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Edited Transcript of IBCP earnings conference call or presentation 25-Oct-18 3:00pm GMT

Q3 2018 Independent Bank Corp Earnings Call

IONIA Oct 31, 2018 (Thomson StreetEvents) -- Edited Transcript of Independent Bank Corp earnings conference call or presentation Thursday, October 25, 2018 at 3:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Robert N. Shuster

Independent Bank Corporation - Executive VP, CFO & Corporate Secretary

* William Bradford Kessel

Independent Bank Corporation - President, CEO & Director

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Conference Call Participants

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* Brendan Jeffrey Nosal

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

* Damon Paul DelMonte

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

* James Prescott Beury

Boenning and Scattergood, Inc., Research Division - Analyst of Banks and Thrifts

* John Lawrence Rodis

FIG Partners, LLC, Research Division - Senior VP & Research Analyst

* Kevin Kennedy Reevey

D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst

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Presentation

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Operator [1]

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Good morning, and welcome to the Independent Bank Corporation Third Quarter 2018 Earnings Conference Call. (Operator Instructions) Please note, this event is being recorded.

I would now like to turn the conference over to Brad Kessel, President and CEO. Please go ahead.

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William Bradford Kessel, Independent Bank Corporation - President, CEO & Director [2]

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Good morning. Thank you for joining Independent Bank Corporation's conference call and webcast to discuss the company's 2018 third quarter results. I am Brad Kessel, President and Chief Executive Officer; and joining me is Rob Shuster, Executive Vice President and Chief Financial Officer. Before we begin today's call, it is my responsibility to direct you to the important information on Page 2 regarding the cautionary note regarding forward-looking statements. If anyone does not already have a copy of the press release issued by Independent today, you can access it at the company's website, www.independentbank.com. The agenda for today's call will include prepared remarks, followed by a question-and-answer session, and then closing remarks.

To follow along, I will begin with Slide 5 of our presentation. We are reporting a very good quarter for the Independent Bank team, with a 73.9% increase in net in and a 53.1% increase in diluted earnings per share.

For the 3 months ended September 30, 2018, we generated net income of $11.9 million or $0.49 per diluted share as compared to $6.9 million or $0.32 per diluted share for the same quarter 1 year ago. This represents a return on average assets of 1.46% and return on average equity of 13.83%. Strong organic loan growth, the addition of Traverse City State Bank and a lower federal corporate income tax rate were the primary drivers of this quarter's positive results. Our consistent quarter-over-quarter loan growth, coupled with the TCSB merger, fueled a year-over-year quarterly increase in net interest income of $6.8 million or 30%. For the third quarter of 2018, we generated net growth in total portfolio loans of $95.3 million or 15.3% annualized. Also for the third quarter of 2018, we recorded net recoveries of $1 million.

Turning to Slide 6 in our presentation. For the 9 months ended September 30, 2018, we have generated net income of $29.9 million or $1.27 per diluted share compared to $18.8 million or $0.87 per diluted share in this year-ago period. This represents an $11.1 million or 59.4% increase in net income and a $0.40 or 46% increase in diluted earnings per share.

Our return on average assets and return on average equity for this 9-month period annualized is 1.3% and 12.73%, respectively.

Slide 7 of our presentation provides a good view of our footprint as well as some bullet points on key economic metrics for our markets. The Michigan economy is now well into its 9th year of recovery. The August 2018 Michigan unemployment rate at 4.1% is lower than 1 year ago, 4.6%, and 0.2% above the U.S. unemployment rate of 3.9%.

Regionally, Grand Rapids unemployment is at 2.7%, Lansing is at 3.1% and Detroit-Livonia-Dearborn is 3.7%. Michigan's workforce is $4.435 million strong, and overall employment is up slightly from 1 year ago.

With regards to housing, the Michigan real estate market can be characterized as affordable with a shortage of inventory. The average sales price of a home in Michigan is $189,000 and Michigan's 5-year average year-over-year -- year-over-year sales price is up 8.8% compared to the U.S. 5-year average change in sale price of 4%.

U.S. housing starts and sales have slightly tapered off the last several quarters; however, Michigan home sales continue to trend positive. The continuation of the positive economic trends can be seen in our regional portfolios shown on Page 8.

We have generated year-over-year loan growth in each of our Michigan regional markets. Our 2 strongest growth regions are the Grand Rapids region, up $118 million in loan balances; and our Southeast Michigan region, up $99 million in loan balances.

