Q2 2023 Financial Institutions Inc Earnings Call

Thomson Reuters StreetEvents

Fri, Jul 28, 2023, 10:36 PM29 min read

In this article:

Participants

Kate Croft; Director of Investor & External Relations; Financial Institutions, Inc.

Martin K. Birmingham; President, CEO & Director; Financial Institutions, Inc.

Sean M. Willett; Executive VP & Chief Administrative Officer; Financial Institutions, Inc.

William Jack Plants; Executive VP, CFO & Treasurer; Financial Institutions, Inc.

Alexander Roberts Huxley Twerdahl; MD & Senior Research Analyst; Piper Sandler & Co., Research Division

Damon Paul DelMonte; MD; Keefe, Bruyette, & Woods, Inc., Research Division

Matthew M. Breese; MD & Analyst; Stephens Inc., Research Division

Nicholas Anthony Cucharale; Director; Hovde Group, LLC, Research Division

Presentation

Operator

Good morning, everyone, and welcome to todays Conference Call, Financial Institutions, Inc. announces second quarter results. My name is Helen, and I'll be coordinating the call for today. (Operator Instructions) I would now like to turn the call over to Kate Croft, Director of Investor Relations, to begin. Kate, please go ahead.

Kate Croft

Thank you for joining us for today's call. Providing prepared comments will be President and CEO, Marty Birmingham; and CFO, Jack Plants. They will be joined by additional members of the company's finance and leadership teams during the question-and-answer session.
Today's prepared comments and Q&A will include forward-looking statements. Actual results may differ materially from forward-looking statements due to a variety of risks, uncertainties and other factors. We refer you to yesterday's earnings release and investor presentation as well as historical SEC filings which are available on our Investor Relations website for safe harbor description and a detailed discussion of the risk factors related to forward-looking statements.
We'll also discuss certain non-GAAP financial measures intended to supplement and not substitute for comparable GAAP measures. Reconciliations of these measures to GAAP financial measures were included in the earnings release filed as an exhibit to a Form 8-K. Please note that this call includes information that may only be accurate as of today's date, July 28, 2023. I'll now turn the call over to President and CEO, Marty Birmingham.

