First Internet Bancorp (NASDAQ:INBK) Q3 2023 Earnings Call Transcript

First Internet Bancorp (NASDAQ:INBK) Q3 2023 Earnings Call Transcript October 26, 2023

Operator: Good day, ladies and gentlemen, and welcome to the First Internet Bancorp Third Quarter 2023 Earnings Conference Call. At this time, all lines are in listen-only mode. Following the presentation, we'll conduct a question-and-answer session. [Operator Instructions] This call is being recorded today, October 26, 2023. I will now like to turn the conference over to Larry Clark from Financial Profiles, Inc. Please go ahead, Mr. Clark.

Larry Clark: Thank you, Sergio. Good day, everyone, and thank you for joining us to discuss First Internet Bancorp's financial results for the third quarter of 2023. The company issued its earnings press release yesterday afternoon, and it's available on the company's website. In addition, the company has included a slide presentation that you can refer to during the call. You can also access these slides on the website. Joining us today from the management team are Chairman and CEO, David Becker; and Executive Vice President and CFO, Ken Lovik. David will provide an overview, and Ken will discuss the financial results. Then we'll open up the call to your questions. Before we begin, I'd like to remind you that this conference call contains forward-looking statements with respect to the future performance and financial condition of First Internet Bancorp that involve risks and uncertainties.

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Various factors could cause actual results to materially be different from any future results expressed or implied by such forward-looking statements. These factors are discussed in the company's SEC filings, which are available on the company's website. The company disclaims any obligation to update any forward-looking statements made during the call. Additionally, management may refer to non-GAAP measures, which are intended to supplement but not substitute for the most directly comparable GAAP measures. The press release, available on the website, contains the financial and other quantitative information to be discussed today, as well as a reconciliation of the GAAP to non-GAAP measures. At this time, I'd like to turn the call over to David.

David Becker: Thank you, Larry. Good afternoon, everyone, and thanks for joining us today as we discuss our third quarter 2023 results. Starting with the highlights on Slide 3, I would like to discuss some key themes for the quarter. We generated strong deposit growth during the quarter, bolstering our liquidity profile and driving down our loan-to-deposit ratio below 92%. We also continued to transition the composition of our loan portfolio and optimize our overall balance sheet mix. As new origination yields were up 50 basis points from the second quarter to 8.92%, and they were up over 360 basis points from the third quarter of 2022. At the same time, both the pace of deposit cost increases and the rate of compression in our net interest margin were the slowest they've been in five quarters.

Moreover, while one month does not make a trend, we were encouraged by the month-over-month increase in our net interest margin in September. Recognizing that macroeconomic and geopolitical factors remain outside of our control, we continue to believe that our net interest margin and overall net interest income have likely bottomed out and will follow an upward path from here. Another highlight for the quarter was our SBA team's continued outstanding performance. The team again posted its highest level of quarterly gain on sale revenue to date, which was up over 14% from the second quarter, driven primarily by a strong increase in the sold loan volume. Following our exit from the consumer mortgage business earlier this year, our mix in non-interest revenue has shifted from what was an overreliance on the cyclicality of the low multiple mortgage business to what we believe is a more consistent, reliable, and growth-oriented revenue stream regardless of the interest rate environment in SBA.

Our nationwide SBA team is doing a great job of providing growth capital to entrepreneurs and small business owners across the country, with year-to-date originations up 165% over the first nine months of 2022. I am especially proud to announce that for the SBA's fiscal year ended September 30, 2023, we were the ninth largest 7A program lender in the country. This is a notable increase from our ranking of 27th position in the prior fiscal year. We believe that the combination of our continued loan portfolio repositioning and consistent revenue growth from our SBA business positions us well for higher earnings and profitability as deposit costs stabilize. Our overall credit quality remains strong as non-performing loans to total loans declined to 16 basis points and non-performing assets to total assets declined to 12 basis points.

Additional delinquencies 30 days or more were 22 basis points of total loans, while net charge-offs to average loans remained low at 16 basis points. And again, I would like to remind everyone that our exposure to office commercial real estate is less than 1% of our total loan balance and does not include any central business district exposure. Our capital levels remain sound with a common equity Tier 1 capital ratio of 9.59% at quarter end. Our deposit growth resulted in carrying above average cash balances, which we think is prudent to do in the current environment. The impact of higher interest rates also contributed to an increase in the accumulated other comprehensive loss that runs through equity. These factors weighed on the tangible common equity ratio, however, our capital – regulatory capital ratios at both the company and bank levels remain well above minimum requirements.

