prior year period. Net income for the full year 2024 totaled $79.6 million, or $4.93 per diluted share compared to $82.2 million, or $5.13 per diluted share during the full year 2023.

While noninterest income increased during both periods, net income was negatively impacted by expected lower net interest income and increased noninterest expense. Interest income on loans increased during the fourth quarter of 2024 compared to the respective prior year period, reflecting strong loan growth that more than offset a lower yield on loans. Average loans totaled $4.57 billion during the fourth quarter of 2024 compared to $4.18 billion during the fourth quarter of 2023.

Our yield on loans during the fourth quarter of 2024 was 12 basis points lower than the fourth quarter of 2023, largely reflecting the aggregate 100 basis point decline in the federal funds rate during the last 4 months of 2024. Interest income on loans increased during the full year 2024 compared to the full year 2023, reflecting strong loan growth and a higher loan yield.

Average loans totaled $4.43 billion during 2024 compared to $4.05 billion in 2023. The yield on loans was 36 basis points higher in 2024 than it was in 2023, primarily reflecting the aggregate 100 basis point increase in the federal funds rate during the first 7 months of 2023, which more than offset the aggregate 100 basis point decline in the federal funds rate during the last 4 months of 2024.

Interest income on securities increased during the fourth quarter and full year 2024 compared to the respective prior year periods, reflecting growth in the securities portfolio and a 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, largely reflecting a higher average balance.

In total, interest income was $8.7 million and $50.1 million higher during the fourth quarter and full year 2024, respectively, compared to the respective prior year time periods. We recorded increased interest expense on deposits during the fourth quarter and full year 2024 compared to the respective prior year periods, primarily reflecting a higher interest rate environment and growth in money market and time deposit products.

Our cost of deposits was 42 basis points and 92 basis points higher during the fourth quarter and full year 2024 compared to the respective prior year periods. The average deposits totaled $4.52 billion during the fourth quarter of 2024 compared to $3.8 billion during the fourth quarter of 2023, while average deposits totaled $4.23 billion during the full year 2024 compared to $3.76 billion during the full year 2023.

Interest expense on Federal Home Loan Bank of Indianapolis advances during the fourth quarter of 2024 was similar to that of the fourth quarter of 2023, reflecting an offsetting lower average balance and higher average cost. Interest expense on Federal Home Loan Bank of Indianapolis advances during the full year 2024 was higher than during the full year 2023, reflecting a higher average balance and average rate.

Interest expense on other borrowed funds during the 2024 periods was similar to the respective prior year periods. In total interest expense was $9.0 million and $52.6 million higher during the fourth quarter and full year 2024 compared to the respective prior year time period. Net interest income declined $0.3 million and $2.5 million during the fourth quarter and full year of 2024 compared to the respective prior year time periods.

Impacting our net interest margin was 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 was in the higher-costing money market and time deposit products, while the purchased securities provide a lower yield than loan products.

Our net interest margin declined 51 basis points during the fourth quarter of 2024 compared to the fourth quarter of 2023. Our yield on earning assets declined 14 basis points during that time period, largely reflecting the aggregate 100 basis point decline in the federal funds rate during the last 4 months of 2024, while our cost of funds was up 37 basis points, primarily reflecting an increased mix of higher costing money market and time deposits.

Our net interest margin declined 47 basis points during the full year 2024 compared to the full year 2023, while our yield on earning assets increased 34 basis points during that time period, our cost of funds was up 81 basis points.

While we experienced rapid growth in our earning asset yield during the period of March of 2022 through July of 2023, when the Federal Reserve 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 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. While loans increased $297 million during 2024, or almost 7%, deposits grew $797 million or over 20% during the same time period, providing a net surplus of funds totaling $500 million. We used that net surplus of funds to grow our securities portfolio by $113 million and reduce our Federal Home Loan Bank of Indianapolis advances by $81 million. A majority of the remainder of the net surplus of funds is on deposit with the Federal Reserve Bank of Chicago.