Martin K. Birmingham

Thank you, Kate. Good morning, everyone, and thank you for joining us today. Our company finished the first half of 2023 in a very solid position. Our second quarter performance was highlighted by incremental loan growth that supported modest net interest income expansion and a continuation of strong and stable credit quality metrics. We also took steps to enhance our wealth management business. Merging our 2 registered investment advisory subsidiaries.
Through this merger, current Capital has additional size and scale to better compete across our footprint for institutional clients, retirement plan sponsors and high net worth individuals and families. Operating under 1 brand also streamlines our business development efforts, primarily deepening relationships with existing wealth, insurance and banking clients.
Second quarter net income available to common shareholders was $14 million or $0.91 per diluted share, up from $11.7 million or $0.76 per share in the first quarter of 2023 and down from $15.3 million or $0.99 per share in the prior year period. And considering the year-over-year decrease in quarterly net income, the company recognized a normalization of loan loss provisioning in the current quarter versus the impact of a large commercial recovery in the second quarter of 2022, in addition to higher quarterly noninterest expenses due to past investments and talent and an increased FDIC insurance assessment.
These increased expenses were partially offset by lower taxes in the current quarter which benefited from investment tax spreads placed in service. I would note that much of our investment in human capital took place in 2022. We believe that this coupled with a previously announced organizational restructuring completed in December has positioned us well for the future, both from an expense standpoint in the near term and in terms of outperformance in our markets in the long term.
We have attracted high-quality talent to our organization, including experienced individuals joining from larger players who want to be a part of a growth story with a true community bank. On a linked quarter basis, our net income growth was driven by a lower level of provisions, higher noninterest income and lower income tax expense in the current quarter. Jack will provide more color on our income statement and performance relative to the first quarter of 2023 in his remarks.
Deposit gathering remains a top focus. And as of June 30, 2023, total deposits were $5 billion, down $106.4 million or 2.1% from March 31, primarily due to normal seasonal public deposit outflows. Within our sizable public deposit portfolio, which includes local municipalities and school districts, we see a seasonal decrease in the second quarter based on cash flow requirements for the customers.
Similarly, first quarter public deposits are typically higher as a result of inflows from tax payments and state funding during the period. While seasonality is the primary driver of the decline in public deposits, we are seeing a normalization of deposit levels in this space post the stimulus injection recognized during the pandemic.
Nonpublic deposits increased from the linked quarter. We continue to see a disintermediation of lower cost demand and savings deposits into higher cost time deposit accounts. And similar trends for new account acquisition amid the current interest rate environment. Competition for deposits is strong in our markets, similar to the rest of the country, and we're focused on defending our deposit base and expanding our reach.
We launched a new marketing campaign for money marketed accounts just this week and are beginning to see some of our anticipated Banking as a Service or BaaS deposits come on board. We consider BaaS deposits to be an alternative to high-cost wholesale funding. Reciprocal deposits also grew during the quarter as this has become an attractive option affording our larger customers the benefit of FDIC insurance on accounts greater than $250,000.
Total loans were work reflecting an increase of $154.5 million or 3.6% from March 31, led by commercial lending. Overall, our commercial portfolio was up 5.7% during the second quarter.
We continue to believe that full year loan growth will be concentrated in the first half of the year. As we aim to reserve balance sheet capacity for our best customers with full relationships.
Commercial mortgage growth, in particular, is expected to slow due to a combination of softer demand amid a challenging economic environment and higher pricing. Our pipelines are more modest than in prior periods with our overall commercial pipeline at June 30, 2023, less than half of what it was at year-end 2022 and 1/3 of the size it was 1 year ago. The change is even more notable in the Mid-Atlantic, where our pipeline is about 20% of what it was on June 30, 2022.
I'd like to discuss our Mid-Atlantic region in a bit more detail given the continued national media coverage of challenges facing major metros in office space, in particular. For context, this team sits in a suburb of Baltimore, and primarily serves customers headquartered in and around the Baltimore and Greater Washington, D.C. area. The majority of loans are for projects and properties throughout Maryland and Virginia and outside of the central business district of DC.
As a result, our committed credit exposure within D.C. itself is very limited at just $25 million and none of our commitments in the Metro D.C. area are for large floor plate buildings. Office space accounts for just over 1/3 of our Mid-Atlantic loans and properties within this asset class and region are primarily located in heavy traffic areas near hospitals with a fair amount of medical leasing and high occupancy levels. As many industries and metros grapple with the return to office trends in the workplace I would note that our commitments relate to much smaller buildings located outside of D.C., where nonfederal workers are returning to the office.
The health of our commercial portfolio remains strong, and we reported just 2 basis points of net charge-offs to average commercial loans during the second quarter. Our residential loan portfolio grew during both the 3 and 12 months ended June 30, 2023, despite the higher interest rate environment and tight housing inventory impacting home sales in our market, primarily due to our partnerships with new homebuilders.
Additionally, internal process enhancements have led to improved cycle times for both mortgages and home equity loans. Consistent with our other loan categories, we've made pricing adjustments to improve margins in this line of business. As expected, consumer and direct loan balances at quarter end were down modestly from both March 31, 2023, and June 30, 2023. This is due in part to our efforts to moderate production in this asset class while maintaining our focus on credit quality as well as lower number of applications given increased cash deals, leasing activity and aggressive rate offers for manufacturers.
The average portfolio FICO score of our indirect portfolio continues to exceed 700 and new production during the quarter came on a weighted average coupon of 9.31%. Our credit team is very experienced in this line of business is actively managing the portfolio to secure recoveries where possible. Accordingly, indirect charge-offs were only 12 basis points for the second quarter. Down from both the linked and year ago quarters.
Our disciplined approach to credit risk management continues to support strong asset quality metrics overall. For the second quarter, we reported 23 basis points of nonperforming loans to total loans and annualized net charge-offs to average loans of just 6 basis points. Provision for credit losses on loans was $3.2 million in the second quarter, supporting the allowance for operating requirement. This concludes my introductory comments, and it's now my pleasure to turn the call over to Jack plants for additional 23.

