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Edited Transcript of FRME earnings conference call or presentation 24-Oct-18 6:30pm GMT

Q3 2018 First Merchants Corp Earnings Call

MUNCIE Oct 30, 2018 (Thomson StreetEvents) -- Edited Transcript of First Merchants Corp earnings conference call or presentation Wednesday, October 24, 2018 at 6:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* John J. Martin

First Merchants Corporation - Executive VP & Chief Credit Officer

* Mark K. Hardwick

First Merchants Corporation - Executive VP, CFO & COO

* Michael C. Rechin

First Merchants Corporation - President, CEO & Director

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Conference Call Participants

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* Damon Paul DelMonte

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

* Nathan James Race

Piper Jaffray Companies, Research Division - VP & Senior Research Analyst

* Robert Scott Siefers

Sandler O'Neill + Partners, L.P., Research Division - Principal of Equity Research

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Presentation

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Operator [1]

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Good day, and welcome to the First Merchants Third Quarter 2018 Earnings Conference Call. (Operator Instructions)

This presentation contains forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act. Such forward-looking statements can often be identified by the use of words like believe, intend, anticipate, expect, should, could, might or may. These forward-looking statements include statements relating to First Merchants' goals, intentions and expectations; business plan and growth strategies; asset quality of First Merchants' loan and investment portfolios; and estimates of First Merchants' risks and future costs and benefits. These statements are subject to significant risks, assumptions and uncertainties that may cause results to differ materially from those set forth in such statements, including changes in economic and business conditions; the ability of First Merchants to integrate recent acquisitions and attract new customers; changes in laws, regulations and requirements of the company's regulators; the effects of easing restrictions on participants in the financial services industry; the cost and other effects of legal and administrative cases; changes in the creditworthiness of customers and the impairment of collectibility of loans; fluctuations in market rates of interest; competitive factors in the banking industry; changes in market, economic, operational, liquidity, credit and interest rate risk associated with the First Merchants business; and other risks and factors identified in First Merchants' filings with the Securities and Exchange Commission. First Merchants undertakes no obligation to update any forward-looking statements, whether written or oral, relating to the matters discussed in this presentation or press release. In addition, the company's past results of operations do not necessarily indicate its anticipated future results. Please note this event is being recorded.

I would now like to turn the conference over to Michael C. Rechin, President and Chief Executive Officer. Please go ahead, sir.

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Michael C. Rechin, First Merchants Corporation - President, CEO & Director [2]

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Okay. Thanks, Chad. Welcome, everyone, to our earnings conference call and webcast for the third quarter ending September 30, 2018. Joining me today are Mark Hardwick, our Chief Operating Officer and CFO; as well as John Martin, our Chief Credit Officer.

First Merchants released our earnings in a press release this morning at approximately 8:00 a.m. Eastern Time, and our presentation today speaks to material from that release. The directions that point to the webcast are also contained at the back end of the release. And my comments will begin on Page 4, a slide titled Third Quarter 2018 Highlights.

So captured right in the top of the release were First Merchants' announcement of earning $41.1 million in net income, a 68.8% increase over the third quarter of 2017; earnings per share for the period of $0.83, a 66% increase over the third quarter of 2017. Total assets grew organically to $9.8 billion, an 8.2% increase over the third quarter, with really similar growth rates in both loans and deposits kind of reflecting the balance of the way we approach the marketplace.

Next bullet point down, some high performance return metrics with a 1.69% return on average assets and 12.10% return on average equity, driven by -- results driven by a really low and stable 49.25% efficiency ratio. And we're excited today to talk a little bit later about the definitive agreement that we discussed 2 weeks ago on October 10 about our upcoming combination and merger with MBT Financial Corp. in Monroe, Michigan.

So at this point, we're going to cover the balance of the release, led off by Mark.

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Mark K. Hardwick, First Merchants Corporation - Executive VP, CFO & COO [3]

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Thanks, Mike. My comments will begin on Slide 6, where total assets, on line 7, increased by $420 million or 6% since year-end 2017. Organic loan -- organic growth in total loans, on line 2, equaled $333 million or 6.6% annualized since year-end '17.