We've also seen year-over-year deposit growth in 3 out of 4 regions, the exception being the Southeast Michigan region, which decreased as a result of 1 public fund relationship reducing its CD holdings with the bank.

The next couple of slides cover our balance sheet.

Turning to Page 8, we provide a couple of charts reflecting the attractive composition of our deposit base as well as the continued growth in this portfolio in 6 of the last 8 quarters, while working to effectively manage our overall cost of funds.

Independent Bank has $2.8 billion in total deposits, of which 77% are non-maturity deposit accounts. When comparing third quarter 2018 to the same quarter 1 year ago, we increased total deposits by $47 million or 2.1%. This excludes brokered CDs and $288 million of deposits acquired in the TCSB merger. Our total cost of deposits is up 9 basis points on a linked quarter basis and is up 26 basis points when comparing to the same quarter 1 year ago.

Our cumulative deposit cost beta for the period of Q4 2016 to Q3 2018 is 21.8% and our cumulative deposit cost beta over the last 4 quarters is 33.8%.

Similar charts are also reflected on Page 10. But in this case, we are displaying the balanced mix of our loan portfolios. We continue to target a diversified loan mix, with the largest portfolio being our commercial book of business. At September 30, 2018, our loan mix included 43% commercial, 40% mortgage and 15% installment. Excluding the portfolio loans acquired in the TCSB merger, we are very pleased to report our 18th consecutive quarter of net loan growth, with total loans outstanding now aggregating to $2.6 billion.

Our commercial portfolio grew by 2% annualized during the quarter, despite the second consecutive quarter of more than normal large payouts and/or pay-downs.

Commercial line usage at the end of the third quarter was 39.4% as compared to 45% for the same period 1 year ago. The payouts or pay-downs related to a combination of asset or business sales again reduced lines -- line usage.

Consumer installment loans were up $22 million or 24% annualized, and portfolio mortgage loans were up $68 million or 27% annualized.

Our capital position also continues to be strong with tangible common equity moving from 9.4% at June 30, to 9.5% at September 30, 2018. This is at the top end of our targeted TCE range of 8.5% to 9.5%.

On October 23, the Board of Directors declared a quarterly cash dividend on a common stock of $0.15 per share. This dividend is payable on November 15, 2018, to shareholders of record on November 5. We do have in place a 5% share repurchase plan; however, year-to-date there have been no share repurchases.

At this time, I would like to turn the presentation over to Rob Shuster to share a few comments on our financials, credit quality, the TCSB acquisition and management's outlook for the last quarter of 2018.

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Robert N. Shuster, Independent Bank Corporation - Executive VP, CFO & Corporate Secretary [3]

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Thanks, Brad, and good morning, everyone. I am starting at Page 12 of our presentation.

Brad discussed the increase in our net interest income during his remarks, so I will focus on our net interest margin.

Our tax equivalent net interest margin was 3.91% during the third quarter of 2018, which is up 25 basis points from the year-ago period, and down 2 basis points from the second quarter of '18. I will have some more detailed comments on this topic in a moment.

Average interest earning assets were $3.04 billion in 3Q '18, compared to $2.52 billion in the year-ago quarter and $2.96 billion in the second quarter of 2018.

The significant year-over-year increase reflects both the Traverse City State Bank merger and organic loan growth.

Page 13 contains more detailed analysis of the linked quarter increase and net interest income. There is a lot of data on this slide, but to summarize a few key points, the linked quarter net interest margin decreased 2 basis points. This was entirely due to a $183,000 decline in net recoveries of interest on previously charged-off or nonaccrual loans.

Third quarter 2018 discount accretion of $608,000 on the TCSB-acquired loan portfolio was relatively unchanged from $628,000 in 2Q '18. This discount accretion increased the net interest margin by 7.9 basis points and 8.5 basis points in 3Q '18 and 2Q '18, respectively.

One other interesting aspect of the third quarter of 2018 was the somewhat muted upward movement of variable rate loans. We have a bullet point about this topic on Slide 12.

After moving up 53 basis points in the first 6 months of the year, 1-month LIBOR was up only 16 basis points in 3Q '18, with essentially all of that move not until September. Similarly, the spot primary did not move up until September 27. Thus, we experienced a more subdued upward movement of interest on variable rate loans and variable rate securities in 3Q '18 compared to the first 6 months of 2018.