William Jack Plants

Thank you, Marty. Good morning, everyone. Net interest income of $42.3 million was up $522,000 from the first quarter of 2023 as interest income from loans was partially offset by higher cost of funds in the current rate environment. Our overall cost of funds in the quarter was 203 basis points, up 41 basis points from the late first quarter.
Different remediation within our nonpublic deposit portfolio into higher cost time deposits Along with additional broker deposits brought on in the second quarter to manage the seasonality of our public deposit portfolio and to help fund loan growth contributed to margin compression in the second quarter. Net interest margin on a fully taxable equivalent basis was 299 basis points for the quarter, compared to 309 basis points in the linked quarter.
As Marty mentioned, and in line with the guidance we provided in April, we expect that loan growth will be concentrated in the first half of the year. Our commercial pipeline, which includes commitments secured but not yet funded, is down considerably from where it stood at the end of the linked and year ago quarters. Relative to the magnitude of FOMC rate increases that occurred in 2022 and so far in 2023, our total deposit portfolio has experienced a cycle-to-date beta of 31.2%, including the cost of time deposits. Excluding the cost of time deposits, the nonmaturity deposit portfolio had a beta of 12%.
Noninterest income totaled $11.5 million in the second quarter, up $542,000 on a linked quarter basis. This growth was driven by a number of components, illustrating the diversity of our noninterest revenue streams. In the second quarter, we recorded a net gain of $489,000 on tax credit investments placed in service in the current and prior periods. Driven by historic tax credit with a New York state component that was placed in service in the second quarter.
While these gains are nonrecurring in nature, we continue to evaluate opportunities to manage our tax rate while supporting meaningful projects in our communities that support historic preservation in low-income housing. Investments from limited partnerships increased $218,000 quarter-over-quarter which was driven by favorable performance of underlying investments. These, along with increased swap income, offset a lower level of insurance income in the second quarter, that was largely seasonal. Reflective of contingent revenue that is typically recognized in the first quarter of the year.
Investment advisory income of $2.8 million, our largest fee income contributor was 104,000 lower than the previous quarter, primarily due to lower transaction-based fees in the most recent period.
Noninterest expense was flat on a linked quarter basis. As lower salaries and benefits, occupancy and equipment and professional services, all of which are typically higher for us in the first quarter of the year were offset by higher other expenses including interest charges related to collateral held for derivative transactions.
I would also note that the FDIC insurance expense increased due in part to the final rule that went into effect earlier this year, increasing the initial base deposit insurance assessment rate schedules uniformly by 2 basis points, coupled with balance sheet growth driven by commercial mortgage loans. Income tax expense was $2.4 million in the quarter, representing an effective tax rate of 14.4% compared to $2.8 million and an effective tax rate of 18.7%, in the first quarter of 2023.
We recognized federal and state tax benefits related to tax credit investments placed in service and/or amortized during the second quarter of 2023, of $761,000 compared to $584,000 in the linked quarter.
Our accumulated other comprehensive loss stood at $134.5 million at June 30, 2023. We reported a TCE ratio at June 30 of 5.53% in tangible common book value per share of $21.79, excluding the AOCI impact, the TCE ratio and tangible common book value per share would have been 7.53% and $29.66 respectively.
We continue to expect these metrics to return to more normalized levels over time given the high quality and cash flow nature of our investment portfolio. I would now like to provide an update on our outlook for 2023 in key areas. Given our year-to-date loan growth, an expectation that growth will be concentrated in the first half of the year, we are adjusting our full year 2023 loan growth outlook to low double-digit growth from the previous high single-digit expectation.
Our commercial pipeline, which includes commitments secured but not yet funded, is down considerably from where it stood at the end of the linked and year ago quarters. We now expect a full year NIM of 300 to 305 basis points. Where the range is narrowed in the bottom is 5 basis points lower than previous guidance, given the continued funding cost pressure that we've experienced.
Our forecast assumes a forward rate curve that reflects the latest 25 basis point increase that occurred this week, along with economists predictions for Fed activity to be muted for the remainder of the year. Given the continued strength of credit quality metrics, we expect full year net charge-offs of between 25 and 30 basis points, 10 basis points lower than previous guidance. We now expect the 2023 effective tax rate to fall within a range of 17% to 18%, down approximately 1% from previous guidance reflecting the impact of the amortization of tax credit investments placed in service in the current quarter and recent years, coupled with the impact of revised margin guidance on pretax income in the second half of 2023.
Recognizing that margin has been pressured through higher funding costs as observed through year-to-date trends, we expect our annualized ROA to fall in a range of 85 to 95 basis points for 2023. Our expectations for flat noninterest income, excluding nonrecurring and semi-recurring items, mid-single-digit full year expense growth and mid-single-digit growth in nonpublic deposits remain unchanged. That concludes my prepared remarks and updated guidance. I'll now turn the call back to Marty.

