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Edited Transcript of FDEF earnings conference call or presentation 23-Jul-19 3:00pm GMT

Q2 2019 First Defiance Financial Corp Earnings Call

DEFIANCE Jul 25, 2019 (Thomson StreetEvents) -- Edited Transcript of First Defiance Financial Corp earnings conference call or presentation Tuesday, July 23, 2019 at 3:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Donald P. Hileman

First Defiance Financial Corp. - President, CEO & Director

* Paul D. Nungester

First Defiance Financial Corp. - CFO & Executive VP

* Tera Murphy

First Defiance Financial Corp. - VP & Marketing Director

* Vincent J. Liuzzi

First Federal Bank of the Midwest - President

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Conference Call Participants

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* Christopher William Marinac

Janney Montgomery Scott LLC, Research Division - Director of Research and Banks & Thrifts Analyst

* Damon Paul DelMonte

Keefe, Bruyette, & Woods, Inc., Research Division - SVP and Director

* Nicholas Anthony Cucharale

Sandler O'Neill + Partners, L.P., Research Division - Director

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Presentation

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Operator [1]

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Good day and welcome to the First Defiance Second Quarter 2019 Earnings Conference Call and Webcast. (Operator Instructions) Please note this event is being recorded.

I would now like to turn the conference over to Ms. Tera Murphy with First Defiance Financial Corp. Please go ahead.

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Tera Murphy, First Defiance Financial Corp. - VP & Marketing Director [2]

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Thank you. Good morning, everyone, and thank you for joining us for today's 2019 second quarter earnings conference call. This call is also being webcast, and the audio replay will be available at the First Defiance website at fdef.com. Providing commentary this morning will be Don Hileman, President and CEO of First Defiance; Paul Nungester, Executive Vice President and Chief Financial Officer. Following their prepared comments on the company's strategy and performance, they will be available to take your questions.

Before we begin, I'd like to remind you that during the conference call today, including during the question-and-answer period, you may hear forward-looking statements related to the future financial results and business operations for First Defiance Financial Corp. Actual results may differ materially from current management forecasts and projections as a result of factors over which the company has no control. Information on these risk factors and additional information on forward-looking statements are included in the news release and in the company's reports on file with the Securities and Exchange Commission.

And now I'll turn the call over to Mr. Hileman for his comments.

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Donald P. Hileman, First Defiance Financial Corp. - President, CEO & Director [3]

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Thank you, Tera, and good morning and welcome to the First Defiance Financial Corporation Second Quarter Conference Call. Last night, we issued our 2019 second quarter earnings release, and I would like to discuss those results and give you an outlook into the remainder of the year. Joining me on the call this morning to give more detail on the financial performance for the quarter is our CFO, Paul Nungester. At the conclusion of our remarks, Paul; Vince Liuzzi, our bank President; Brent Beard, our Controller and Treasurer; and I will answer any questions you might have.

Overall, we had a strong quarter with sustained movement toward our strategic goals and a positive trend in our profitability. The second quarter results reflect our expected operating performance. Net income for the second quarter of '19 on a GAAP basis was $12.2 million or $0.61 per diluted common share compared to $11.1 million or $0.54 per diluted common share in the second quarter of '18, a 13% increase in EPS. Our overall core performance this quarter helped drive a solid return on average assets of 1.52% compared to 1.48% in the second quarter of 2018.

Loan growth rebounded in the second quarter reflecting an annualized growth rate of 12%. On a year-to-date basis, our loan growth rate was 6.6%, which is more in line with our full year expectation, and year-over-year growth was at 10%. We believe that upper single-digit annual loan growth is still an achievable goal.

We did see an increase in loan yields of 6 basis points on a linked quarter basis and 37 basis points compared with second quarter of '18. Total deposits were up 8% year-over-year and down 0.08% on a linked quarter annualized basis. We're also very pleased with our margin's stability this quarter maintaining 4.03%, an increase of 8 basis points over the second quarter of 2018. We expect to see very expanded rates on select lending deals going forward with more request for longer-term fixed rates in this environment. We expect to see some margin compression in the second half of the year due in part to downward pressure on asset yield and some remixing of balances on the liability side as well as more limited downward pricing opportunities on the liabilities.

