Jul 24, 2012
Operator
Good day and welcome to the First Interstate Bancsystem, Inc. second quarter 2012 earnings conference call and webcast.
All participants will be in listen-only mode. (Operator Instructions).
After today's presentation, there will be an opportunity to ask questions. (Operator Instructions).
Please note this event is being recorded. I would now like to turn the conference over to Ms.
Marcy Mutch, Investor Relations Officer. Ms.
Mutch, the floor is yours ma’am.
Marcy Mutch
Thanks, Mike. Good morning.
Thank you for joining us for our earnings conference call for the second quarter of 2012. Before we begin, I would like to direct all listeners to the cautionary note regarding forward-looking statements and factors that could affect future results in our most recently filed Forms 10-Q and 10-K.
Joining us from management this morning are Ed Garding, our Chief Executive Officer; and Terry Moore, our Chief Financial Officer. Ed will begin by giving you a general overview of the company’s results and review credit quality information.
Terry will follow up with specific information behind the quarterly results. Bob Cerkovnik, our Chief Credit Officer will also be available during the question-and-answer time to address specific questions concerning asset quality.
At this time, I would like to turn the call over to Ed Garding. Ed?
Edward Garding
Thanks, Marcy. Good morning and thanks again to all of you for joining us on the call today.
Last night, we were pleased to report earnings for the second quarter of $12.1 million, which equates to earnings per share of $0.28. This represents an increase of 7% from last quarter and an increase of 33% from the same quarter a year ago.
Edward Garding
Let's start by discussing the loan portfolio, which overall was fairly stable. This is notable to us given the higher level of charge-offs that we had during the quarter.
We saw a modest loan growth in a number of the loan types, but that was offset by the expected run-off in the construction portfolio, specifically, land acquisition and development portion of the construction portfolio.
Edward Garding
Terry told you at the end of last year that our total construction portfolio could shrink to around $300 million. And that’s looking like it will be pretty accurate.
28% of that construction portfolio is still considered criticized and so although we continue to make new construction loans, we will likely see further declines in that category as we clean up the remaining criticized loans.
Edward Garding
Residential mortgage lending continues to be a source of strength for us with volume being over twice for what it was last year. We’ve indicated in the past that we’re retaining some of our residential mortgages.
These are typically the 10 to 15 year mortgages that do meet secondary market standards. Because of soft loan demand in other areas, we anticipate continuing to retain many of these mortgages.
As we looked across our footprint for the quarter, we saw modest levels of loan growth in the majority of our markets. However, these were offset by significant declines within the Jackson and Flathead markets, not only from charge offs and transfers to other real estate, but also from pay downs on loans.
Edward Garding
Overall, we think loan growth will be flat for the calendar year. There is some pickup in economic activity in the region especially in the areas where they’re drilling for oil, but there are just too many banks chasing too few loans to predict any significant loan growth.
We have made meaningful strides this quarter in coming to resolution on some of our problem credits. Our current credit trends reflect later stages of a typical credit cycle where there is a slowdown and the emergence of new problem credits and charge offs exceed provision expense as a result of the problem assets that we have already reserved for.
While we still consider our ratio of non-performing loans to total loans of 4.13% to be elevated, it does reflect a decline of over 200 basis points year-over-year and a decline of 123 basis points from last quarter which is a significant improvement.
Edward Garding
The overall decrease in non-performing loans of $51 million was mainly due to $27 million in charge offs and $20 million of inflow into other real estate. So 90% of that increase in non-performing loans was due to charge offs and transfers to other real estate 10% is from payments.
That doesn’t tell the whole story though, it is the actual decline in non-performing loans on a gross basis was $66 million and we added some $15 million. So the good news is that we were able to off load about 66 million, so there was actually more payments and upgrades than the net results which show.
Edward Garding
This quarter, the pace of inflows into non-performing loans continued to decline with substantially lower than the inflows we saw at the peak of this credit cycle. As we said last quarter, we didn’t expect charge offs to remain at that low level and obviously with $25 million in net charge offs this quarter, they didn’t.
While this is a much higher level of charge offs than we typically see during any one quarter, this wasn’t a shock to us. There was nothing particularly unusual driving the higher level of charge offs this quarter.
It was simply a matter of a large number of credits that had been non performing for quite a while, all reaching the point where it became appropriate to take them into other real estate or take partial charge offs at the same time.