We recorded a provision expense of $1.5 million and $7.4 million during the fourth quarter and full year 2024, respectively. The fourth quarter 2024 provision expense primarily reflects an increased allocation for slower prepayment speeds on residential mortgage loans and allocations necessitated by net loan growth.

The provision expense recorded during the full year 2024 also includes specific allocations for 2 nonperforming non-real estate-related commercial loan relationships that were established during the first and second quarters, along with allocations necessitated by net loan growth.

Noninterest expenses were $3.9 million and $10.5 million higher during the fourth quarter and full year 2024 compared to the respective prior year time periods. The increases largely reflect higher salary benefit costs including annual merit pay increases, market adjustments, higher residential mortgage lender commissions, lower residential mortgage loan deferred cost -- salary costs and increased medical insurance costs. Higher data processing costs also comprised a notable portion of the increased noninterest expense levels, primarily reflecting higher transaction volumes and software support costs along with the introduction of new cash management products and services.

Contributions to the Mercantile Bank Foundation totaled $1.0 million and $1.7 million during the fourth quarter and full year 2024 respectively, compared to $0.3 million and $0.7 million during the respective prior year periods. 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 2024, about $214 million above the minimum threshold to be categorized as well capitalized. We did not repurchase shares during 2024. We have $6.8 million available in our current repurchase plan.

On Slide 23 of the presentation, we share our assumptions on the interest rate environment and key performance metrics for 2025 with the caveat that market conditions remain volatile, making forecasting difficult. This forecast is predicated on no changes in the federal funds rate during 2025. We project loan growth in a range of 5% to 7% and we are forecasting our net interest margin to be in a range of 3.3% to 3.4% during all time periods. Expected results for noninterest income and noninterest expense as well as our federal income tax rate are also provided for your reference.

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.

That concludes my prepared remarks. I'll now turn the call back over to Ray.

Thank you, Chuck. That concludes our prepared remarks from management. We will now move to the question-and-answer portion of the call.

[Operator Instructions] Our first question is from Brendan Nosal with Hovde Group.

This is John on for Brendan. So I wonder if we could just start with the margin. I know your guide calls for no changes in your short-term rates. Can you maybe just add some color on how the margin outlook would change, if we end up getting say, 1 to 2 rate cuts this year?

Yes, sure. This is Chuck. We've all -- as you would expect, we've been through a lot of different scenarios as we put our budget together for the year. And if we were looking at a 1 or 2 declines in the Fed funds rate during the first half of this year, we'd be looking at somewhere a margin of about 5 basis points lower than what we're projecting if rates don't change for the whole year.

That's very helpful. And then maybe just pivoting to loan growth. The outlook looks pretty healthy and definitely keeping with what you generated in 2024. Can -- maybe just offer a little bit of detail on where you might be seeing pockets of strength and maybe areas of weakness?

So, this is Ray. The areas of weakness, the automotive suppliers that we bank are coming out of the weakness that we've identified in prior quarters. But I'd say they're still under their average state of being. So I'd say that's probably the area that we're watching the closest. But they do report that they've picked up work and that the outlook is improving.

And then everything else is fairly even C&I opportunities around transition and ownership and the like continue to be strong. And the real estate markets that we serve are pretty firm as well. So I'd say there really isn't much change to what we've experienced in the recent past.

The next question is from Daniel Tamayo with Raymond James.

Yes. Maybe we start just on the loan deposit initiative, Ray. You guys have really made some significant progress there in not a lot of time and gotten the loan deposit ratio down to 98% already. So curious, I know you've talked about in the past getting that to mid-90s range, if that's still the goal? And then as we think about that bigger picture, is there any impact that that's having on loan growth in your mind? And as you get or approach that goal, is there some kind of change in the way that you would be thinking about loan or deposit growth following that?

Yes, I appreciate the question. What we've tried to do is focus on our deposit base in a way that is not to the detriment of loan growth. And one of the key components of that is the rather artful way that our mortgage department has continued to meet the needs of the community in an increasing way and increase market share and yet put fewer of those on the balance sheet. So we end up in a position where we actually shrunk that portfolio slightly in this environment.