Martin K. Birmingham

Thanks, Jack. Overall, Financial Institutions Incorporated and Five Star Bank are well positioned heading into the second half of 2023. We continue to maintain a healthy capital position, exceeding well-capitalized minimum standards for the bank. We are very focused as we have been on deposit gathering. Our balance sheet is strengthened by the granularity of our community banking franchise. We operate through 49 banking locations across our upstate New York footprint, which have average deposit balances per branch of approximately $78 million, excluding reciprocal and brokered deposits.
We have top 3 market share and more than 70% of the counties where we have a branch presence. And our first or second in 8 of those 14 counties. Independent of the balance sheet, our available committed liquidity remains strong and stable at approximately $1.1 billion. Our focus in the near term remains the same, protecting our margin, limiting noninterest expense and expanding our customer base across all areas of our diversified financial services company.
That concludes our prepared remarks. Operator, please open the call for questions.

Question and Answer Session

Operator

Thank you. We go now into our Q&A session. (Operator Instructions) Our first question comes from Damon DelMonte from KBW. Please go ahead.

Damon Paul DelMonte

So my first question, just regarding the outlook for loan growth here in the back half. I mean, clearly, a very strong first half. And I was just wondering like what do you think is driving the smaller pipeline? Is that being more reflected by just slowing demand from borrowers, which imply that maybe economic conditions are kind of slowing? Or is it more of you guys just kind of sharpening the pencil a little bit more and being a little bit more selective with the types of credits that you're adding?

Martin K. Birmingham

I think it's a combination of both. The -- our borrowers, the economy has been dealing with a recession that is not showing up, but there's certainly a lot of uncertainty and volatility, and that is impacting confidence levels in terms of moving forward with projects both in real estate as well as in our C&I portfolio.
But at the same time, we continue to push our spreads up as a result of the markets resetting, increases in rate and the capital and debt markets resetting, which is slowing down demand as well as selectivity on our side of it, Damon, we're trying at this point now to reserve space on our balance sheet for those that have the deepest and broadest relationships with us.

Damon Paul DelMonte

Got it. Okay. That's good color. And then maybe one for Jack on the margin outlook. Could you just remind us a little bit about the asset side of the balance sheet and how you're positioned in the next couple of quarters as far as repricing goes? And when you look at, I guess, loans and securities cash flows?

William Jack Plants

Yes, Damon, this is Jack. So as you -- we've instructed in the past, we're north of 30%, about 34% of the balance sheet is positioned as variable rate structure. So we see the benefit there with increases in Fed funds rates and -- as far as cash flow is concerned, we continue to guide on a 12-month basis of approximately $1 billion in cash flow coming off primarily the loan portfolio and then about $130 million coming off of the securities portfolio. And that's just a function of the continued growth we've seen this year and the cash flow in nature of our total loan portfolio, which has a duration of about 4.4 years.

Damon Paul DelMonte

Got it. Okay. So your guidance for the margin is pretty favorable compared to some others that we've heard -- I mean, on the deposit pricing side, do you feel like it's starting to rationalize a little bit and the mix shift is slowing?