Improved credit quality metrics have been anticipated, and this quarter's improvement was evident when compared to both the second quarter of '18 and on a linked quarter basis. At the quarter end, we ended with 0 balances in OREO. It's been a long time since I can remember this ever being the case. Paul will provide details on the movement of nonperforming assets and nonperforming loans in a few minutes.

With this positive shift this quarter, we know we must continue to work hard to see stable to improving asset quality trends across the board in the near term. We are also pleased to announce a 2019 third quarter dividend of $0.19 per share representing a 27% increase over the second quarter of '18 and an annual dividend yield of approximately 2.8%.

I will now ask Paul to provide additional financial details for the quarter before I conclude with an overview. Paul?

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Paul D. Nungester, First Defiance Financial Corp. - CFO & Executive VP [4]

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Thank you, Don, and good morning, everyone. I'm pleased to provide a deeper look into our second quarter 2019 financial results and outlook for the remainder of the year.

As Don noted, net income for the quarter was $12.2 million, up 10% from $11.1 million last year; and earnings per share was $0.61, up 13% from $0.54 last year. The year-over-year comparison primarily reflects our continued strong core profitability growth as well as improved asset quality.

Beginning with the balance sheet. Loan growth for the second quarter of 2019 improved significantly from the first quarter as we expected. After experiencing only $9 million in net loan growth last quarter, we achieved impressive growth of approximately $75 million in the second quarter. That translates to annualized loan growth of approximately 7% for the first half of the year. Looking ahead, our loan pipeline remains robust, and we do not currently expect significant payoffs in the second half of the year. As a result, we still anticipate solid upper single-digit loan growth for the year, as we previously stated.

Turning to deposits. We were essentially flat for second quarter after robust growth of $65 million in the first quarter. A very competitive pricing environment has led to continued rate increases within our markets. However, we are pleased to be up almost 8% in deposit balances from the prior year, and we do expect to rebound in growth during the second half of the year.

Other balance sheet items to note for the second quarter included $6.6 million BOLI premium purchased in May and $30 million of FHLB fixed rate advances in late June at an average cost of 2.05% to support our loan growth initiatives. Overall, growth has been consistent for the first half of the year, and we are very pleased with the strength of our balance sheet. Our strong earnings asset mix, coupled with rising but manageable low-cost deposit funding, continue to generate a very profitable margin, and we anticipate solid balance sheet growth to continue in the second half of 2019.

Turning now to the income statement. Our net interest income was $29 million for the second quarter of 2019, up from $28.3 million in the linked quarter and up $2.4 million or 9.2% from the $26.5 million in the second quarter last year. The increase over the prior year quarter is primarily driven by growth in earning assets as well as margin expansion from a year ago.

Our margin this quarter was 4.03%, consistent with last quarter and up 8 basis points from 3.95% in the second quarter last year. On a linked quarter basis, our yield on earning assets was up 7 basis points as our loan portfolio yield rose to 5.12%, while our cost of interest-bearing liabilities was up 8 basis points to 1.14%. However, despite the slightly narrow spread, our noninterest deposit mix helped our overall funding costs in support of a solid margin again this quarter. Our earning asset mix and funding mix have both performed well, and we have maintained our consistently balanced exposure to interest rate changes. As such, we believe that our margin would continue to perform well. However, we do expect contraction beginning in the third quarter primarily due to an expected Fed fund rate cut. The severity will depend on how deep they cut and whether they cut once or multiple times.

In addition, we have been fortunate to generate some healthy interest recoveries such that our second quarter NIM would have been 3.98% excluding those, and that's not something we would rely on a go forward. Rather, we are proactively addressing our funding costs while maintaining our loan pricing discipline, focusing on cost containment and evaluating other revenue enhancements.

Total noninterest income was $10.5 million in the second quarter of 2019, down from $10.8 million in the linked quarter primarily due to $920,000 of contingent interest commissions -- insurance commissions included in the first quarter but up from $10.2 million in the second quarter of 2018. The year-over-year increase is primarily attributable to both mortgage banking and insurance commissions.