Tangible common equity was also affected by our share repurchase activity as we repurchased nearly 100,000 shares during the quarter at an average price equating to less than half of our tangible book value per share. I would also like to point out that the prudent conservative management of our investment portfolio and overall balance sheet has resulted in First Internet being among the few banks to have grown tangible book value per share, a key measure of shareholder value creation from the start of this historic cycle of interest rate hikes at the beginning of last year through the end of the most recent quarter. Now turning to our financial and operating results for the third quarter of 2023, we reported net income of $3.4 million and diluted earnings per share of $0.39.

Despite higher funding costs, total revenue was $24.8 million, up from $24 million in the second quarter as the growth in SBA revenue helped to offset a decline in net interest income. Additionally, operating expenses were in line with our expectations given the strong origination and activity in SBA and our non-interest expense to average assets was relatively flat at 1.53%. We produced a healthy 9.6% annualized rate of overall loan growth with gains in franchise finance, construction, small business lending, and consumer. These were offset partially by declines in public finance, healthcare finance, single tenant lease financing, and investor commercial real estate. As a reminder, the shift in loan mix is the result of a strategic initiative to focus on variable rate, higher yielding products during a historic rapidly rising interest rate.

Our construction team had another strong quarter originating almost $180 million in new commitments and producing growth of nearly $60 million in funded balances. At quarter end, total non – unfunded commitments in our construction line of business increased to $527 million, leaving us well positioned to continue shifting the composition of the loan portfolio towards higher yielding variable rate loans. Our consumer lending team also had another solid quarter as the trailers, recreational vehicles, and other consumer loan portfolios were up on a combined basis over $17 million. We remain focused on high quality borrowers and continue to obtain rates on new production in the mid 8% range. Delinquencies in these portfolios remain low as well at just 1 basis point.

And lastly, I want to provide an update on our Banking-as-a-Service and Fintech partnership initiative. In the third quarter, we announced a new relationship with jaris, a leading financial technology provider of fully managed commercial financial solutions for small businesses. Initially, we will provide loan origination services for a large portion of their short-term working capital lending product offered to their client base. We are very impressed with the jaris team and excited about the opportunity. This partnership will enable us to further increase our goal of providing small business owners and entrepreneurs access to capital while maintaining the highest compliance and credit quality standards. It is emblematic of the potential we see for banks and fintechs to partner for positive customer outcomes.

In conclusion, our third quarter results provide us with optimism regarding the outlook for our business. From a safety and soundness perspective, liquidity and credit quality remain very strong and capital levels are sound. With the Federal Reserve rate hikes likely nearing an end, we expect to see a continued decline in the pace of deposit cost increases and eventually stabilization. This combined with a strong performance of our SP18 and a continued improvement in our loan product portfolio composition, leas is well positioned to achieve higher earnings and profitability as we look to 2024 and beyond. With that, I would like to turn the call over to Ken for more details of our financial results for the quarter.

Ken Lovik: Thanks, David. Now turning to Slide 4, David covered the highlights for the quarter from a lending perspective, so I will just provide some additional color. Consistent with our focus on variable rate and higher yielding asset classes, we were pleased that our third quarter funded portfolio origination yields continued to increase from the second quarter. Because of the fixed rate nature of some of our larger portfolios, there is a lagging impact of the higher origination yields on the overall loan portfolio. However, as new origination yields have been consistently higher throughout 2023, we expect the overall loan yield to continue to increase in future periods. Our SBA, construction and franchise finance channels continue to have very strong pipelines.

There is one caveat to our outlook on loan pipelines that I will speak to in a little more detail later, that being the possibility of a government shutdown in November and the potential impact on the SBA pipeline. As David just said moments ago, some macroeconomic and geopolitical factors remain outside of our control. If we avert a shutdown, and similar to what we accomplished in the second and third quarters, our goal is to fund a portion of this production using cash flows from other portfolios as we continue to rebalance and optimize the composition of the total loan portfolio. Moving on to deposits on slides 5 through 7, deposit balances continued to increase and were up $229 million or 6% from the end of the second quarter. The majority of the deposit growth during the quarter came from CDs with strong demand from consumers and small business.

We originated $428 million in new production and renewals during the quarter at an average cost of 5.14% and a weighted average term of 15 months. These were partially offset by maturities of $180 million with an average cost of 3.07%. Looking forward, we have $276 million of CDs maturing in the fourth quarter with an average cost of 4.34% and $459 million maturing in the first quarter of 2024 with an average cost of 4.62%. So you can see the repricing gap between the cost of new CDs and the cost of maturing CDs is closing, which will contribute significantly to the continued pace of slowing deposit costs. Non-maturity deposits were down slightly at quarter end as declines in interest-bearing checking and money market balances were offset by an increase in banking-as-a-service deposits driven by higher payments volume.

