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Edited Transcript of IBCP earnings conference call or presentation 22-Apr-19 3:00pm GMT

Q1 2019 Independent Bank Corp Earnings Call

IONIA Apr 23, 2019 (Thomson StreetEvents) -- Edited Transcript of Independent Bank Corp earnings conference call or presentation Monday, April 22, 2019 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

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Presentation

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Operator [1]

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Good day, and welcome to the Independent Bank Corporation First 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 Mr. 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 2019 first 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's my responsibility to direct you to the important information on Page 2 regarding the cautionary note for 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're pleased to report a solid start to 2019 with first quarter net income of $9.4 million or $0.39 per diluted share versus net income of $9.2 million or $0.42 per diluted share in the prior year period. Impacting our first quarter 2019 results is the acquisition of TCSB, which closed on April 1, 2018. Also significantly impacting both the first quarter of 2019 and 2018 were the changes in the fair value due to price of our capitalized mortgage loan servicing rights. For the first quarter of 2019, the change was a negative $2.2 million or $0.07 per diluted share after-tax and a positive $1.5 million or $0.05 per diluted share after-tax for the first quarter of 2018.

When excluding the after-tax impact of the MSR change, net income and diluted earnings per share increased by 38.9% and 26%, respectively, in 2019 as compared to 2018. The positive change in year-over-year quarterly results was driven by growth in net interest income and growth in mortgage loan gains, partially offset by an increase in expenses. Net interest income totaled $30.2 million during the first quarter of 2019, an increase of $6.3 million or 26.3% from the year ago period. Gains on mortgage loans totaled $3.6 million and $2.6 million for the first quarters of 2019 and 2018, respectively. Noninterest expense totaled $28 million in the first quarter of 2019 compared to $24.1 million in the year ago period.

Rob will provide more detail on the increase in expenses in his prepared remarks. I do believe we will return to our previously shared expected expense range of $27 million to $27.5 million. During the first quarter, we grew portfolio loans by $36 million or 6% annualized. This represents the 20th consecutive quarter of loan growth. This loan growth is net of $30 million of mortgage loans we securitized and transferred to securities available for sale during the first quarter of 2019. We subsequently sold most of these securities. The purpose of the securitization corresponds to the management of our interest rate risk position, our liquidity position as well as our targeted earning asset mix.

On the funding side, during the first quarter, total deposits were up $21 million or 3% annualized. Excluding broker deposits, the growth rate was 12% annualized. This -- the growth this past quarter was primarily in savings, interest-bearing checking account balances, reciprocal deposits which were partially offset by a decline in noninterest-bearing account balances.

Slide 6 of our presentation provides a good view of our footprint.

Turning to Slide 7. Michigan business conditions continue to be favorable with low unemployment, some job growth, affordable housing and continued good demand for commercial real estate. The February 2019 Michigan unemployment rate at 4% is lower than one year ago when it was 4.4% and 0.2% above the U.S. unemployment rate of 3.8%. Regionally, Grand Rapids' unemployment is at 3.1%, Lansing is at 3.7% and Detroit, Livonia and Dearborn is 4.3%. Michigan's workforce is 4.44 million strong. And overall, employment is up slightly from one year ago. Regards to housing, the Michigan real estate market can be characterized as affordable with a continued shortage of inventory. The average sales price of a home in Michigan is $172,000 and Michigan's year-over-year sales price is down slightly at 4.6%.

The continuation of the positive economic trends can be seen in our regional portfolios shown on Page 8. Our 2 strongest growth regions are the Grand Rapids region, up $102 million in loan balances and our Southeast Michigan region, up $58 million in loan balances. Our Traverse City team has produced 6% growth since the acquisition. We've also seen very good year-over-year deposit growth in most of our regions. The next couple of slides cover our balance sheet.

Turning to Page 9, we provided a couple of charts reflecting the attractive composition of our deposit base as well as the continued growth in this portfolio, while working to effectively manage our overall cost of funds. Independent has $2.93 billion in total deposits, of which 78% are nonmaturity deposit accounts. When comparing first quarter 2019 to the same quarter one year ago, we increased total deposits by $153 million or 6.6% annualized -- 6.6%. This excludes brokered deposits and $254 million of nonbrokered deposits acquired in the TCSB merger. Our total cost of deposits is up 10 basis points on a linked quarter basis and is up 41 basis points when comparing to the same quarter one year ago.