Regarding mortgage banking. Revenues for the second quarter of 2019 were $2.1 million, up $296,000 from the linked quarter and up $124,000 in the second quarter of 2018. Second quarter 2019 mortgage originations were $85.5 million, seasonally up compared to $46 million last quarter but also up from $80.5 million in the second quarter 2018. Gain-on-sale income was $1.8 million in the second quarter of 2019, up both from $1.3 million in the linked quarter and $1.4 million in the second quarter last year. Offsetting these improvements were the negative MSR valuation allowance adjustment of $190,000 after a negative adjustment of $113,000 last quarter and compared to a positive adjustment of $47,000 in the prior year.

Aside from mortgage banking, we generated insurance commissions of $3.6 million, up $123,000 or 3.5% from last year; and service charges of $3.3 million, essentially flat from a year ago. BOLI income increased $136,000 from the linked quarter but declined $39,000 from the second quarter of 2018. These fluctuations reflect both the $6.6 million premium purchase I mentioned earlier as well as a $93,000 death benefit received in the second quarter of 2019 compared to $168,000 in the second quarter of 2018. Overall, we are pleased with the performance of our core fee businesses in the second quarter.

Regarding noninterest expenses. Second quarter 2019 totaled $24.2 million, down from $24.9 million in the linked quarter but up from $22.7 million for the second quarter of 2018. As a reminder, the first quarter 2019 included $264,000 in other expenses for OREO write-downs. The expense increase compared to last year is primarily attributable to compensation and benefits, which rose $0.3 million from last quarter and $1.5 million from last year. This increase reflects costs for our continued metro market expansion efforts as well as higher medical benefit costs.

All of the above contributed to strong and improved operating profitability. Pretax pre-provision income was $15.2 million for second quarter 2019, an increase of 7% from $14.2 million in the linked quarter and 8% from $14.1 million in the second quarter of 2018.

Regarding asset quality. Provision expense for the quarter was $282,000 compared to last quarter's expense of $212,000 and the second quarter 2018's expense of $423,000. The provision this quarter was lower than anticipated mostly due to net loan recoveries of $488,000 versus net charge-off of $379,000 last quarter and $369,000 last year. However, strong loan growth for the quarter drove an increase in the allowance overall. Our allowance for loan loss at June 30, 2019, was $28.9 million, up from $28.2 million at March 31 and up from $27.3 million on June 30 of last year with the year-over-year change mostly driven by the growth in loans. The allowance to total loans ratio at June 30, 2019, was 1.10%, consistent with last quarter and down from 1.15% a year ago, which reflects reduced levels of nonperforming loans and improved asset quality metrics. Nonperforming loans declined this quarter to $15.3 million from $17.6 million last quarter and were down 16% from $18.3 million at June 30, 2018.

Our OREO balance also decreased this quarter to 0 from $0.9 million last quarter and $1.8 million in the second quarter last year. As noted earlier, we did take an OREO write-down of $264,000 in the first quarter of 2019, and we completed the disposition of that asset in the second quarter. Our accruing troubled debt restructured loans this quarter also declined to $10.3 million from $11.9 million last quarter and were down 35% from $15.8 million a year ago. With the change in NPAs, the allowance coverage of nonperforming assets at quarter end improved to 189% compared to 152% at March 31 and 136% a year ago. Obviously, we are extremely pleased with our recent trends and improvement from a year ago. We remain confident in our overall portfolio strength and asset quality as we continue to pursue our growth strategies.

Looking at our capital position. Total quarter end stockholders' equity was $407 million, up from $387 million at June 30, 2018. As a reminder, during the first quarter this year, we repurchased approximately 515,000 shares for $15.1 million. However, our capital position remains strong with quarter end tangible equity to asset ratio of 9.60%, down only slightly from 9.65% last year. Consolidated total risk-based capital ratio was approximately 12.6% at quarter end, June 30, 2019. So our healthy capital position supports our growth and shareholder value enhancement strategies.

In summary, our positive momentum continued in the second quarter with diluted EPS up 13% from a year ago, return on assets of 1.52% versus 1.48% last year and return on equity of 12.28% versus 11.69% a year ago. Our balance sheet remains strong. Our operating profitability is high. Our asset quality has improved, and our capital position is solid. While we have indicated an expectation of margin contraction over the remainder of the year, we feel these indicators and expense containment support our positive outlook for being in line with expectations for the second half of 2019. That completes my financial review.