Deposits from our banking-as-a-service partners were up 5% from the second quarter and totaled $162 million at quarter end. Additionally, these partners generated over $3.4 billion in payments volume, which was up 16% from the volume we processed in the second quarter. From a revenue perspective, total banking-as-a-service fees were up 24% quarter-over-quarter, with a large majority of the increase consisting of recurring oversight and transaction fees. Additionally, broker deposits decreased $12 million from the end of the second quarter as a contractual relationship matured early in the quarter and we continued to reduce higher cost portions of our deposit base. As a result of all the deposit and interest rate activity during the third quarter, the cost of our interest-bearing deposits increased by 34 basis points from the second quarter, which as David mentioned, is the slowest pace of growth over the last five quarters.

In addition to the large volume of CDs maturing over the next two quarters, we also have about $75 million of broker deposits maturing in the fourth quarter with a weighted average cost of almost 5%. Part of our strategy in driving deposit growth earlier in the third quarter was to get in front of the July Fed rate hike and lock in lower costs to replace the outflows from maturing deposits while still maintaining more than adequate liquidity. As I mentioned earlier, the weighted cost of new CDs during the third quarter was 5.14%, whereas the market is now pricing 12- to 24-month CDs between 5.6% and 6%. While we expect a certain percentage of maturing consumer and small business CDs to renew, we are not competitive in pricing in the institutional and public funds markets.

When combined with the broker deposit maturities, we do expect deposit and cash balances to be lower at the end of the year, which should have the added benefit of relieving some pressure on both our capital ratios and our net interest margin. Looking at Slide 6, at quarter end, we estimate that our uninsured deposit balances were $948 million or 23% of total deposits, down slightly from 24% at the end of the second quarter. The decrease was driven primarily by the new CD production, which generally consisted of balances below the insured limit. As a reminder, included in the uninsured balance total are Indiana-based municipal deposits, which are insured by the Indiana Board for Depositories and neither require collateral nor are reported as preferred deposits on the bank's call report, as well as certain larger balance accounts under contractual agreements that only allow withdrawal under certain conditions.

After adjusting for these types of deposits, our adjusted uninsured balances dropped to $704 million or 17% of total deposits, comparing favorably relative to the rest of the industry. Moving to Slide 7, at quarter end, total liquidity remains very strong as we had cash and unused borrowing capacity of $1.7 billion. Our unused borrowing capacity increased during the quarter as we pledged additional collateral to the Federal Reserve. With the deposit growth over the course of the quarter, cash balances increased over $55 million. Furthermore, our loans-to-deposits ratio declined to 91.5%. At quarter end, our cash and unused borrowing capacity represents 182% of total uninsured deposits and 244% of adjusted uninsured deposits. Turning to Slides 8 and 9, net interest income for the quarter was $17.4 million and $18.6 million on a fully taxable equivalent basis, down 4.2% and 4.4% respectively from the second quarter.

The yield on average interest-earning assets increased to 5.02% from 4.89% in the linked quarter, due primarily to a 29 basis point increase in the yield earned on other earning assets, a 9 basis point increase in the average loan yield, and a 20 basis point increase in the yield earned on securities. The higher yields on interest-earning assets, combined with growth in average loan and cash balances, produced strong top-line growth in interest income, increasing over 8% compared to the linked quarter. While deposit costs continued to rise, again, the pace of increase was the slowest in the past five quarters, and as a result, net interest income contraction was also the lowest in the past five quarters and in line with our expectations. We reported a net interest margin of 1.39% in the third quarter, a decrease of 14 basis points from the second quarter.

Fully taxable equivalent net interest margin for the quarter was 1.49%, down 15 basis points from the prior quarter. We estimate the higher cash balances we carried during the quarter negatively impacted net interest margin by 10 to 12 basis points. The net interest margin rolled forward on Slide 9 highlights the drivers of change in fully taxable equivalent net interest margin during the quarter. Similar to this quarter, with higher-priced new loan originations and variable rate assets repriced higher for an entire quarter, we believe that we will deliver another increase in total interest income for the quarter. Currently, we expect the yield on the loan portfolio to be up around 20 to 25 basis points for the fourth quarter. Furthermore, with short-term interest rates stabilizing and the repricing gap in CDs expected to narrow, we anticipate only a modest increase in interest-bearing deposit costs.

With these expectations, combined with our forecast for a smaller balance sheet by year-end, and with the acknowledgement that some macroeconomic factors remain outside of our control, we continue to believe that the third quarter will represent the inflection point for net interest income and net interest margin, consistent with our comments from last quarter's call. Turning to non-interest income on Slide 10. Non-interest income for the quarter was $7.4 million, up $1.5 million from the second quarter. Gain on sale of loans totaled $5.6 million for the quarter, up 14% over the second quarter, and consisted entirely of gain on sales of U.S. Small Business Administration 7(a) guaranteed loans. Our SBA team continued its track record of growth as sold loan volume increased 22% quarter-over-quarter, which was partially offset as net premiums were down 38 basis points.