On the commercial side, we really haven't talked about reining that in at all, but it's more of a shift in focus to clients that have stronger deposit characteristics than average in our prospecting efforts, and as a result, we've been able to make the mathematical moves that you see in this entire year. The first quarter of next year is a seasonally challenging one for us as tax payments and bonuses flow out of our commercial clients' accounts, but we expect to continue the progress that we've made and the mid-90s is still the goal.

Great. And do you have thoughts on what you expect to achieve or think is a reasonable number for deposit growth next year -- this year?

I think that to repeat this year is a tall order. So probably something in the low double-digits would be more along the lines of expectations, certainly won't stop our efforts there, but that's where our expectations lie.

Terrific. And then just one more for me on CRE concentration. So you had the mix shift in the loan portfolio that caused that concentration to go up a little bit. I mean you're still not at or near 300%, but you're closer. Does that enter your mind as you think about loan growth? I'm just curious how you guys -- I mean, you've got a slide on it, but just curious how you're thinking about that in the overall...

Yes, the way we haven't thought -- the way we think about it hasn't changed at all. And C&I was a little bit less at the end of this year, but we don't expect that to necessarily persist. We think our mix will remain fairly consistent in the 55, 45 sort of split that we've shown for a large number of years.

And Danny, this is Chuck. I'll add something else is -- while it's still relatively significant, our volume of construction loans to fund as we sit here today compared to what it was 12 and 18 months ago is down quite a bit. I would say about $100 million to $120 million. So it's still a significant number, I think, overall to fund, but it's not as significant because in 2024, we funded a lot of that and the pipeline just isn't quite as strong as it was in the past. So a long way of saying that the growth in the CRE will be a little bit lessened because of less funding of construction loans.

In general, housing stock is in short supply in the markets that we serve, and that's really what pushed that number slightly up. And I think that, that's still a true statement about our markets that they're short on housing stock, but we expect our proportions to follow what we've shown historically.

The next question is from Nathan Race with Piper Sandler.

Just a question on kind of the sizes of the securities portfolio going forward. Obviously you've grown it here in 4Q and you have still pretty strong deposit growth aspirations going forward. So just curious how you're thinking about the size of the securities portfolio going forward, and what you're seeing, or expecting in terms of some investment rates there?

Yes. This is Chuck. We're expecting continued growth in the securities portfolio this year as it is the recipient of the additional funding with deposits exceeding loans. I would expect in the long-term that, that probably kind of goes up to maybe the 15%, 16%, perhaps the 17% range, and that's where we would be with a loan-to-deposit in the mid-90s.

So I would expect that, if we keep loan-to-deposits around the mid-90s, which is likely our expectation, at least in the near-term, the securities portfolio will be somewhere in that 15% to 17% range. Part of that is how much money we continue to keep at the Federal Reserve.

When we look at on-balance sheet liquidity, look at the environment, regulatory encouragement, those types of things, if we bring that down, that might add another basis point or 2 to the securities portfolio, but at least in the short-term, say 2025, we expect our on-balance sheet liquidity, primarily that balance of the Fed to remain relatively high.

Got it. That's helpful. And just going back to the margin discussion. Curious how we can kind of think about the trajectory of loan yields just given what you're seeing in terms of new loan pricing these days, assuming the Fed remains on pause at least over the next quarter or 2?

Yes. I think we continue to be very vigilant in how we price loans, that's something we learned during the Great Recession is that we needed to be vigilant and making sure that we were getting paid for the risk and obviously taking into account our cost of funds. So I think our loan pricing, when we look at our spreads, which a lot of that's driven by the loan grade, obviously, as well as competition, I think we continue -- as we employ that formula and we maintain our discipline, I think we continue to get the loan rates that are commensurate with the risk as well as what's going on with market rates. So really no concern on how we're pricing loans.

And then on the deposit side, especially with growth, a lot of our loans are floating rate as we talk about a lot, but what we have seen is on the deposit side, that deposit structure, especially with the growth in the money market, which in large, is not legally -- very little of it's legally tied to Fed funds rate, but the way we manage it will be tied to Fed funds rate. We get some really good strong matching regardless of what rates do.