And I'll turn the call back over to Don.

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Donald P. Hileman, First Defiance Financial Corp. - President, CEO & Director [5]

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Thank you, Paul. I'm very pleased with the results this quarter and the increase in our core earnings. Improvement in asset quality, strong loan pipeline and our expected rebound in deposit growth give us confidence that our strong performance will continue for the remainder of the year. Collaborative efforts between leadership and the teams within all of our market areas support our focus on core balance sheet growth with specific attention to loan and deposit growth, expense control and improved asset quality.

Successful execution of our metro market strategy is evident as we noted significantly greater contributions from Columbus, Ohio market during the second quarter. The addition of lenders and treasury management staff to this market will support future growth objectives and help continue this pace. Fort Wayne, Indiana market noted a record month for a total dollar amount in retail loans in June, and this momentum is carrying forward into July. As we work together to closely balance our exposure to interest rate changes, we constantly monitor and address deposit funding costs while maintaining our disciplined loan pricing.

In addition, our focus on optimizing our digital channels leads our strategy to improve our client experience as transactions move beyond the branch. Over the next several years, we're going to have a new digital banking platform that will enhance digital banking capabilities for our personal and business clients. The same platform will create a uniformed user experience for clients and employees that will allow us to deliver even greater levels of customer service.

While we are committed to providing our clients with smart solutions that fit their financial needs, we also know that supporting our communities is essential to living out our Better Together philosophy. This June marked the second consecutive year that our month-long Building Better Communities initiative in celebration of National Homeownership Month generated a contribution of 500-plus hours of community service. Through our employee involvement from part-time to executive level, we were able to benefit homeowners and housing-related community partners.

As Paul noted, we expect some narrowing of the margin over the remainder of the year but feel we can compensate for this and anticipate performing at expected levels on a full year basis. Our strong performance, client-focused values and engaged employees consistently come together to deliver exceptional results for our shareholders. First Defiance will leverage these principles to keep moving forward, and we anticipate the confidence you have placed in us as we work to make First Defiance a company known for providing smart solutions to our customers and communities.

Thank you for your interest in First Defiance Financial Corp., and we thank you for joining us this morning. We will now be glad to answer your questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Nick Cucharale from Sandler O'Neill + Partners.

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Nicholas Anthony Cucharale, Sandler O'Neill + Partners, L.P., Research Division - Director [2]

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So first, I appreciate your commentary on the margin. Can you give us some color on deposit pricing in your markets? Have others eased up? Or is this still as competitive as ever?

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Paul D. Nungester, First Defiance Financial Corp. - CFO & Executive VP [3]

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I'd say it's still competitive, but yes, we have thankfully seen some easing in various markets. So depending on which ones we're talking about, we've had competitors come in 10, 25 basis points depending on time deposits and whatnot.

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Nicholas Anthony Cucharale, Sandler O'Neill + Partners, L.P., Research Division - Director [4]

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Okay. And then secondly, just with respect to loan growth, it looks like the end of the second quarter was especially strong given the end of period compared to the average balances. You mentioned that robust pipeline. How does the pipeline compare to this time last quarter?

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Vincent J. Liuzzi, First Federal Bank of the Midwest - President [5]

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This is Vince. The pipeline is pretty significant quarter-over-quarter. We've got about $400 million in the commercial pipeline, about $120 million in the residential pipeline. I think our lending results in the second quarter really reflected team commitment and effort to focus on high-quality run originations and building and managing that pipeline very closely.

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Nicholas Anthony Cucharale, Sandler O'Neill + Partners, L.P., Research Division - Director [6]

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Okay. Great. And then just on expenses, there's a nice drop this quarter as anticipated. Do you expect the $24.2 million to be a good run rate going forward?

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Paul D. Nungester, First Defiance Financial Corp. - CFO & Executive VP [7]

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We hope to do better than that. I think we've talked about $24 million as a bogey, but we look to obviously try and beat that. And especially as the margin compresses here, we're focused on finding areas to contain to help with net earnings at the end of the day.

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Operator [8]

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The next question comes from Damon DelMonte of KBW.