William Jack Plants

We've continued to see consumer demand for time deposits. As Marty mentioned, we just rolled out this week a soft launch of a money market campaign that's going to have some more formal advertising behind it beginning next week. So our expectation is we'll see a lift there on the consumer side for nonmaturity deposits.
And then we continue to remain focused on that Baas deposit pipeline. Which we've previously guided to on a full year basis of about $150 million. And we've seen a lot of momentum post quarter end, really in July, and they're about 1/3 of a way there as we speak today.

Operator

We will now take our next question from Alex Twerdahl from Piper Sandler.

Alexander Roberts Huxley Twerdahl

I wanted to go back to your comment, Marty, on reserving balance sheet capacity for the best customers and just sort of figure out exactly what you mean by that. Is it is sort of the constraining factor on loan growth, a function of liquidity, is a function of capital? Is it a function of concentrations in specific segments and just get a little bit more color on how you think about the sort of a capacity issue so that we can sort of incorporate that into some of the longer-term balance sheet complexion and growth projections that we have.

Martin K. Birmingham

So the first half of the year loan growth has been driven by our pipeline cycling in our commercial real estate book. And inherently, those loans do not come with a lot of deposits. And as a result of that, that's where we're also seeing the temper growth on our borrower side and as well actions we're taking. Driving our spreads up and encouraging our lenders to pursue and drive full relationships.

Alexander Roberts Huxley Twerdahl

Okay. So it's really about trying to target more customers that have deposit relationships than specific constraints on the balance sheet today.

William Jack Plants

Yes, Alex, this is Jack. That's exactly right. So the focus is to step away from transaction-only type opportunities and those that come with deposits that partially fund the outstanding balance, take a little bit of pressure off of wholesale funding and then look for opportunities to build full relationships with our wealth management and insurance businesses.

Alexander Roberts Huxley Twerdahl

Okay. And then that's a reason to my next question, which is the merger of the 2 investment managers, and you kind of alluded to a little bit in your prepared remarks, Marty, but I'm just curious if there's a way to sort of define the opportunity that may be in front of the larger company now just given more capacity, I think that you mentioned and just how to think about some of the other potential efficiencies both on the revenue and expense side that could be associated with the completion of that merger?

William Jack Plants

Yes, Alex, this is Jack. I'll take that. So day 1 of that merger was effectively on May 1. So we're early stages of that merger, but really the opportunity there, was to rightsize the business of a function by creating more of a focus on high net worth managed accounts and lesser focus on the retail broker-dealer type relationships that are traditionally offered in the branch network.
And from a revenue standpoint, you can see that, that impacted transaction fee income by about $104,000 a during the quarter. However, we did observe a greater reduction in expenses, which resulted in a higher EBITDA margin for that business, which is now trending above 25%. So we do have some operational opportunities down the road, but we're in early stages.

Alexander Roberts Huxley Twerdahl

Great. And one question on the Auto. I think you mentioned that new -- the new weighted coupon is around 930, which sounds pretty enticing in terms of actually growing that as sort of a mix of the balance sheet just to kind of improve margins. But has the structure of those loans changed to allow for the larger coupon, like is the amortization period extended out just to kind keep the sort of the normal payments lower? Or just kind of help me understand how customers are reacting to that rate and whether or not it could actually wind up being a better asset class and 1 that you maybe want to have a little bit more of on the balance sheet?

Martin K. Birmingham

Consistent kind of with our comments relative to commercial, we've been focused on spread in that business as well. And maintaining our approach to credit and the focus on 700 and above credit scores in our Tier 1 bucket. That's, again, taking advantage of the market's resetting and driving wider spreads there. And we agree. It's an asset class that we've been comfortable with that has served us well is performing very well right now, which gives us some options relative to trying to defend the NIM.

Alexander Roberts Huxley Twerdahl

Great. As I think if I'm remembering correctly, it's normally around a 30-month product that just in terms of the sort of the life of the typical loan. Is that extended out as a result of rates moving higher? -- churn is slow.

William Jack Plants

Yes, Alex, this is Jack. So over the course of the past, I would say, 2 to 3 years, customers have had more of a desire to move into the 5 or 6-year term. which has had a little bit of an impact on duration extension in the portfolio. So we've moved from about a 3-year duration to about a 3.3 year duration.

Operator

Our next question comes from Nick Cucharale from the Hovde Group.