The composition of our $7.1 billion loan portfolio, shown on the left of Slide 7, continues to produce strong loan yields. The loan portfolio yield for the third quarter of 2018 totaled 5.25%, up from the first quarter of '18 total of 4.86% and a second quarter total of 5.12%. The prime rate has increased 125 basis points over the past 6 quarters, and our loan yields, when normalized for fair value accretion, have improved 77 basis points. As the graph on the right illustrates, 68% of our loans are variable, with half repricing daily, demonstrating the asset sensitivity of our bank.

On Slide 8, our $1.6 billion bond portfolio continues to be high performing. Our portfolio yield of 3.48% is 1 basis point better than our 3.47% yield that we reported in both the first quarter and second quarter, while the unrealized loss increased by $18.2 million during the quarter to $34.6 million.

Now on Slide 9, non-maturity deposits, on line 1, represent 83% of total customer deposits. Non-maturity deposits growth over year-end 2017 totaled $343 million or 8% annualized. Customer time deposits, on line 2, represents the remaining 17% of total customer deposits and increased by $176 million from year-end or an annualized 22.3%.

Capital and liquidity are positioned very well for the future, and management is pleased with the structure of our balance sheet. Our loan-to-deposit ratio totals 93%, and our loan-to-asset ratio totals 72% while the tangible common equity ratio totals 9.55%.

As previously mentioned, the mix of our deposits, on Slide 10, is a true strength of our company. Third quarter deposit costs totaled 90 basis points, up from the first quarter total of 65 basis points and the second quarter total of 81 basis points. Over the past 6 quarters, the Fed funds rate has increased, again, 125 basis points, and our cost of deposits increased 51 basis points for deposit beta of 41%.

All capital -- all regulatory capital ratios, on Slide 11, are above the regulatory definition of well capitalized and our internal target rates, providing strength -- capital strength and flexibility into the future.

The corporation's net interest margin, on Slide 12, reflects an improvement from Q1 of '18 to Q2 of 7 basis points and another 6 basis point improvement from the second quarter of '18 to the third quarter of '18. As noted at the bottom of the page, federal tax reform negatively impacted net interest margin by 13 basis points in the first quarter, 12 basis points in the second quarter and 13 basis points in the third quarter of 2018 due to the amount of tax-exempt income we have. And we're just giving you those numbers if you're attempting to compare our current margins to prior year.

Total noninterest income, on Slide 13, totaled $19.5 million, returning back to Q1 of 2018 levels. The improvements were led by service charges on deposits, on line 1.

Noninterest expense, on Slide 14, is up slightly for the quarter due to small increases across several expense categories and due to incentive accruals, reflecting the positive performance of our company for the year. Our current expense levels position us well for continued organic growth in the approaching acquisition of Monroe Bank & Trust in 2019.

Now on Slide 15, as Mike previously mentioned in his opening remarks, net income grew 68.8% over the third quarter of '17 and totaled $41.1 million. On line 9, EPS totaled $0.83, an increase of 66% over the same period last year. And on line 10, the efficiency ratio remains below 50% and improved over the second quarter, now totaling 49.25%.

On Slide 16, we feel the first 3 quarters of 2018 were very clean with strong earnings and are reflective of what you can expect from First Merchants' core earnings power looking into the future. The increases year-over-year were substantial when you're talking about 66% and 69%. And just wanted to bring a little bit of color to that. We attribute the growth in our net income and EPS for the year to several factors, including the completion of 2 acquisitions in 2017, strong organic loan growth in both '17 and '18, margin expansion, the absence of onetime charges related to acquisitions and tax reform.

And on Slide 16 and 17, you will notice continued improvement in all categories lifted -- listed.

Thanks for your attention. And now John Martin will discuss our loan portfolio composition and related asset quality trends.

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John J. Martin, First Merchants Corporation - Executive VP & Chief Credit Officer [4]

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All right. Thanks, Mark, and good afternoon. Beginning on Slide 19, I'll provide an update on the loan portfolio, then review asset quality and the asset quality roll forward, cover the allowance and provisioning and then close with a few remarks on the portfolio and market conditions.