We'll comment more specifically on our outlook for net interest income for the balance of 2018 later in the presentation.

Page 14 is a new slide, compares our quarterly average cost of funds, which is annualized interest expense divided by our average earning assets, to the monthly average of federal funds rate during the quarter and the spot federal funds rate during the quarter.

You can see the relatively low cumulative beta of 8.6% for the first 81 basis points of movement in the effective federal funds rate from Q3 '15 to Q2 '17. And the increase in the cumulative beta to 28.9% for the next 97 basis points of movement in the effective federal funds rate from Q2 '17 to Q3 '18.

Moving on to Page 15, noninterest income totaled $11.8 million in 3Q '18 as compared to $10.3 million in the year-ago quarter and $12.3 million in the second quarter of '18.

The mortgage loan servicing caused most of the quarterly comparative year-over-year variability in noninterest income. We have a table in the text of our earnings release that breaks out mortgage loans servicing into its component parts, net revenue, fair value change due to price and fair value change due to pay-downs.

The fair value change due to price, which we view as not being a part of core results, was a positive $610,000 or $0.02 per diluted share after tax in 3Q '18 compared to a negative $572,000 or $0.02 per diluted share after tax in 3Q '17.

The year-over-year increases in the interchange income and interchange expense were primarily due to the implementation of ASU 2014-09 as described in the text of our earnings release.

Gains on mortgage loans declined despite an increase in mortgage loan sales volume due to margin pressure. I thought I would share a quote from the chief economist of the Mortgage Bankers Association. While the macroeconomic and housing market backdrops are and should remain quite favorable, the mortgage industry continues to be challenged by the drop in origination volume coupled with significant margin compression. Lenders of all types and sizes are seeing elevated costs coupled with intensely competitive pricing to capture more volume. This in turn is depressing revenues.

I think that pretty well sums up the very competitive nature of the mortgage banking business right now.

As detailed on Page 16, our noninterest expenses totaled $26.7 million in 3Q '18 as compared to $22.6 million in the year-ago quarter and $29.8 million in the second quarter of '18.

This year-over-year quarterly increase was primarily in compensation and benefits, occupancy, data processing, interchange expense as I described earlier, and the amortization of intangible assets. Much of the increases reflect the impact of the TCSB merger.

Outside of the impact of the merger, performance-based compensation has increased due to our anticipated actual performance relative to targets and a new incentive compensation plan for hourly employees that was implemented in the first quarter of '18. In addition, healthcare costs increased by $487,000 on a quarterly year-over-year basis due to an increase in actual and estimated incurred but not reported claims.

We do expect to recover much of this 3Q '18 increase prior to year-end through our stop-loss reinsurance policy and a projected decline in our IBNR claims accrual.

One final comment about noninterest expense. Incentive compensation is influenced by several factors, including asset quality metrics such as nonperforming asset levels and loan net charge-offs as well as net income. Plus, a better-than-expected level of provision for loan losses does increase incentive compensation and should be viewed somewhat collectively. Further, as I just stated, we do expect to recover much of the increase in 3Q '18 healthcare costs in 4Q '18.

Investment securities available for sale decreased $13.6 million during the third quarter of '18.

Page 17 provides an overview of our investments at September 30, 2018.

Approximately 29% of the portfolio is variable rate and much of the fixed rate portion of the portfolio is in maturities or average lives of 5 years or less.

The average duration of the portfolio is about 3.06 years with a weighted average tax equivalent yield 3.01%, which is up 10 basis points from June 30.

Page 18 provides data on nonperforming loans, other real estate, nonperforming assets and early-stage delinquencies.

Total nonperforming assets were $10.8 million or 0.33% of total assets at September 30, 2018. This was essentially unchanged from June 30, 2018.

At September 30, 2018, 30- to 89-day commercial loan delinquencies were just 0.08%, and mortgage and consumer loan delinquencies were 0.34%.

Moving on to Page 19. We recorded a credit provision for loan losses of $53,000 compared to an expense of $582,000 in the third quarters of '18 and '17, respectively.

We had $950,000 of loan net recoveries in 3Q '18, which drove the provision down. This was offset by the impact of loan growth in 3Q '18.

The allowance for loan losses totaled $24.4 million or 0.95% of portfolio loans and 1.06% of originated loans at September 30, '18.