Edward Garding
It doesn’t signal any change in our approach to managing our problem credits. It is just a matter of cleaning up what was there.
A breakdown of that total net charge offs of $25 million by percentage is 56% of what was construction loans, 24% commercial real estate, 10% commercial loans and the other 10% was consumer and consumer real estate loans.
Edward Garding
We are on the downward side of the credit cycle and we expect to see some lumpiness in our charge offs as we see the last quarter at the end of 2012, we would anticipate total charge offs for the year to approximate 2011 levels. I mentioned a minute ago that we saw total inflows of $20 million into other real estate.
This consisted of 27 properties, five of which made up the bulk of the additions, in total 15 million or 75% of the inflow. Three of those five properties came out of the construction real estate portfolio and two were commercial real estate properties.
Edward Garding
Summer months are typically our strong selling seasons and we are pleased with the $10 million and other real estate dispositions during this quarter. These properties were disposed off at a small net gain, yes I said gain, which provided us with some confidence that we continue to take marks when appropriate and that our other real estate is valued at close to the amount we will see on its ultimate disposition.
Terry is going to provide you with a little more color around the marks we've taken on our other real estate in just a couple of minutes.
Edward Garding
On the front end of the problem loan pipeline total criticized loans continue to trend downward in all categories and declined $66 million from last quarter. At $546 million criticized loans are almost back to the level we saw in the second quarter of ’09.
We do expect the overall downward trend in total criticized loans will continue.
Edward Garding
Our economies continue to stabilize with a few bright spots; Eastern Montana which would include Billings, our largest market continues to be positively impacted by the Williston Basin oil field.
Edward Garding
In the last year, the average price of house in Billings is increased by 3%. Additionally, the vacancy rate for residential rental property in Billings is at 2% which as you know is extremely low.
We are seeing generally positive trends in the economic data across our footprint, although it certainly doesn't point to the level of economic recovery that we would like to see.
Edward Garding
Through the first quarter, we experienced a positive housing index in Montana, Wyoming and South Dakota. While we think the rest of the nation is still flat or going down, we are happy to see housing values increasing in our three states.
Edward Garding
Similarly, we have had a percentage increases in building permits across our three states which exceed the national average. Overall, individual bankruptcy filings continued to trend down at a faster pace than the national average.
And as of May, unemployment rates in our three states were still well below the national average.
Edward Garding
At the end of the second quarter, national park visits within our region were up over last year as were hotel occupancy rates. So, it looks like we are going to have a good tourism season.
Our customers doing business in this industry are telling us that activity related to tourism is well above last year’s levels, and that hotel, motel bookings for the rest of the season look good.
Edward Garding
While commodity prices remain high right now, we are facing drought conditions, reprising the news of that pretty much across the country. So we are anticipating a decrease in crop yields and a lack of feed for livestock or many of our ranchers are being forced to sell cattle, before they would otherwise like to which has led to some pricing pressure in the cattle industry.
Edward Garding
With that said, most of our agricultural customers are in much better financial condition than they have been in past years because of the recent high commodity prices. So with that overview, I am going to turn it over to Terry for some more detail.
Terrill Moore
Thanks, Ed, and thanks for joining us this morning. Our net interest margin which was 3.74% for the second quarter was up two basis points from last quarter.
As we stated in the press release, the main factor behind the increase related to the recovery of interest on loans upgraded to accrual status. This factor also contributed to the increase in average yield on loans quarter-over-quarter.
Having meaningful recovery of interest is opposed to a net charge-off is another indicator of improving credit quality and we’re at in this credit cycle.
Terrill Moore
The continued shift in the deposit mix that we’ve seen over the last couple of years helped drive the decline in cost of funds to 49 basis points, down three basis points from last quarter. The yield on the investment portfolio remained flat quarter-over-quarter as well.
However, we’re still seeing new purchases priced at lower yields than what is maturing or playing down. So it remains a challenge to maintain yield on the portfolio.
Terrill Moore
On an average basis, our interest-bearing deposits which are mainly funds held at the Federal Reserve Bank were higher than in the first quarter but by the end of the quarter, we reduced these funds to $387 million.
Terrill Moore
When we consider where our net interest margin will be going on a go-forward basis, we anticipate the average loan and investment yields will continue to be pressured and with limited room to improve cost of funds, it would be natural to expect a decline of a few basis points in each of the next few quarters.