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 loan mix -- a balanced loan mix with the largest portfolio being our commercial book of business. At March 31, 2019, our loan mix is 44% commercial, 39% mortgage, 15% installment and 2% held-for-sale. The total loans outstanding now aggregate to $2.66 billion, including $43.1 million of loans held-for-sale. The commercial portfolio grew by $24 million or 8.5% annualized during the quarter. Consumer installment loans were up by $11.5 million or 11.8% for the quarter and portfolio mortgage loans increased by $900,000, which is net of a $30 million securitization.

In terms of capital management, our capital levels continue to be strong with tangible common equity to tangible assets moving from 9.17% at December 31, 2018 to 9.26% at March 31, 2019. This is well within our targeted TCE range of 8.5% to 9.5%. Our Board of Directors declared in January and we paid on February 15, 2019, an $0.18 per share cash dividend on our common stock, which represents a 20% increase from our prior quarterly cash dividend level. Under the company's share repurchase plan, during the first quarter of 2019, the company repurchased 115,787 shares at an average price of $21.85 per share.

At this time, I would like to turn the presentation over to Rob Shuster to share a few comments on our financials, credit quality, CECL and our outlook for the remainder of 2019.

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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 year-over-year 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 3.88% during the first quarter of 2019, which is up 17 basis points from the year ago period, but down 5 basis points from the fourth quarter of 2018. I will have some more detailed comments on this topic in a moment. Average interest-earning assets were $3.15 billion in the first quarter of 2019 compared to $2.61 billion in the year ago quarter and $3.12 billion in the fourth quarter of 2018.

Page 13 contains a more detailed analysis of the linked quarter decrease in net interest income. There is a lot of data on this slide, but to summarize a few key points, the 5 basis point decline in the linked quarter net interest margin was primarily due to changes in the mix of interest-earning assets and the decline in average noninterest-bearing deposits. Two less days in the first quarter of 2019 reduced net interest income by $319,000 compared to the fourth quarter of '18. Interest recoveries on nonaccrual or previously charged-off loans declined by $111,000 compared to fourth quarter '18. The average cost of funds was up 9 basis points, 2.82% from 0.73% in the fourth quarter of '18.

A couple -- a little more color on a couple of these points. The amount of average loans actually declined by $5.7 million in the first quarter of '19 and average loans represented 83.2% of total earning assets in the first quarter of '19 as compared to 84.2% in the fourth quarter of '18. This decline was principally due to 2 factors: One, the securitization of $29.9 million of portfolio loans, mortgage loans into Freddie Mac mortgage-backed securities, most of which were sold; and two, much of the first quarter 2019 commercial loan growth occurred very late in the quarter. We do not expect either of these factors to persist and therefore expect a resumption of growth in the amount of average loans, as we move through the balance of 2019. We also experienced a $27 million decline in average noninterest-bearing deposit balance -- balances as customers become more conscious of moving noninterest-bearing funds into interest-bearing accounts. We do expect this phenomenon to continue at some level over the next few quarters. We will comment more specifically on our outlook for net interest income for the balance of 2019 later in the presentation.

Page 14 compares our quarterly average cost of funds, which is annualized interest expense divided by our average earning assets to the monthly average effective 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, which encompasses the period of Q3 '15 to Q2 '17 and then the increase in the cumulative beta to 33.1% for the next 145 basis points of movement in the effective federal funds rate from Q2 '17 to Q1 '19.

Moving onto Page 15. Noninterest income totaled $10 million in the first quarter of 2019 as compared to $11.7 million in the year ago quarter and $9 million in the fourth quarter of 2018. As Brad mentioned, mortgage loan servicing caused most of the comparative -- the quarterly comparative year-over-year variability in noninterest income and he shared the dollar figures regarding this change. Q1 '19 net gains on mortgage loans increased to $3.6 million compared to $2.6 million in the first quarter of '18. The increase in these gains was due to increases in mortgage loan sales volume and in the mortgage loan pipeline. If you exclude portfolio mortgage loan sales and fair value adjustments, the profit margin on mortgage loan sales was 2.59% in the first quarter of '19 as compared to 2.68% in the year ago quarter.