Page 20 provides some additional asset quality data, including information on new loan defaults and on classified assets. New loan defaults were just $2 million in 3Q '18.

Page 21 provides information on our TDR portfolio that totaled $59.3 million at September 30 of '18, a decline of $2.2 million during the third quarter. This portfolio continues to perform very well with 95% of these loans performing and 92.6% of these loans being current at September 30, 2018.

Page 22 provides some detailed information on our April 1, 2018 merger with TCSB Bancorp, Inc., which we covered in detail in our 2Q '18 earnings conference call. The only change from the prior quarter relates to a recent recovery on a loan that TCSB had charged-off in full at March 31 of '18. We determined that this recovery should be treated as what is called the measurement period adjustment. And as a result, after-tax goodwill was reduced by $0.7 million.

Page 23 is our update for 2018. We compare our actual performance during the year to the original outlook that we provided back in January of '18. Overall, we believe that our actual performance for the first 9 months of '18 is better than our original outlook.

We achieved annualized organic portfolio loan growth of approximately 15.3%, 16.5% for the first quarter and first 9 months of 2018, and for the third quarter and first 9 months of 2018, respectively.

We expect a bit of seasonal slowdown in 4Q '18 with final full year net loan growth between 15% and 16%, excluding the TCSB acquired loans.

3Q '18 net interest income grew significantly on a year-over-year quarterly basis and, as I mentioned earlier, the net interest margin was 3.91%.

We expect the net interest margin to be stable in 4Q '18, and further expansion of net interest income to be primarily a result of growth in the average balance of loans.

We had a credit provision for loan losses of $53,000 in 3Q '18, driven by loan net recoveries. We do not expect a similar level of loan net recoveries in 4Q '18 and, given the forecasted loan growth, we would expect to see a provision expense in the last quarter of '18.

3Q '18 actual noninterest income was slightly above our forecast, primarily due to mortgage loan servicing. We expect 4Q '18 noninterest income to move down towards an $11.1 million to $11.3 million range due primarily to seasonal and competitive factors impacting mortgage banking revenues, absent any fair value changes in capitalized mortgage loan servicing due to price.

3Q '18 noninterest expense was above our forecasted range due largely to increases in performance-based compensation and healthcare costs as well as some merger-related cost saves in personnel not being realized until the end of July or mid-August.

We expect noninterest expense in the $26.2 million to $26.4 million range in the last quarter of 2018. Finally, we expect an effective income tax rate between 19% and 20% in the last quarter of '18.

That concludes my prepared remarks. And I would now like to turn the call back over to Brad.

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William Bradford Kessel, Independent Bank Corporation - President, CEO & Director [4]

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Thanks, Rob. We continue to pride ourselves on investing in our communities and providing exceptional customer service. Along those lines this past quarter, we were very pleased to be named one of the best in-state banks by Forbes Magazine, coming in as the best bank headquartered in Michigan. In wrapping up our prepared remarks, we have listed our ongoing strategic initiatives on Slide 24. Three points to be made here: First, we want to continue the rotation of and growth in earning assets through balanced growth in our loan portfolios; second, we will continue to carefully manage expenses and look for opportunities to gain further efficiencies; and third, we continue to invest in our associates and technology, working to make it easier to bank with Independent and easier for our associates to service our customers.

After taking into consideration the recent reduced federal corporate income tax rate, our return on asset and return on equity targets are 1.25% and 12.5% or better, respectively. I'm very pleased that through 9 months of 2018, we have been able to perform at or near these targeted levels.

At this point, we will now open up the call for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) The first question comes from Brendan Nosal of Sandler O'Neill.

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Brendan Jeffrey Nosal, Sandler O'Neill + Partners, L.P., Research Division - Director [2]

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Just want to start off with the one on the expense side. I mean, I appreciate that this quarter, you had the increased health care costs, you had some performance-based comp. But as I look at the new expense guide for the fourth quarter of $26.2 million to $26.4 million, just comparing it to the old one of $25.2 million to $25.8 million, I'm just curious as to kind of your thoughts as to what underlying trends push up that expectation?