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Damon Paul DelMonte, Keefe, Bruyette, & Woods, Inc., Research Division - SVP and Director [9]

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So just to follow up on the margin. Just want to make sure, Paul, I understand this correctly. So you said there was about 5-basis-point benefit from interest recoveries this quarter. So as we think about the downward trajectory here, we're kind of starting out like a 3.98% level. Is that fair?

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Paul D. Nungester, First Defiance Financial Corp. - CFO & Executive VP [10]

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Exactly. Yes.

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Donald P. Hileman, First Defiance Financial Corp. - President, CEO & Director [11]

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Yes. That's correct.

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Damon Paul DelMonte, Keefe, Bruyette, & Woods, Inc., Research Division - SVP and Director [12]

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Okay. And are you able to estimate roughly how much of an impact a 25-basis-point cut would be?

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Paul D. Nungester, First Defiance Financial Corp. - CFO & Executive VP [13]

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Well, yes.

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Donald P. Hileman, First Defiance Financial Corp. - President, CEO & Director [14]

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Yes, we're looking for 5 or 6 basis points on decline. And as we look to target the end of the year, that's where we will focus on a quarterly basis. So it's maybe a couple of percent decline in the margin over the course of the year.

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Paul D. Nungester, First Defiance Financial Corp. - CFO & Executive VP [15]

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And obviously, yes, it depends on how successful we can be on the deposit side, what we can do on borrowing that's needed and so on to help support that. But as Don said, if you just take a straight Fed fund rate cut, you're looking at 5 to 6 right off the top there.

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Damon Paul DelMonte, Keefe, Bruyette, & Woods, Inc., Research Division - SVP and Director [16]

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Got it. Okay. And then with regards to deposits and the gathering efforts that you guys have going on, could you just give a little bit of an update as to what you're seeing in some of your newer markets, where you've opened up LPO? Have you started to try to gather some deposits in like Ann Arbor and whatnot?

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Donald P. Hileman, First Defiance Financial Corp. - President, CEO & Director [17]

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Not on a significant basis. I think I did cover -- mention we're -- we had some treasury management staff in our Columbus market that's been very recent. Really haven't seen any significant impact on that from a deposit side, expect to, and we're a little slower in Ann Arbor. So I think we're focused more on some of the other metro markets, the Fort Waynes and Toledos as well. But our core deposit franchise is our legacy markets, and I think we can still do a little bit better there, and we expect to. We expect to. We're -- part of what we look at is the opportunity maybe for some mixed change. Customers are looking there to lock in.

On the loan side, longer fixed rates stuff and then on the deposit side keep it short because I believe interest rates will go up at some point. So taking advantage of a customer attitude right now to lower cost of funds is I think where we're looking and seeing an opportunity.

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Damon Paul DelMonte, Keefe, Bruyette, & Woods, Inc., Research Division - SVP and Director [18]

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Okay. Great. And then I guess just lastly, can you help us think a little bit about the provision expense going forward? I mean obviously, really strong quarter was with NPAs going down and booking some net recoveries. But on a more normalized, expect to level something in that maybe $1.2 million to $1.3 million range?

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Paul D. Nungester, First Defiance Financial Corp. - CFO & Executive VP [19]

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Maybe not quite that high, but yes definitely. I mean if you just add back recoveries there, you're getting closer to a more normalized run rate, so $750 million in that area and tracking up as growth, as we build balances, that would track up with it.

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Donald P. Hileman, First Defiance Financial Corp. - President, CEO & Director [20]

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Really an indicator on the growth factor, Damon. If we have the growth, then that will be the number.

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Operator [21]

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Our next question comes from Christopher Marinac of Janney Montgomery Scott.

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Christopher William Marinac, Janney Montgomery Scott LLC, Research Division - Director of Research and Banks & Thrifts Analyst [22]

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I wanted to go back on the loan receivable yield. I presume if we take the 5.12% and we back 5 basis points off of that, that would kind of be our base excluding the recoveries. How does that compare with new business that you were able to do today? And is that new business yield going to come under that 5, high 5 or just over 5 level as this quarter plays out?