As detailed on Page 16, noninterest expenses totaled $28 million in the first quarter of 2019 as compared to $24.1 million in the year ago quarter. This increase reflects our merger with Traverse City State Bank that occurred on April 1, '18, as well as increases in health care costs, loss on other real estate and costs for unfunded lending commitments due primarily to a minor methodology change in the calculation of these costs. We will have more comments on our outlook for noninterest expenses later in the presentation. Investment securities available for sale increased $33.6 million during the first quarter of 2019. Page 17 provides an overview of our investments at quarter end March 31, 2019. Approximately 31% of the portfolio was variable rate and much of the fixed rate portion of the portfolio is in maturities or average lives of 5 years or less. The estimated average duration of the portfolio is about 2.4 years with the weighted average tax equivalent yield at 3.17%, which is up 6 basis points from year-end 2018.

Page 18 provides data on nonperforming loans, other real estate, nonperforming assets and early-stage delinquencies. Total nonperforming assets were $10.2 million or 0.3% of total assets at March 31, '19. Nonperforming loans decreased by $0.2 million during the first quarter of '19. At March 31, 2019, 30- to 89-day commercial loan delinquencies were virtually 0.003% and mortgage loan and commercial loan delinquencies were 0.39%.

Moving onto Page 19. We recorded a provision for loan losses expense of $664,000 and $315,000 in the first quarter of 2019 and 2018, respectively. We recorded net loan charge-offs of $298,000 in the first quarter of '19 compared to loan net recoveries of $169,000 in the first quarter of '18. The allowance for loan losses increased to $25.3 million or 0.96% of portfolio loans and 1.05% of originated loans at March 31, 2019.

Page 20 provides some additional asset quality data, including information on new loan defaults and unclassified assets. New loan defaults were just $1.6 million in the first quarter of 2019.

Page 21 provides information on our TDR portfolio that totaled $53.4 million at March 31, 2019. This represents a decline of $2.7 million during the first quarter. This portfolio continues to perform very well with 95% of these loans performing and 93% of these loans being current at March 31, 2019.

Page 22 is a new slide. This provides a detailed time line for our implementation of the CECL accounting standard. As you can see, we expect to publicly disclose the estimated impact of CECL on our allowance for loan losses when we file our second quarter 2019 Form 10-Q in early August.

Page 23 is our first update for 2019, where we compare our actual performance during the year to the original outlook that we provided back in January of '19. Overall, we believe that our actual performance in the first quarter, when factoring out the negative fair value adjustment on capitalized MSRs, was a bit better than our original outlook. We achieved actual annualized loan growth of 5.7% in the first quarter of '19. Typically, our first quarter growth rate is slower due to seasonal factors. So we expect this growth rate to accelerate over the next couple of quarters and remain comfortable with our full year expectation of 8% to 9% loan growth.

With the current shape of the yield curve and an expected lack of any upward interest rate moves by the Fed, we do expect a bit of downward pressure on our net interest margin. However, we remain comfortable with our forecasted growth rate of 10% to 11% for net interest income for all of 2019 due to an increase in average interest-earning assets. We had a provision for loan losses expense in 1Q '19 of $664,000. This was below our anticipated level because of better-than-expected asset quality metrics. We expect generally stable asset quality metrics during the remainder of 2019, so loan growth is anticipated to be the main driver of our loan loss provision.

Excluding the negative fair value adjustment due to price on MSRs, adjusted first quarter '19 noninterest income would have been at the high end of our forecasted range. We continue to expect noninterest income to be within our forecasted range with -- for the balance of quarters in 2019, excluding any volatility associated with changes due to price and the fair value of MSRs. My comment here that we've retraced through April about 60% of the decline in mortgage rates, so if things stay where they're at through the end of June, we'd expect to recoup some of that fair value MSR decline from the first quarter.

As I discussed previously, actual first quarter noninterest expenses were a bit above our forecasted range due primarily to health care costs and a loss on other real estate that we budget at 0. However, we do believe that noninterest expenses, as Brad mentioned, will fall back within the forecasted range for the last 3 quarters of 2019. Specific areas, where we anticipate lower expenses in the next 3 quarters, include payroll taxes, snow removal costs which totaled $421,000 in the first quarter of '19 and then credit-related items which include loss on ORE, costs related to unfunded lending commitments and the provision for loss reimbursement on sold loans, which collectively totaled $390,000 in the first quarter of '19.

Finally, although our effective income tax rate was 18.8% in the first quarter of '19, we do expect an effective income tax rate of closer to 20% going forward in 2019 as the first quarter of '19 and '18 were reduced by about $170,000 due to the tax benefit of stock awards that vested or stock options that were exercised.