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Robert N. Shuster, Independent Bank Corporation - Executive VP, CFO & Corporate Secretary [3]

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Well, I'd say a couple. One is the -- is the performance-based comp. I mean, it -- as we moved into the last half of the year, that was -- I probably underestimated on some of the various components where we were going to land for the year. So you have, what I would call, sort of, a catch-up component as you move through the year. To give you some reference point, a year ago, we were tracking at about 100% of what we would call our target incentive comp levels. This year, we're tracking at about 145%. So that's certainly part of it. Now if we don't do as well as anticipated, that moves in the other direction. And to just give you some sense of the waiting, I mean, earnings per share is about 32%. There's a couple of asset quality metrics, NPAs and net charge-offs, which are both 8% efficiency ratio, 16% loan growth, 8% deposit growth, 8% -- if you add that up, that's 80%. And then, individual targets for that particular person is the other 20%. So that would be a part of it. Another part of it was the healthcare costs, but we expect to recover a chunk of that. And then, probably, the last thing would just be maybe a little bit of an increase in just overall cost on the comp side, we're just seeing some lift from a competitive standpoint in wage rates. And then the final piece, I would say, is we have a certain level of compensation that we defer related to direct loan origination costs, and as our, in particular, mortgage volumes decline a bit, that deferral of direct loan origination costs, which the primary component is compensation, that deferral goes down a bit. So that sort of boosts up. I mean, you could kind of think about it that our level of the percent of people doing, processing, closing, et cetera, that there's a little bit less -- there's a little more downtime as volumes go lower. So we're deferring a little bit less in direct origination costs. So that collection of items would be the kind of group that would influence it the most.

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William Bradford Kessel, Independent Bank Corporation - President, CEO & Director [4]

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Rob, I'd add in there. Also, for the third quarter of 2018, we did have a net gain on sale of ORE of $325,000 too.

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Robert N. Shuster, Independent Bank Corporation - Executive VP, CFO & Corporate Secretary [5]

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Right, yes. But he's comparing that to our previous guidance on expenses. So yes, we didn't expect in our previous guidance to have a gain on ORE, so.

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Brendan Jeffrey Nosal, Sandler O'Neill + Partners, L.P., Research Division - Director [6]

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Got it, got it. That's fantastic color. And then, next one, just moving over to the mortgage side of things. I mean, this is as far from a unique occurrence to you guys. But I mean, gain on sale of margin was pretty pressured in this third quarter. I guess, 2 things: One, do you have any sense of -- that could rebound in coming quarters? And then, two, if it does stay at this level, do that kind of change the calculus for your appetite for the mortgage business?

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Robert N. Shuster, Independent Bank Corporation - Executive VP, CFO & Corporate Secretary [7]

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Well, a couple of things there, I think -- I would be surprised to see it get much more under pressure than what we've sort of already been experiencing on that front. So I don't expect it to deteriorate further. Hopefully, we could get some gains on the margin here a little bit as we move into the fourth quarter. Although I think anyone in the sort of Midwest, you start to see some seasonal factors influencing overall volumes as you move into the fourth quarter and then the first quarter of the prior year. The one other thing that I would mention is -- and I know we take this out of core and I would expect always to do that on the fair value changes, but one of the benefits we have as a retail mortgage originator and servicing loans is that, in this kind of environment where rates are moving up and you're getting pressure and margin on the gain side, the one benefit you get having a large servicing portfolio is you do get some lift in the value of that portfolio. So I kind of view that, a little bit, as counteracting some of the margin pressure. And because of that, I guess, having been in this business a long time, you just -- you see these cycles in this business. I mean, at some periods of time, your margins are under pressure when volumes contract. And at some point down the road, there will be improvement in margins as hopefully rates stabilize and things get better in that business. So longer term, I think we still feel it's important business as a community bank. Brad, I don't know if you want to add anything.

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William Bradford Kessel, Independent Bank Corporation - President, CEO & Director [8]

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I think that was very good, Rob. And I would say that we continue to work extremely hard on getting more efficient and reducing the costs in this line of business. We, this past year, have hired a process expert and engineer that has made significant improvements just in eliminating a lot of inefficiencies and we're going to continue to do that. And then, I also feel like we continue to do an excellent job in recruiting and retaining strong origination professionals. So tough business, but Independent feels it's very important for us in the long term.

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Operator [9]

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The next question comes from Kevin Reevey with D.A. Davidson.

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Kevin Kennedy Reevey, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [10]

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So given the shortage of housing supply in your market, do you think this is -- A, do you think this is going to continue? And then, how do you think this will impact mortgage origination volume as we go into early 2019?