So starting on Slide 19. Total loans grew slower in the quarter as compared to the first half of the year. We expect -- experienced payoffs and momentum in construction loans in the quarter -- excuse me, movement in construction loans in the quarter, which were lower by $46 million; and CRE nonowner-occupied or investment real estate, on line 3, which increased by $61 million. We continue to manage the dynamic and transient construction investment real estate portfolio where loans move from construction to mini-perm and then refinance out to the permanent market. In the first half of the year, where construction and CRE owner occupied loans, on line 2 and 3, grew at a roughly 17% annualized rate, those same categories netted nominal growth in the third quarter. The same thing can be said for C&I loans, which grew at a 22% annualized growth rate in the first half of the year and were flat for the quarter.

Moving down to residential mortgage and consumer lending. There was a similar slowdown in the quarter, with residential mortgage and consumer loans growing $5 million. Although looking forward, it appears we are heading into the fourth quarter with a good consumer and commercial pipeline, tempered by the reality of higher interest rates and their effect on mortgage lending.

Turning to asset quality on Slide 20. Asset quality was solid for the quarter. On line 1, nonaccrual loans were up $300,000. On line 2, other real estate owned declined $200,000. And on lines 3 and 4, renegotiated and 90-day delinquent loans increased by $400,000 and declined by $100,000, respectively. In other words, really, there's no significant changes to asset quality, remaining solid in the quarter. This resulted in NPAs and 90-day delinquent loans remaining at 43 basis points of loans and other real estate owned.

Finishing out the slide on Slide 7 (sic) [line 7]. Classified assets increased by $8 million after declining $12.1 million in the second quarter. This is the normal ebb and flow which occurs from the portfolio review and just general loan grading that we see.

Turning to Slide 21, which reconciles the migration of nonperforming assets. We started the quarter in the far right corner -- column, titled Q3 '18, with $29.9 million in NPAs and 90-day delinquencies. We added $4.6 million of new nonaccruals, resolved $2.5 million of the same, on line 3, with $1.7 million of gross charge-offs, on line 5. This netted to the $3 million increase in nonaccrual loans on line 6. And dropping down to line 7, we added $100,000 in new ORE, while on lines 8 and 9, we sold $200,000 while writing down $100,000 in ORE balances. So after changes in restructured 90 days past due, we ended the quarter up $400,000.

Let's move on to Slide 22. Provision expense in the quarter of $1.4 million was driven mostly by the migration of loans from the purchased to non-purchased portfolio of roughly $80 million, plus coverage of the $500,000 in net charge-offs. The allowance increased 2 basis points to 1.11% of total loans and was flat to non-purchased loans at 1.28%. Fair value adjustments, on line 8, decreased $3.3 million from $37.2 million to $33.9 million. We had $3.2 million in accretion and only $82,000 in offset charge-offs.

We continue to work on our CECL modeling. As a point, there continues to be a lot of discussion in the industry and internally around methods and approaches. And at this point, we've not really come to a conclusion on what ultimately will be the impact, if any, on CECL -- or from CECL.

Then, summarizing on Slide 23. As I mentioned earlier, loans slowed after 2 strong quarters. Growth was impacted by C&I and CRE payoffs and construction loans moving through the portfolio. Our commercial and consumer loan pipelines appear healthy heading into the fourth quarter, with the interest rate increases and housing headwinds affecting new mortgage loan volume.

Credit metrics remained solid and remained stable. Regulatory classified loans are bumping around with a $7.9 million increase this quarter. And I will just say that I don't really see any trends in the data that I see. Charge-offs have remained low, and allowance coverage is stable with current provisioning. And so really from a macro level, we pay attention to the national economy while, at the micro level, staying abreast of the portfolio for trends to report to you. Thanks for your attention.

I'll turn the call back over to Mike Rechin.

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Michael C. Rechin, First Merchants Corporation - President, CEO & Director [5]

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Thanks, John. I'm going to move to Page 25 and 26, cover 2 of the slides that we used in our October 10 investor call, as a way of quick reminder about the profile of MBT Financial or Monroe Bank & Trust and what that could bring to our company.