Terrill Moore
However, there are a couple of positive factors that will help offset some of this margin compression. As we indicated back in April, we redeemed $40 million of TruPS at the end of June.
Going forward beginning this third quarter this redemption results in a two basis point impact on net interest margin.
Terrill Moore
Additionally, we have $45 million of remaining TruPS which are currently at an average fixed rate of 7.06% which will reprise on a variable rate basis at the end of this year. Based on current LIBOR rates, the additional lift in net interest margin next year from these TruPS reprising is an additional three basis points which will help mitigate net interest margin compression in 2013, as well as improved earnings per share.
Terrill Moore
Provision expense remained relatively flat up $750,000 from last quarter. You shouldn’t take this minimal uptick as an indication of a weakening credit portfolio, on the contrary as that explained we continue to see positive credit metric trends and don’t anticipate any change of a downward trend in the coming quarters.
Overall, we still anticipate 2012 provision to be less than last year’s.
Terrill Moore
In the second quarter, non-interest income which was $28 million was an increase of almost 5% on a linked quarter basis. Origination of residential real estate loans continues to be the main driver behind the increase.
We talked some last year about the exodus of mortgage originators from our markets and that we were hoping to gain market share as a result.
Terrill Moore
We have added additional real estate lenders across our footprint, and we are experiencing a significant increase in the volume of originations as a result. Total volume this quarter was up 52% from the same quarter last year and up a 111% over the first two quarters of last year.
Terrill Moore
Now why we don’t feel that the phase of refinance activity is sustainable on the long-term perhaps not even much past the third quarter. Our efforts are focused on gaining market share and replacing a portion of the refi activity, we are currently enjoying with purchased activity.
Terrill Moore
We have been in the residential origination business for a long-time, and consider this to be one of the core products we offer our customers. Because of the positive housing trends in our markets that I had shared with you earlier along with less competition in our marketplace and low interest rates, we think this will continue to be a good revenue source for us for years to come.
Terrill Moore
Non-interest expense remains flat at $57 million on a linked quarter basis. There is really only one item I would add additional comment on, as we discussed briefly in the press release, we sold a building to a charitable organization this past quarter.
This transaction resulted in a gain on sale of about $500,000 which is included in other income and a large non-cash contribution expense of $1.5 million which is included in the other expense line item.
Terrill Moore
Other real estate expense was up quarter-over-quarter, but down from last year with expenses higher this quarter due to the volume of property coming into other real estate. Other real estate expense will remain high and like our provision expense maybe a bit lumpy.
We expected other real estate expenses to be higher - excuse me, we expect OREO expenses to be higher during the second half of this year than what was recorded in the first six months. All-in, total other real estate expense for the year is likely to approximate or possibly exceed the 2011 levels.
Terrill Moore
The largest other real estate properties we currently hold that we looked at the top five are recorded at $24 million and make up 44% of our total other real estate. Charge-offs and write-downs related to these five properties have been $25 million which is a 52% haircut.
Terrill Moore
On the other end of the spectrum $9.2 million or 17% of our other real estate is related to 66 different properties each valued at $500,000 or less. At an average carrying value of $139,000 there is limited exposure to further significant adjustments on those properties.
Terrill Moore
Overall, throughout this credit cycle we haven't had to take any material losses on other real estate upon sale. So we are relatively comfortable that our marks have been timely.
We continue to aggressively market our other real estate properties and early indications are that the sales of OREO will continue to hold up in this third quarter.
Terrill Moore
Capital levels remain strong with Tier 1 capital increasing to 11.51% nearly 1% higher than just a year ago. Also net tangible common equity increased 20 basis points over this past quarter to 8.52%.
Terrill Moore
Along with the rest of the banking industry, we’re in the process of evaluating the impact of the proposed Basel III that would have on our organization. As we understand the current proposal, we expect the short-term implications to be minimal and we will comfortably exceed proposed regulatory guidelines.
Terrill Moore
With that, I’ll turn it back to Ed to wrap up.
Edward Garding
Thanks, Terry. As a general comment on our outlook, we continue to be committed to seeking new ways to improve revenue growth and become more efficient on the expense side.
That probably sounds like every other bank in the country too.