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Robert N. Shuster, Independent Bank Corporation - Executive VP, CFO & Corporate Secretary [11]

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Well, most of the forecast for -- that we're seeing from sources like the Mortgage Bankers Association is anticipating for '19 that purchase volume is going to be still up a bit, and we would expect that to be the case here. They do expect refinanced volume to be lower. Again, that is more because of rate conditions -- interest rate conditions. So I still am optimistic for '19, that our volumes will be as good or slightly better than where we were in 2018. I think the housing shortage is something we've already been dealing with. I actually do think it's balancing out a little bit more. In other words, it was more of a sellers’ market for some period of time, but I think that's balancing out just a bit. Brad, I don't know if you want to add anything.

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William Bradford Kessel, Independent Bank Corporation - President, CEO & Director [12]

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I think it's good enough.

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Kevin Kennedy Reevey, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [13]

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And then can you talk about some of the tactics that you're employing in order to grow your small and middle market business deposit base and to expand your retail deposit base?

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William Bradford Kessel, Independent Bank Corporation - President, CEO & Director [14]

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Well, I think, first of all, it starts with our people. And I believe that they are on the grounds day-to-day, active, out calling. I'll give you an example. Here recently, we had our Saginaw market team that, in one day, did a blitz on the market and came away with, I think, 80 or 90 leads. And so it's just being on the ground and getting out and asking for the business.

I think the second piece that's very important to the community bank model is to be referring business from business line to business line. And so I'm very pleased with retail referring over to commercial and mortgage and vice versa. So that intracompany referral is very, very important.

And then third, Kevin, we have been on a journey and we will continue to be on this journey. And that is to not only invest in our people, but to invest in technology that makes it easier for customers to bank with Independent, but also easier for our staff to service our customers. And so it's in-house automating workflows; outside upgrading or updating the product offering; and then, finally, I think when you're out there competing for that segment that you mentioned, small, middle market, what they -- that market wants is honesty, trustworthiness and timeliness in decision-making. So we work really hard to be timely in our turnaround on loan request. Rob, if you have anything to add there?

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Robert N. Shuster, Independent Bank Corporation - Executive VP, CFO & Corporate Secretary [15]

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Yes, I'd say probably the last piece I'd add too is, similarly to what Brad had indicated on, the sort of retail or community banker. Let's -- we have a very active treasury management department that is calling on both municipal and commercial customers. And we continue to work very hard to bring in new relationships through just calling on customers and our markets, and have had some recent success on that front as well.

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Kevin Kennedy Reevey, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [16]

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And then, lastly, I wanted to ask you how aggressive do you plan to being active with your buyback plan, given where your share price is today?

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William Bradford Kessel, Independent Bank Corporation - President, CEO & Director [17]

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Well, that's a great question. So obviously, right now we're in a blackout period. And that will open up here, following quarter end. But -- and the stock has moved down. We have shared on prior calls that we do have a model that we use and, at start of this year, our board approved a 5% share repurchase amount year-to-date. We have not repurchased any. But within that model, we look at what we consider to be sort of a forecast where we see our earnings going, future dividends and so on, and compute out an earn back level. And if we can be within sight of that earn back tangible book, dilution earn back level, I think you'll see us active. But Rob, I don't know if you have anything to add there.

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Robert N. Shuster, Independent Bank Corporation - Executive VP, CFO & Corporate Secretary [18]

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Yes, I'd add 2 things. One is that we marshaled a significant amount of cash at the parent company. Now it's approaching over $40 million. So we have quite an arsenal to support and defend the stock price. And I certainly feel like it is very attractive at this juncture.

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Kevin Kennedy Reevey, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [19]

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I would agree.

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Operator [20]

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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 [21]

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I just wanted to touch on the loan yield this quarter, which are down a couple of basis points. Rob, you may have alluded to that in your prepared remarks, but could you just revisit that for us, please?