And so on Page 25 in particular, a little bit of pro forma work on what a combined balance sheet might look like. We talked on that day and I'll repeat again that one of the strengths of the company was the quality and richness and the cost of their deposit base and so, on an overall basis, provides First Merchants, on a pro forma basis, with some liquidity, reduces our loan-to-deposit ratio right around 90%. And so we're excited about that. You can see that there's no overlap, and so it serves as a very real extension of the First Merchants franchise.

Page 26, some additional glimpse of MBT on a stand-alone basis. Some of the balance sheet and income statement were kind of a -- reflect some of the positives of First Merchants in my mind. Deposits dominated by quality, transaction-based low-cost deposits, granular community bank credit extension, makes for powerful earnings, as you can see here, of Monroe on a stand-alone basis. The attraction, as you can gather then, is somewhat of a performance history of the company, the market composition that they pulled together and then the leadership that they have inside the bank and inside their communities. So we're excited about what it can do for us.

I'm going to flip to Page 27, make some summary comments and then take questions. Finishing up our planning for 2019 and look forward to more of the disciplined, fast-paced market coverage that is our core banking business. John referenced slower growth in our loan portfolio in the last quarter and yet, kind of reaffirmed what we view to be a nice growth rate moving forward. We have that nice great growth rate going forward in the third quarter on our deposit gathering, which is an equally important part of the company.

So that's prominent in our 2019 plan, as is the absolute completion of our new account migration. I referenced that I think, in each of the last 2 quarters, it's a big project for us to kind of reshape some of our primary checking products for our client preference. And that will be completed on time before the end of the calendar year.

Third bullet speaks to our Specialty Finance businesses, kind of driven by the growth of our sponsor finance business, and all 3 of the items here, to include our investment in loan syndications capability, are just nice growth extensions of our Midwestern commercial banking strength. We talked about our preparedness for crossing the $10 billion in asset threshold, which will take place in the first quarter of 2019.

So Mark talked about some of the increases in our expense base, none of them tremendously pronounced. But at this point, we feel really comfortable with our investments in model build, technology to support that, the staffing to utilize it on a day-to-day basis and feel like our run rate of noninterest expense carries us into next year kind of at the level that you saw in the third quarter of this year.

And lastly, we're mindful of the exciting work ahead in one of our competencies, which is to design the integration schedule and to introduce our brand, led by the MBT professionals, into the Michigan marketplace. So we look to execute that change event while maintaining the high level of client service that the Monroe professionals have been providing their clients all through.

So all told, between a really strong third quarter, as Mark highlighted, coupled with the opportunity to grow into the State of Michigan with a really proven high-performing banking company, we like the run rate of our existing business in combination with the acquisition. All told, it has us continuing to be very optimistic about 2019.

So Chad, at this point, we'll take questions, should you have any in the queue.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Scott Siefers with Sandler O'Neill + Partners.

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Robert Scott Siefers, Sandler O'Neill + Partners, L.P., Research Division - Principal of Equity Research [2]

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Mike, I guess, first question is for you. So a little bit of a slowdown in loan growth in the third quarter, which I appreciate the color on, and it's pretty symptomatic of what we've seen at others. But regardless, it looks like you guys are still on pace to hit the 7% to 9% organic growth that you called for, for the full year. So I guess, one, does that still feel doable to you? And then more importantly, I guess, what's your best guess for how annualized growth will trend from here into the fourth quarter and into '19 as well?

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Michael C. Rechin, First Merchants Corporation - President, CEO & Director [3]

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Well, for the fourth quarter, which is we're kind of living in right now, we have a pretty close-up look at it, Scott. And it looks to me like it's going to be stronger than the last quarter, which was effectively flat and yet, probably not as robust as the first 2 quarters of the year that we're growing kind of at 9% or 9.5% annualized kind of rates. So I think if you were to take a 4-quarter composite with 3 of the quarters completed and our best look at the fourth quarter, is that this 7%, 8%, 9% annualized rate ought to occur. John referred to the pipeline, and I've got some information on that, that would bear out. Actually, our originations in the third quarter were at a level that, absent some construction reductions and some line utilization reduction, would have probably had us been in that 1% raw growth rate, kind of 4% annualized that didn't take place because of what John referred to. But we clearly see, absent changes that we can't forecast, the ability to convert some of our commercial pipeline, which is about $0.5 billion, into originations through the fourth quarter and into the first quarter. And our plan, the back half of your question, was a little further out into '19. We feel like the local economies from the -- all of the state of Indiana, Central Ohio and what we know of Michigan are going to allow us to grow at similar levels.