And again, our goal is to be as interest rate agnostic as we possibly can to build our balance sheet whether rates go up or down or sideways, whatever they do, that has a nominal impact on our net interest margin, and then really think of that -- that's our strategy, and we think that, that makes sense. And I think what we've seen over the last couple of years, especially 2024, that, that is a successful strategy for us.

And maybe one last one for me. Just curious how comfortable you guys are allowing capital levels to build over the course of this year before maybe contemplating some more significant deployment of excess capital. Just any thoughts on just kind of the comfort range for maybe [ TCE ] or some of the other capital levels as 2025 progresses?

Yes. I think I don't really foresee any significant change in our capital the way that we've been managing it, certainly in 2024, and I would say before that, at least a year or 2. We want to be very judicious in maintaining, I would say, relatively strong capital ratios. I think for most of that is just to make sure we're supporting our loan growth. 5% to 7% loan growth is still a very solid number. And of course, it takes capital to manage that. We do -- we have and we announced today that we continue to increase our cash dividend. We typically do that twice a year and don't have any plans to change that notwithstanding, obviously, anything that's going on with our performance or anything in the marketplace.

So I would say if you looked at our capital position, we look at our growth rate and our overall earnings expectations is that our capital will remain relatively steady as we go forward that our retained earnings basically supports our capital growth -- excuse me our loan growth and overall asset growth. And we're pretty comfortable with where the capital ratios are at currently.

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

Hope you guys are all doing well and then New Year is off to a good start. Just a couple of quick follow-ups here. And as we think about credit and provisioning, obviously very strong credit trends with very low NPLs, and it seems like the underlying trends continue to support that kind of outlook. So how -- Chuck, could you give us a little insight on how to think about the provision going forward? It seems like it will just be driven by the pace of loan growth. Is that a fair way to look at it?

That's the way that we're looking at it, Damon is that a large percent of the provision that we're expecting for 2025 is necessitated by loan growth. We think the economic environment will remain relatively stable, knock on wood. So we don't see a lot of provision one way or the other because of grade changes and those types of trends that we might see in the loan portfolio.

And yes, we're budgeting, and I -- is what we have seen from this company for a decade now is relatively low loan losses, and we think that, that will -- looking at our current asset quality again, an expected steady economic environment at least in the near-term, we expect a pretty low level of net charge-offs for 2025.

Okay. Great. And then I know there's seasonality here through the winter months with mortgage banking, but could you just give us an update on the mortgage banking pipeline and kind of with the shift in the approach to that business line, kind of what the outlook is for '25?

So the current state of the pipeline is, I'd say seasonally strong. It's held up quite well through this quarter, and in spite of a material deterioration in the weather and the ability to view a home that you consider purchasing. And I think I'll let Chuck speak to how we view that and factor it into next year.

Yes. I think if you look at the guidance that we give on Page 23, I think when you look at that change quarter-to-quarter in fee income, that really is reflective of the seasonality of the mortgage operation.

Got it. Okay. Great. And then I guess just lastly, kind of a modeling question here. Your guidance for the tax rate is 19% next year. This quarter was lower. Was there just some year-end true-up items that caused the lower tax rate this quarter?

Yes. Mostly some true-up, and it was really related to what we started about 18 months, almost 24 months ago is our activity associated with low-income housing tax credits and historical tax credits, that operation has gone fantastically. We're very, very happy with the trends that we see. And those types of things take a while before they start settling into our income statement. And we saw some of that happening in 2024, but really didn't book much of that until the last quarter as we made sure that we understood the entries and the performance of the activities that we're engaged in.

We think that, that will continue to be an increasing impact on our overall profitability. And we see that with a tax rate of, say that was 20% over the last few years, getting down to 19%, and we're hopeful that as we go forward and that operation continues to be successful, that we can bring that rate down even more. But for the fourth quarter, there was definitely some true-up and most of that was related to those activities.

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

Thank you for your participation in today's call and for your interest in the Bank. That concludes today's call.

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