Furthermore, the growth in our SBA business has resulted in a servicing portfolio approaching $500 million, which produced $800,000 of net servicing revenue during the quarter. Additionally, other income was up $500,000 from the linked quarter due primarily to distributions from fund investments. Looking at the bar chart of quarterly non-interest income, you can see that with the growth in our SBA business over the last several quarters, we have effectively backfilled and even exceeded any potential gap in revenue from exiting the mortgage business. Moving to Slide 11, non-interest expense for the quarter was $19.8 million, up $1.1 million from the second quarter. The majority of the increase was in salaries and employee benefits, due primarily to higher benefit plan costs, as well as higher incentive compensation related to SBA and construction lending.

Loan expenses were up due mostly to higher third-party loan servicing fees and other miscellaneous lending costs. Data processing costs increased primarily because of variable deposit account opening costs, driven by the significant deposit growth earlier in the quarter. These increases were partially offset by declines in several other expense categories. Turning to asset quality on Slide 2, David covered the major components of asset quality for the quarter in his comments. I will just add some color around the provision and the allowance for credit losses. The provision for credit losses in the third quarter was $1.9 million, compared to $1.7 million in the second quarter. The provision for the third quarter reflects net charge-off activity during the quarter, additional specific reserves, and an increase in the reserve for unfunded commitments, partially offset by the positive impact of economic forecasts on loss rates and qualitative factors related to the allowance for credit losses for certain portfolios.

The allowance for credit losses as a percentage of total loans was 98 basis points as of September 30, compared to 99 basis points as of June 30. The decrease in the allowance for credit losses reflects the impact of certain economic data on forecasted loss rates and adjustments to qualitative factors on certain portfolios mentioned earlier, partially offset by higher coverage ratios in the C&I and SBA portfolios and additional specific reserves. If you exclude the balances and reserves on our public finance and residential mortgage portfolios, which have modest coverage ratios given their lower inherent risk, the allowance for credit losses represented 1.17% of loan balances. Additionally, with minimal office exposure, we do not have the excess reserves around that asset class that many other banks have.

With respect to capital, as shown on Slide 13, our overall capital levels at both the company and the bank remained solid. The tangible common equity ratio declined 43 basis points to 6.64%. This was due to a combination of factors. First, like many other banks have experienced this quarter, our accumulated other comprehensive loss grew as interest rates increased at quarter end. Second, we continued to repurchase shares throughout the quarter. And third, as David mentioned earlier, the tangible common equity ratio was impacted by deposit growth during the quarter and maintaining elevated cash balances. If you exclude accumulated other comprehensive loss and adjust for normalized cash balances of $300 million, the adjusted tangible common equity ratio would be 7.77%.

However, we do expect the balance sheet to shrink in the fourth quarter due to a decline in deposits and cash, which will have a beneficial impact on the tangible common equity ratio. From a regulatory capital perspective, the common equity Tier 1 capital ratio remains solid at 9.59%. During the quarter, we repurchased over 97,000 shares of our common stock at an average price of $18.29 per share as part of our authorized stock repurchase program. In total, we have repurchased almost $41 million of stock under our authorized programs since November of 2021. At quarter end, tangible book value per share was $39.57, which is up over 3% on a year-over-year basis. Before I wrap up my comments, I’d like to provide some additional comments on components of forward earnings.

With regard to non-interest income, as our SBA team continues to grow and deliver consistently higher origination activity, we expect non-interest income to be in the range of $6.5 million to $7 million in the fourth quarter. However, two factors may affect our forecast. First, if the government shuts down in mid-November for an extended period of time, sales of SBA loans and the origination of new SBA loans will be halted. And second, if we see a continued softening and gain on sale premiums, it may make economic sense to hold a loan yielding 11% or more versus selling for a premium far below the annual spread income we would earn. In connection with the continued increase in the level of SBA originations and additional back office personnel to support the increase, we do expect compensation expense to increase as well.

Therefore, we now expect total non-interest expense to be in the range of $20 million to $21 million for the fourth quarter. Looking toward the future, it is undeniable that there are macroeconomic and geopolitical forces beyond our control. Yet, we maintain confidence in our stalwart foundation remains firmly intact. Overall, asset quality is sound. Our capital position is strong. Our teams are focused. We believe we are well-positioned to improve our earnings and profitability profile as funding costs stabilize. With that, I’ll turn it back to the operator so we can take your questions.

Operator: Thank you. Ladies and gentlemen, we will now begin the question-and-answer session. [Operator Instructions] Your first question comes from Nathan Race from Piper Sandler. Please go ahead.

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