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Robert N. Shuster, Independent Bank Corporation - Executive VP, CFO & Corporate Secretary [22]

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Yes, the loan yield, that really was driven by that change in interest recoveries net and previously charged-off or nonaccrual loans. So that was -- in Slide 13 kind of goes through portfolio by portfolio what the yields were. So if you'd kind of go through, you'll look -- commercial was down about 4 basis points, but the interest recoveries was 3 of the 4 basis points, so it was relatively flat outside of that. And I did allude to sort of the phenomenon too in my remarks, that we have a fair amount of the commercial portfolio tied to either LIBOR prime and that, that really didn't change until very late in the quarter, so there wasn't really the same relative lift in variable rates in the third quarter that we saw in the second quarter. So like I said, it really was flat when you take out the change in the interest recoveries net. Mortgage loans was actually up 5 basis points, even though their interest recoveries decreased the average yield by 4. So they were -- if you take out that, impact would've been up 9 basis points.

And then finally, consumer installment loans was down 5 basis points. That really wasn't due to interest recoveries because the change there was negligible. That really had more to do within the indirect area, we had some elevated prepayment activity, and we kept amortized dealer reserves that go against the -- and dealer reserves is what we pay the indirect dealer kind of an incentive for sending us the loan. And that gets amortized over the expected life of the loans. So that expected life went down a little bit the third quarter, which elevated the amortization. So that was the primary factor there for the decline in yield.

But if you mix all that together, the bottom line is -- the yield was mostly impacted just by that change in -- of about $180,000 in net interest recoveries on previously charged-off loans. So I expect fourth quarter, the variable rate impact to sort of come back because we got those changes in September. So they'll be there for the full fourth quarter. And if I look at where new loan originations are in terms of yield relative to the portfolio, that's not a drag. So I anticipate that yield to be certainly stable, but maybe drifting up some.

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Damon Paul DelMonte, Keefe, Bruyette, & Woods, Inc., Research Division - SVP and Director [23]

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Okay. So with the ongoing rising costs in deposits, do you think -- so you're basically saying that kind of the snapback or the pull-through from the linked quarter rate increases will help to mitigate the impact from rising the deposit cost. Is that fair?

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Robert N. Shuster, Independent Bank Corporation - Executive VP, CFO & Corporate Secretary [24]

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Well, not only that, but the continued rotation of dollars from lower-yielding investments into higher-yielding loans. So as I had indicated in my comment, we expect the margin to be at least stable at where we were this quarter at 391 to maybe improving just a hair.

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Damon Paul DelMonte, Keefe, Bruyette, & Woods, Inc., Research Division - SVP and Director [25]

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Okay. Great. And then could you maybe put a little bit more context around your expectation for the provision expense next quarter?

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Robert N. Shuster, Independent Bank Corporation - Executive VP, CFO & Corporate Secretary [26]

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Well, that's the one that's probably the hardest to project. I mean, if you looked at kind of loan growth as a driver, you'd probably in get that $0.5 million to $1 million range based on loan, at least where loan growth was this past quarter. Now we expect the loan growth to be somewhat muted. And then, when you pull off from that, the other key drivers are going to be net charge-offs and loan defaults, and those have both been positives here, more recently. So absent all those other things, like I said, that loan growth factor gets you sort of in that $0.5 million to $1 million range.

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Operator [27]

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The next question comes from John Rodis with FIG Partners.

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John Lawrence Rodis, FIG Partners, LLC, Research Division - Senior VP & Research Analyst [28]

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Rob, I guess, most -- a lot of my questions have been asked and answered. But just, Rob, just back to expenses as we looked to -- or as we look to 2019, given what you got going on the mortgage side, improved efficiencies and stuff. Do you sort of think you can keep expenses sort of flat in that $26 million a quarter, sort of the range you gave for the fourth quarter going into 2019?

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Robert N. Shuster, Independent Bank Corporation - Executive VP, CFO & Corporate Secretary [29]

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Well, that's bad. And we just are kind of going through our first iteration on the budget side. I would say it's never easy. I think you're seeing pressure on wages mostly. When you have a low unemployment rate, that certainly is a factor on trying to retain and attract talent. So that's one element. I would say, when you get outside of that area, I don't see a lot of pressures -- comp and benefits, that's probably a little bit better than half your total cost. But when you get outside of that area, and I go through sort of, line by line, all the different items, I don't see pressures in those areas in terms of expense. So it's really that one particular area.

The other comment I'd made is there's a large variable cost component to our comp and benefits. If we look at where we're at this year and annualize it, the incentive comp, when I look at it outside of pieces related more directly to lending, this year is going to be in that $7.5 million to $8 million range. That's a big number. And so that number -- I mean, we start out 2019 and everything gets recalibrated. All those things are laid out right in our proxy statement. So we have to earn that incentive comp starting on January 1 of '19. And again, $7.5 million to $8 million this year of comp is directly that particular plan. So if we're not doing as well in some other area, that goes down or even away. And so that's a pretty good lever on overall expenses in terms of it relative to our overall performance. So I could see some drift up in comp and benefits on the wage side. But it's got to be paid for with better revenue and performance overall.