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. For many years, we have shared our performance goals, including return on assets and return on equity, which we believe to be 2 of the most significant drivers of total shareholder return. Our current year performance goals include an ROA of 1.3% and an ROE of 13%. For the first quarter of 2019, our return on average assets and return on average equity were 1.13% and 11.14%, respectively. These ratios increased to 1.34% and 13.2%, when excluding the after-tax impact of the MSR change.

We have listed our strategic initiatives on Slide 24. During the first quarter of 2019, we made progress on each of these. We believe successful execution on these initiatives will continue to drive strong returns as a community bank, at the center of all of our strategies is staying focused on serving our customers and investing in our markets and in our people.

At this point in time, we'd like to 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) Our 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 here on the NII outlook. So you guys maintained the outlook for 10% to 11% growth, and it looks like the loan growth side of that is holding in quite nicely and it should ramp up throughout the year, but it feels like the NIM is a little more pressured now than we would have thought 3 months ago. Just help us understand how if the growth outlook is more or less the same and the NIM outlook is a little worse, what is it that allows you guys to maintain that 10% to 11% NII growth for 2019?

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

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I think a couple things. One is, I think, on the loan growth side, we're going to be probably a bit more toward that higher end of that range. The second thing is, I do think the mix change will continue to help with a bit more loans and investment securities being at the level or maybe down a bit so the remix will help a little bit as well. And generally the last thing I would say is even with the flat curve, we're generally seeing the new loan growth at or better than the average yield for the portfolio. So we'd expect an upward move on yield on earning assets even with the Fed kind of on hold and the flatter curve. So I think it's those things in combination allow us to still feel comfortable with that overall growth in dollars of net interest income.

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Brendan Jeffrey Nosal, Sandler O'Neill + Partners, L.P., Research Division - Director [4]

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Got it. Okay. That makes sense. And then one more from me. Moving over to the mortgage side of things. I mean obviously a strong start to the year for gain on sale of mortgage. Just curious your updated thoughts on mortgage banking throughout year. I mean obviously the dip in rates could help refi volume, but how are you seeing things progress in your markets?

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

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Yes. So -- I mean, we did see some pickup in refinancing. Now recognized with the pipeline growth, you're sort of capturing a little bit of that within the first quarter gains, but even with that we've seen an acceleration on application volume here through the first 3 weeks of April. So you have 2 things working: you have seasonal factors, where home sales and purchase activity and we're 80%-plus purchase mortgage activity, so you see that picking up; and then there's some pickup in refinance volume although, as I mentioned, we had subsequent to March 31, the 10-year treasury and mortgage rate sort of come back up a bit. So I don't think it's going to necessarily be a refinance boom, but I think it's going to be more than what we anticipated at the outset of the year combined with a strong purchase market. So we feel that, that is going to be a solid part of our results for the next few quarters. Brad, I don't know if you want to add anything?

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William Bradford Kessel, Independent Bank Corporation - President, CEO & Director [6]

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No. I think you're on track, Rob.

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Operator [7]

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Our next question comes from Damon DelMonte of KBW.

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Damon Paul DelMonte, Keefe, Bruyette, & Woods, Inc., Research Division - SVP and Director [8]

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So my first question, just to kind of circle back on the margin. Rob, can you give a little color on the amount of compression you could be expecting in the next couple of quarters?

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Robert N. Shuster, Independent Bank Corporation - Executive VP, CFO & Corporate Secretary [9]

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Well, the one wildcard, if I knew exactly what was going to be happening on the deposit side and we did see a bit of pressure really from rotation out of noninterest bearing into interest bearing, that's the one where it's a little bit harder to predict, but we're extremely mindful of trying to walk this fine line of managing our interest costs yet not losing deposit relationships where you're replacing funds north of 2%. So I'll caveat my comment with the fact that we're not expecting any significant pressure on the deposit side.

We're expecting that more to kind of move up as it has the last few quarters. So given that and given what we anticipate on the earning asset side and, I mentioned earlier, with loan growth accelerating and where we're seeing sort of incoming loans, the rates on incoming loans being a benefit versus our average yield in the loan portfolio, the compression would be very modest. So I'm not anticipating anything of significance, maybe a couple of basis points. And I will say in the first quarter, one sort of odd item and you could see it kind of in the balance sheet or in our average balance and yield table, we had a fair amount of seasonal growth in deposits. We typically see that particularly with our municipal customers in the first quarter, and we weren't able to peel off broker deposits lockstep with that growth. So we had about $30 million more in kind of overnight deposits, which were at lower yield. So that kind of affected the first quarter margin a little bit as well, and I don't expect that to recur here as we move through the next couple of quarters. So that's the other reason, I feel, like the pressure is not going to be very significant on the net interest margin. But again, if I miss, it's probably going to be on that deposit base.