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Robert Scott Siefers, Sandler O'Neill + Partners, L.P., Research Division - Principal of Equity Research [4]

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Okay, that's perfect. And then just separately, Mark, I was a little surprised to see the pace of expansion in the core margin actually accelerate in the third quarter. It looks like the core, exclusive of PAAs, was up about 9 basis points to 390. I guess first question is, was there anything unusual in there? Like were there any interest recoveries or anything we should be aware of? And then where does that core margin go from the third quarter's 390 level, at least in your view?

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Mark K. Hardwick, First Merchants Corporation - Executive VP, CFO & COO [5]

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Well, in terms of something extraordinary, we always have some recoveries, but nothing that was really a needle mover this quarter in terms of overall basis points in spread. We had a rate increase in June that helped carry us through the third quarter. And we have another rate increase at the very end of September that we think will help carry us through the fourth quarter. Even though we're making increases through our deposit rates and being very aware especially of our most sensitive deposit customers, I feel like, our fourth quarter, we end up probably with another basis point or 2 in margin expansion. Our plan for next year -- obviously, based on what's happening in the economy today, rate forecasts are moving around. We currently have one increase built into our plan next year, and we have seen forecasts that suggest just the December rate hike, and we've had others that suggest it may go as high as 3% or 3.25%. So today, we only have one built into our plan, and we feel like, with a December rate hike and one in June -- or likely June, the way we're modeling it, that our margin is very stable throughout all of '19. So I guess, if the Fed stops moving and the yield curve stays flat, then we start to see some repricing pressure on the deposit side, where we're not getting the lift on the assets.

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Operator [6]

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The next question will come from Nathan Race with Piper Jaffray.

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Nathan James Race, Piper Jaffray Companies, Research Division - VP & Senior Research Analyst [7]

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Mark, just going back to that last line of question around the core margin in 2019. With MBTF coming onboard in the first half of the year, obviously, their margins are a little below yours. So I guess, how should we kind of think about the timing of some of their excess liquidity deployment, how that may kind of impact the margin, perhaps kind of maybe settling into the maybe the high 380s as that balance sheet comes on board? Is that kind of a fair assumption?

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Mark K. Hardwick, First Merchants Corporation - Executive VP, CFO & COO [8]

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Yes. I think Mike's comment about our loan growth for next year does include some of the deployment of that liquidity. And then on the margin side, we're really anticipating just the bond portfolio shift. We know that we're likely to sell their bond portfolio around close and that we can get a nice pickup in yield on those bonds going into 2019. That's the only, I guess, real item that I think you should consider when you're trying to put the 2 banks together in your modeling assumptions.

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Nathan James Race, Piper Jaffray Companies, Research Division - VP & Senior Research Analyst [9]

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Okay, that's helpful. And changing gears a little bit and thinking about expenses. I appreciate your comments in terms of the higher incentive accruals in the quarter that drove up the personnel costs. It also looks like other expenses were also up sequentially. Was there any driver there that may come out in the radar? Is that kind of a good number to kind of plug in going forward?

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Mark K. Hardwick, First Merchants Corporation - Executive VP, CFO & COO [10]

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I think it's a good number going forward.

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Nathan James Race, Piper Jaffray Companies, Research Division - VP & Senior Research Analyst [11]

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Okay, got it. And just one last...

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Mark K. Hardwick, First Merchants Corporation - Executive VP, CFO & COO [12]

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And I always say, we do have some real estate activity with -- in our branch network or -- where we're moving some assets. And you see a little bit of that volatility quarter by quarter, so this was a really clean quarter.

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Nathan James Race, Piper Jaffray Companies, Research Division - VP & Senior Research Analyst [13]

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Okay, got it. Helpful. And then just maybe one last question for John. Just thinking about your commercial real estate exposure. Can you remind us what type of retail CRE exposure you have? And any potential exposure that you guys may have to some of the larger retailers as well, be it Sears, Kmart and the like?