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Operator [30]

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The next question comes from Scott Beury of Boenning and Scattergood.

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James Prescott Beury, Boenning and Scattergood, Inc., Research Division - Analyst of Banks and Thrifts [31]

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Most of my questions have been asked and answered, and I appreciate the slide with the forward guidance. I think the -- relative to what you said about (inaudible) I'm curious to know if you're sort of seeing any changes in underwriting characteristics and better quality standards from competitors. I just wanted to get a feel for -- if there was anything you were seeing market to market that has changed in that area?

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William Bradford Kessel, Independent Bank Corporation - President, CEO & Director [32]

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So Scott, this is Brad. And actually, the front end of your question on our end was a little muffled, but what I heard was a change in what we're seeing in the marketplace in terms of underwriting by maybe competitors. Is that correct?

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James Prescott Beury, Boenning and Scattergood, Inc., Research Division - Analyst of Banks and Thrifts [33]

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Yes.

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William Bradford Kessel, Independent Bank Corporation - President, CEO & Director [34]

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Yes. Okay, I think it -- very aggressive, very competitive and there is some concession on deal by deal with maybe relaxing guarantees going higher on LTVs and/or relaxing on covenants. I couldn't say necessarily that it's one particular bank or credit union, although -- so it's not particular one credit union bank. I think that where we're really seeing maybe some concession is in price. And while I feel very good about where our pipeline -- pipelines are today in terms of what has been approved and we expect to close, we've seen a number of deals that just have not gone our way as competitors have come in with very aggressive pricing. So Rob, I don't know if you have anything to add there.

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Robert N. Shuster, Independent Bank Corporation - Executive VP, CFO & Corporate Secretary [35]

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No, I mean, I would say it's more acute on the commercial side of things, on the retail side. I don't think it's underwriting characteristics. I really think it's more, particularly on the mortgage banking side, it's really just on the pricing and margin side of things. And as you could probably appreciate, particularly with mortgage lending, I don't want to call it a pure commodity business, but it's more of a commodity business, particularly when you're selling loans to Fannie Mae, Freddie Mac, Ginnie Mae, I mean the underwriting characteristics are really established by the secondary markets. So you're really competing more there on price and service. As Brad indicated, I think you're seeing a little more on the commercial side. But I don't feel like we've had to relax underwriting standards to compete. I think on a selective basis, we've had to be maybe more aggressive in pricing where we thought it made sense, but I don't feel like we've been pushed to get outside of the comfort zone on underwriting characteristics at all.

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James Prescott Beury, Boenning and Scattergood, Inc., Research Division - Analyst of Banks and Thrifts [36]

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That is very helpful. I mean, I just -- maybe one follow-up would be -- in terms of the more aggressive pricing that you referenced, is that concentrated by any certain-size banks? I mean, are you seeing that mostly from the bigger players?

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Robert N. Shuster, Independent Bank Corporation - Executive VP, CFO & Corporate Secretary [37]

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No, I think -- on commercial, I don't think that's the case. On mortgage, it's the large originators. I mean, what we kind of -- when we get a lot of pricing information, but on mortgage, you're really reacting to the people that control significant shares in the market, which would typically be your very large originators. I think on the commercial side, it's a lot more dispersed. Don't you agree, Brad?

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William Bradford Kessel, Independent Bank Corporation - President, CEO & Director [38]

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I do. I think back here, just on some of the opportunities that we have been looking at and the Feds now had 8 quarter point moves. And this past year, I think in multiple instances, it seems like, maybe at the community bank level, small community banks, they were a move or 2 behind and were just like very difficult. But at the same time, I think there's some large regionals too that, as they look to expand their business, that have come in and I think stole the business through pricing. So it's not -- I think it's across-the-board.

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Operator [39]

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

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William Bradford Kessel, Independent Bank Corporation - President, CEO & Director [40]

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We would like to thank each of you for your interest in Independent Bank Corporation and for joining us on today's call.

We wish everybody a great day.

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Operator [41]

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

You may now disconnect.