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Damon Paul DelMonte, Keefe, Bruyette, & Woods, Inc., Research Division - SVP and Director [10]

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Got you. And then as far as like the impact from fair value accretion, I think, it was $357,000 this quarter, last quarter is $423,000. So we'll be modeling something in that $300,000 to $400,000 range?

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

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Yes. It's just drifting down a little bit quarter-by-quarter. So that kind of rate of decline, you could probably kind of project for the next couple of quarters. So it's going to be drifting down towards $300,000 and maybe by end of year, maybe being a bit below that. But when we talk about our expectation of growth in net interest income, we take that downward drift into account.

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

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Got it. Okay. That's helpful. And then with respect to the loan growth, you guys are saying you're comfortable on kind of the higher end of your previously disclosed range. Could you talk a little bit about some of the drivers of the growth? And what areas of the footprint you're seeing the best opportunities?

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William Bradford Kessel, Independent Bank Corporation - President, CEO & Director [13]

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Sure, Damon. This is Brad. And I feel really good about getting out of the gates in 2019, particularly with our commercial team. We saw the strongest growth here in our West Michigan market and followed closely by the Southeast Michigan group. It was really nice. It was a very balanced mix in terms of CRE and C&I, and that's actually what is very intentional. And I was looking at some reports here and it's very granular. We had 25 credits that were $500,000 and above and only one of those credits here in the first quarter of new business was over $10 million. So spread out throughout our footprint very granular and good mix between C&I and CRE.

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Robert N. Shuster, Independent Bank Corporation - Executive VP, CFO & Corporate Secretary [14]

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And then I'd add on the retail side, just for seasonal factors, we have historically seen a pick up on the consumer installment side, although that's another area where we started out strong right out of the gate. And then certainly on the mortgage side, we'll see some seasonal pickup there, both on the portfolio side and then holding larger balances of mortgages held-for-sale, where we're earning interest on those loans during the time period we're holding them for sale. So all of those things we think will contribute to that movement up towards the higher end of our range.

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Operator [15]

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Our next question comes from John Rodis of FIG Partners.

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John Lawrence Rodis, FIG Partners, LLC, Research Division - Senior VP & Research Analyst [16]

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Rob, I guess, per your earlier comment, I guess, on the securities portfolio, it sounds like flat to down some. Is that correct?

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Robert N. Shuster, Independent Bank Corporation - Executive VP, CFO & Corporate Secretary [17]

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Yes. We were -- some of that will just be driven by what's going on, on the deposit side. So what we kind of added were relatively short duration in the first quarter, but for liquidity reasons, we do want to see that portfolio represent a certain percentage of our earning assets. And the one thing that you're doing there, is if you're bringing in wholesale funds and putting it into securities, that spread is not that high although it contributes to dollars of net interest income and -- so I view that as a positive. It doesn't help the NIM. So yes, I think the flat to maybe a little drift down is a good kind of place to be with the dollars being made up in the loan portfolio.

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John Lawrence Rodis, FIG Partners, LLC, Research Division - Senior VP & Research Analyst [18]

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Got it. Got it. And on the buybacks, so you guys bought back a little bit over 100,000 shares in the quarter. How should we sort of think about activity going forward? Is it more opportunistic? Or do you really want to buy back the 5% this year?

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Robert N. Shuster, Independent Bank Corporation - Executive VP, CFO & Corporate Secretary [19]

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I would say, it's somewhat more opportunistic. I mean we'll kind of see where things fall out. I mean we get a lot of feedback about what levels and where -- I mean, we certainly -- you could kind of see from what we did last year to what we did in the first quarter kind of where we've been buying at, it's generally been south of 22, but I don't think we're set on getting to the 5%, but I think we -- if the opportunity presents, we'd like to buy back more.

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William Bradford Kessel, Independent Bank Corporation - President, CEO & Director [20]

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Yes. And Rob, I'd add there. It's also a function of what all the other opportunities are. And today, there was a period we were running a little bit above our targeted TCE range. And in 2018, we were able to buy back quite a few shares, get back within our range. We used a lot of cash. Now we're in a very comfortable level, and we'll see what the opportunities are here for the balance of 2019, John.