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John J. Martin, First Merchants Corporation - Executive VP & Chief Credit Officer [14]

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Yes. I went through the portfolio and looked at -- looked for potential Sears exposure and actually JCPenney as well, and it's fairly nominal. We do have a couple of properties that -- one in particular is anchored by JCPenney, kind of about $10 million worth of exposure there. But so far, it continues to perform. And the Sears exposure, actually, I didn't see any there at all outside of kind of almost tangentially. We've got participation in a shared national credit that has some de minimis level of exposure to it. But outside of that, there's not anything material that I saw.

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Operator [15]

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(Operator Instructions) The next question will be from Damon DelMonte with KBW.

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

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Just to kind of follow up on the loan growth. Mike, could you -- can you kind of attribute what maybe led to some of the slowdown in the C&I portfolio this quarter? I mean, is it -- I know you touched on some commercial real estate paydowns and whatnot, but were you seeing commercial -- C&I loans, seeing accelerated paydowns as well?

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Michael C. Rechin, First Merchants Corporation - President, CEO & Director [17]

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We actually had a couple of clients that were sold, which accounts for some. None of these, by the way, in aggregate -- I'll give you a couple of you views of it, Damon. None of them are particularly dramatic, but in aggregate, they kind of result in the flat C&I number that you see. We had a couple of clients that were sold. I referenced in an earlier question just a moment ago work that John Martin provides me on our line -- C&I line commitments and the utilization against those commitments. And I think in last quarter's call, I had mentioned that our utilization was up 2% on roughly a $1.8 billion commitment from the first quarter to the end of the second quarter. We gave half of that back, so we were actually down 1% in utilization on that $1.8 billion in C&I commitments. So not really a meaningful change. We like C&I lending. It's a strength of ours because it's typically accompanied by deposits, but we'd look for that to rebound as the balance of the portfolio as well.

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

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Got it. Okay, that's helpful. And then with respect to your exposure to the ag market, ag sector, have you seen any impact on your borrowers with the tariffs or just general market conditions?

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Michael C. Rechin, First Merchants Corporation - President, CEO & Director [19]

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Yes. I would say that the -- probably the portfolio that's seen the most in terms of downgrades, if you look at that, classified as a percentage of the total portfolio, are the -- are some of our ag land and production portfolios. Is it directly related to -- it's really coming off of a couple of years, quite frankly, in that market where we've graded it, and it's just a reflection of the challenges in that space right now. And I'm not sure that I would attribute it necessarily to the tariffs though.

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Damon Paul DelMonte, Keefe, Bruyette, & Woods, Inc., Research Division - SVP and Director [20]

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Okay. And then, I guess, just lastly with respect to capital management. The -- there's a lot of volatility in the financial sector the last 3, 4 weeks, 6 weeks or so. Just wondering what your thoughts are on buying back shares with the decrease in stock price.

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Michael C. Rechin, First Merchants Corporation - President, CEO & Director [21]

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Yes. Damon, that's something that we do talk about almost every board meeting. And so that's a great topic of conversation that I know we'll be having in November, but I don't have, really, guidance or direction for you. Always just trying to make sure that we maximize our capital, and we typically think of it as -- in thirds, that we have 1/3 for growth, we use 1/3 for dividend payments and the other 1/3 typically is used for other uses like cash and then acquisition or potentially buybacks. But it's a good question, especially given where stock prices are today.

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Damon Paul DelMonte, Keefe, Bruyette, & Woods, Inc., Research Division - SVP and Director [22]

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And can you just remind us if you guys currently have an authorization outstanding? Or do you need to have one approved by the board?

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Michael C. Rechin, First Merchants Corporation - President, CEO & Director [23]

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We would need to approve one by the board.

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Operator [24]

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Ladies and gentlemen, this concludes our question-and-answer session. So this does conclude our question-and-answer session.

So Mr. Rechin, I'll turn it back to you for any closing remarks.

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Michael C. Rechin, First Merchants Corporation - President, CEO & Director [25]

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Chad, I have none. I appreciate the attendees today by conference call. Look forward to talking about our full year 2018 results in about 90 days. Have a great afternoon.

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Operator [26]

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