Edward Garding
Credit costs should continue to decline going forward, resulting in improved earnings for us. The lack of organic growth opportunities in the marketplace, M&A activity is always a question, we do continue to have conversations and as you expect, we would be interested in opportunities that would add value to our franchise.
Edward Garding
That being said, we continue, I think the real opportunities for us along M&A lines are probably in 2013.
Edward Garding
So with that, lets open up for questions.
Operator
(Operator Instructions) Our first question comes from Jeff Rulis of D.A. Davidson.
Jeff Rulis
Terry, I had a question about just a follow up on the non-interest expenses; some moving pieces in there and I wanted to kind of make sure I understand what's happening. You know in Q1, you had a $3 million in collection and settlement costs.
I am looking at that other non-interest expense line item, around, it was $13 million and change and if you back out the cost of the trust preferred move; that was roughly flat quarter-to-quarter. I was just a little surprised that the number didn’t come down granted it sounds like you had $1.5 million donation, but what made up the other, was it OREO cost that had increased, linked quarter, why that $3 million wasn’t absent, I guess, quarter-to-quarter is really the question?
Terrill Moore
Yes, a great question, Jeff. Good morning.
I think you’ve got most of the large elements there if you looked at the $3 million is no longer there; that was there in the first quarter. But the other expenses you identified were the donation expense of about $1.5 million and roughly $500,000 of the TruPS cost; so there is $2 million and if you’re tallying the difference.
There were -- second quarter, we have a little bit higher director fee expense from our Shareholder Meeting and some of the one-time retainer costs that are expense. So that was about $250,000; a little bit higher visa debit card expenses just from what we can best tell, just associated activity levels being a bit higher, so those will be the main elements that nearly offset that $3 million from a quarter-to-quarter basis.
Certainly, as we would look on a run rate basis, we would not anticipate it being between $13 million and $14 million, but outside of some unusual surprises like this that it might approach something closer to in the $11 million range.
Jeff Rulis
Okay. And with that backdrop then coupled with your comments on the expecting OREO cost to be higher in the second half; I guess there is some offset to that, but again, that on a net basis expect non-interest expense to be down from this level?
Terrill Moore
Probably a little bit, Jeff. I was talking particularly about other expense line item and so other real estate expenses are not included there.
But I do think that it’s reasonable to expect that there will be some higher level of OREO expense from what we have recorded in the first two quarters. And I think all-in last year we are may be in the $8 million range for total other real estate expenses, and I think a reasonable estimate is that’s where we will end up and I think we are at $3 million or $3.5 million year-to-date so far.
So we are expecting those maybe increase slightly in other real estate probably as you are surmising that would offset in large part some of these other savings that will have another expense.
Jeff Rulis
Got you, I did mean to talk about the two line items probably there. Just a follow up on the trust preferreds; I guess the remaining balance you talked about some, that the rate is adjusting, but any idea on additional redemptions that you would consider with the remaining balance?
Terrill Moore
They are certainly up for consideration; at this point there are no specific plans to have further redemptions of the TruPS and I would find it probably unlikely that it will occur in the short next couple of quarters. So it might be up in the future a little longer when we evaluate that obviously we know they are going away overtime in the counter risk based capital, but they still -- the offset is that they are still up fairly low cost of funding, if we want to retain it and think that there is a good leverage proposition there; so at this point no specific plans to redeem.
Jeff Rulis
And one last one if I could on the tax rate; you’ve kind been running a little bit higher north of 33% last three quarters or so; is that now the new run rate; is it I think last year you were closer to sort of 32 and change but I just wanted to get some clarification?
Terrill Moore
You know I think it is and it’s largely driven because of our increased profitability and the other primary item would be municipal securities haven’t kept pace, or that tax exempt income hasn’t kept pace with our increase in overall pretax profitability side; I would think that the 33% is a better run rate than 32%.
Operator
(Operator Instructions) Our next question comes from Fred Cannon of KBW
Frederick Cannon
Just a question, it sounds you know that was very interesting in terms of seeing a bit of a rebound in the housing market out there, and I was wondering if we might be seeing a bottom in your construction portfolio in terms of the continued run off that we’ve seen there, for we maybe near a bottom given and perhaps some opportunities to either stabilize or grow the portfolio?
Edward Garding
Fred, I'm going to ask Bob Cerkovnik our Chief Credit Officer, address that one.