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John Lawrence Rodis, FIG Partners, LLC, Research Division - Senior VP & Research Analyst [21]

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Okay. That makes sense, Brad. And guys, just one other question from me. Just the -- I know it's early, but the Chemical-TCF merger, any -- have you seen any sort of early opportunities or probably still too early to tell?

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William Bradford Kessel, Independent Bank Corporation - President, CEO & Director [22]

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That is -- that's ongoing. And we do see it -- when we look at our competitor base, Chemical probably would be one that matches up with us on a -- our branch footprint more than anybody else. To say, of our 69 locations, we probably crossed over with them 60 -- on 60 locations. And so our team is out there knocking on doors and having success, but it's a long race and they are a good competitor, and I've shared a whole lot, it will all be good at the end.

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Operator [23]

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Our 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 [24]

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Most of my questions have already been answered, but looking at the fee income piece, I was just curious, one thing I noticed was the service charges. Looking year-over-year, they're actually down from previous levels, like prior to TCSB. And I was just curious, is that just the ongoing industry pressure on that revenue source? Or any commentary you have there on kind of how you're thinking about that going forward?

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William Bradford Kessel, Independent Bank Corporation - President, CEO & Director [25]

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Scott, absolutely, you're dead on with that observation. And I think a lot of that has to do with -- we are seeing a higher and higher adoption rate of our customer base using online and mobile banking. And they are getting real-time views of their account balances. And so I think people are just being smarter about -- and more prudent about managing their money, and so we have observed that. We expect to probably see a continued challenge on that line. And quite frankly, so our efforts are geared towards getting boost in the interchange category and getting new customers on board, debit cards in those customers' hands and incenting them to swipe and generate that interchange income.

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James Prescott Beury, Boenning and Scattergood, Inc., Research Division - Analyst of Banks and Thrifts [26]

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Got it. That makes a lot of sense. That's definitely a helpful explanation. My only other question that I had was just -- as it relates to the MSR portfolio. Obviously, I know this is a sophisticated endeavor, but you've seen a lot of volatility in that line item quarter-to-quarter as rates move and prepayments change. Is there anything you can do even on a high level that kind of get some stability in that market you're having to put on the MSRs every quarter with some hedging programs?

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Robert N. Shuster, Independent Bank Corporation - Executive VP, CFO & Corporate Secretary [27]

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Yes. That's a fine observation, and we have debated that here for quite some time. The issue we have is twofold. One is, when you hedge, there is a cost to that. So no matter how good you are at hedging it and sometimes, for example, if you're using treasuries to hedge, you can get a decoupling where mortgage rates and prepayments move differently than treasuries. So you could have more than just a little bit of hedge ineffectiveness. Even if you're very effective at hedging, there is still a cost to it. So you're giving up real economic value to smooth earnings. The other point for us, which is unique at least not probably to communities banks but it might be to someone who is more on the wholesale side, all we do is retail origination.

So our belief is when we get that volatility and declines in fair value, eventually we will recapture some of that refinancing. So we kind of have a natural hedge even though it's not smoothing out earnings from an economic standpoint because we're retail shop. We're recapturing, we believe a good share of that refinance activity, which allows us to kind of rebuild that servicing assets. So again, we feel the economics weigh against hedging it, but we'd like to see not the earnings volatility that we get. I think the fortunate thing is our analyst group sort of gets it and looks more to the core or operating numbers and we really do appreciate that. As I just mentioned, we've already retraced about 60% of the first quarter decline, so if that holds out or likely to get a jump back on that fair value change. So while frustrating, that's kind of where we end up when all the dust settles.

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William Bradford Kessel, Independent Bank Corporation - President, CEO & Director [28]

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And Rob, when we look at 2018, there was a lot of volatility there for the entire fiscal year.

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

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We changed $200,000. So if you go and look at last year, we were up in fair value due to price in the first 3 quarters. The 2 middle quarters were lower numbers, and then we gave back most of it in the fourth quarter. So we ended the year, as Brad said, we're plus $190,000. So that's what we kind of hope when all the dust settles this year. That when we get to year-end, it's not a big number either way, but I know it is frustrating for us, too, so.

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William Bradford Kessel, Independent Bank Corporation - President, CEO & Director [30]

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Good question, Scott.

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Operator [31]

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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 [32]

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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 you all a great day.

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Operator [33]

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