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Donald P. Hileman, First Defiance Financial Corp. - President, CEO & Director [23]

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Yes. I think that our target is to still be about 5. We did see some decline in the quarter-over-quarter new yield of about 15 basis points. So I think when we start to look at that, the low 5s is probably where we think it'll come in for the quarter on the new business on an average basis.

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Christopher William Marinac, Janney Montgomery Scott LLC, Research Division - Director of Research and Banks & Thrifts Analyst [24]

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Okay. So again, that really does limit the pressure that you have, and you have some pressure, as you talked about, but it's not -- it may not be as significant as some investors may worry about.

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Donald P. Hileman, First Defiance Financial Corp. - President, CEO & Director [25]

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Yes. I think there is some flexibility there. But I think the things that we're really balancing, Chris, is the growth and the benefit we'll get from the additional balances and what rate is that coming on. And with the decline -- anticipated decline next week in market rates, I think there'll be a little bit more pressure on our origination rates going forward. So I think we're cautious about that impact, and I think we're trying to really manage toward that, where really focused customers are looking for longer rate opportunities and variables and what the prime plus kind of scenario now compare to a 5-year fix. There's really not much spread there -- differential. So I think there'll be a little bit more challenge for us to maintain that new origination rate going forward.

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Paul D. Nungester, First Defiance Financial Corp. - CFO & Executive VP [26]

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Yes. I'd agree. It's not just the new originations. Almost 1/4 of our loan book is variable, so we'll see some pressure coming from that pool there. And then we would expect, as Don has alluded to here, that we'll get refi requests that we'll have to evaluate and look at those on a case-by-case basis if it's worth keeping the balances at a lower yield versus letting that run off and having to originate to cover it.

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Christopher William Marinac, Janney Montgomery Scott LLC, Research Division - Director of Research and Banks & Thrifts Analyst [27]

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Okay. You mentioned at the beginning of the call that the payoff was not going to -- payoffs were not going to be necessarily a problem on the back half of the year. So you have some visibility to what you expect to pay off, right?

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Donald P. Hileman, First Defiance Financial Corp. - President, CEO & Director [28]

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Yes.

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Paul D. Nungester, First Defiance Financial Corp. - CFO & Executive VP [29]

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Correct.

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Donald P. Hileman, First Defiance Financial Corp. - President, CEO & Director [30]

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Yes, I'm not worried about payoffs. I think it's when somebody has maybe got 2 years left to the loan coming in and asking for a refi opportunity. And the prepayments not only is -- is probably not going to be enough to offset having to do something for good clients. So...

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Christopher William Marinac, Janney Montgomery Scott LLC, Research Division - Director of Research and Banks & Thrifts Analyst [31]

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Okay. Got you. And then as you think about deposit resets, you've been fortunate to have -- if I think over this rate cycle make up less than a 30% deposit beta cumulatively. Will that behave that way on the way down? I know recycle is a little bit different, so it might be hard to predict it at this point. But just curious if that's something like that was reasonable as next several quarters play out.

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Donald P. Hileman, First Defiance Financial Corp. - President, CEO & Director [32]

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Yes, we believe so.

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Paul D. Nungester, First Defiance Financial Corp. - CFO & Executive VP [33]

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Yes.

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Christopher William Marinac, Janney Montgomery Scott LLC, Research Division - Director of Research and Banks & Thrifts Analyst [34]

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And then last question. This has to do with Columbus and the success you're having there. To what extent do you have -- any difference in structure in terms of how those are -- those loans are done relative to the rest of the franchise?

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Donald P. Hileman, First Defiance Financial Corp. - President, CEO & Director [35]

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No. We don't have any kind of a strategy to have a different structure. I think we just have more of an opportunity for CRE and ICRE down in Columbus than some others, where we might be more saturated from a geographic concentration standpoint. But we don't price differently, Chris, or we don't have a lot of different structure in the Columbus market compared to other markets.

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Operator [36]

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(Operator Instructions) This concludes our question-and-answer session. I would like to turn the conference back over to Tera Murphy for any closing remarks.

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Tera Murphy, First Defiance Financial Corp. - VP & Marketing Director [37]

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Thank you for joining us today as we discussed our quarterly results. We appreciate your time and interest in First Defiance Financial Corp. Have a great day.

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Operator [38]

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