Robert M. Cerkovnik
Yes, that's a very good question. We are seeing some stabilization across the market and our construction portfolio.
We do think we are on the downward cycle of that portfolio as far as problems go.
Frederick Cannon
And then I was wondering if there was any more color on the building that you did the donation and the gain on, in particular did you maintain any kind of loan on that property or is there no lending relationship still there?
Terrill Moore
Yes, Fred, this was bank building that we had vacated and had built a new building and so it had been empty for a couple of years and so it wasn’t through a customer relationship or another real estate so it was a bit unique and it was a very large building and still a usable building and this looked like a great opportunity in disposition for that property. I would make a comment that we don't have any other buildings that are like this that are being held for sale in any kind of a portfolio so this was kind of a one-time item.
Frederick Cannon
And then just one final question on your loan yield. They seem to be quite stable this quarter, I was wondering if there's any color on that, I mean we would, I think we have to expect them to tail off in the future given where the yield curve currently is and loan pricing, so any kind of color on that, any kind of discussion about loan pricing would be helpful.
Terrill Moore
Absolutely, Fred, this is Terry again. I will take you back to the recovered interest from loans put back on accrual and there were several hundred thousand dollars in the quarter and when you annualize that impact on the loan yield.
The loan yield is without that would it went down several basis points maybe around four or five basis points instead of reflecting a slight increase. And so we would expect without, that we may have some quarters of having charged-off interests recovered or charged-off, but when we net that impact out we would have otherwise and would expect in the future that our loan yield will go down and certainly we are still seeing compressed yields from kind of the new generation, new loans being generated, there are still a lot of competitive pressure in that repricing front and I think it’s reasonable to expect a few basis points decline in that loan yield on a run rate basis for the next several quarters.
Frederick Cannon
And just as a follow-up on that, are you seeing a lot of push out in terms of the duration on some of the loan request out in for a multi year kind of lending?
Terrill Moore
I would say yes, I am not sure a lot is the right terminology but certainly there is a lot more interest in that and so there has been some extension in fixed rate, but nothing that would change the substantial make up of our portfolio so certainly a lot more interest. For the most part, when you offer three or five or seven year rate that's fixed and you just price it right, the customer will tend to opt for a shorter term fixed rate as opposed to pay the higher rate for the long-term fixed rate.
Operator
The next question we have comes from Tim Coffey of FIG.
Timothy Coffey
Terry, you gave some good color about kind of your forward outlook on the gain on the sales from the mortgage origination business and I am wondering do you anticipate seeing a ramp up in gain on sale or originations or you see kind of more of a level you now have at these elevated levels?
Terrill Moore
Well, good morning, Tim. I would see that it will probably level off here this third quarter and not ramp up, but if we ramp back and look at the purchased activity and we were to segregate the activity as purchased versus refi, we are certainly committed to this line of business; this product that is offered to our customers and we would like to have higher penetration and market share in the markets we’re serving in capturing that business.
So overall on the macro side, we would see it having peaking here this year and perhaps in this quarter and next and beginning to tail off as refi business; we're expecting that maybe rates are approaching their low, we were expecting that a year ago as well. But so, to the extent that rates are near their low that we’re about there and that that revenue would decline some in years to come on a total basis, but increase on a purchase basis.
Timothy Coffey
Do you feel you’ve added really traded markets for the mortgage origination business that you want to or how do you see potential more expansion?
Terrill Moore
For the most part, we’ve tried to stick to the states that we operate in, Tim, and so we're not looking to make this a national growth engine, with a separate product that’s largely occurring in the markets that we have our banking footprint in and we just try to do a much better job of penetrating that and having the right people and adequate number of people to capture the opportunity that’s fair.
Timothy Coffey
Okay, so you have the adequate number of people for your footprint?
Terrill Moore
Well, in the refi business in the last six months I suspect that a team of folks would suggest that they could have used some more help. But we do think that we are adequately staffed on a go forward basis certainly for that purchase growth.
Operator
Hey, Ms. Mutch and gentlemen, it appears that we have no further questions at this time.
Do you want to make any final comments?
Edward Garding
No, we don’t have any final comments.
Operator
Okay, well thank you, sir. The conference call has now concluded.
We thank you all for attending today’s presentation. At this time you may disconnect your lines.
Thank you and take care.