Jul 23, 2013
Executives
Ed Garding - President and CEO Terrill Moore - EVP and CFO Bob Cerkovnik -SVP and CCO
Analysts
Jeff Rulis - D.A. Davidson Brad Milsaps - Sandler O'Neill Brett Rabatin - Sterne Agee Matthew Keating - Barclays Capital Jackie Chimera - KBW
Operator
Good morning and welcome to First Interstate Bancsystem, Inc., Second Quarter 2013 Earnings Conference Call. All participants will be in a 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 Allison Johnston. Please go ahead.
Allison Johnston
Thanks John. Good morning.
Thank you for joining us for our second quarter earnings conference call. As we begin, I would like to direct all listeners to the cautionary note regarding forward-looking statements and factors that could affect future results and our most recently filed Form’s 10-Q and 10-K.
Relevant factors that would cause actual results to differ materially from any forward-looking statements are listed in the earnings release and in our SEC filings. The company does not intend to correct or update any of the forward-looking statements made today.
Joining us from management this morning are Ed Garding, our Chief Executive Officer and Terrill Moore, our Chief Financial Officer. At this time I will turn the call over to Ed Garding.
Ed?
Ed Garding
Thanks, Allison. Good morning and thanks again to all of you for joining us on the call.
Yesterday we were pleased to report improved second quarter earnings of $21.5 million or $0.49 per share. This represents our sixth consecutive quarter of improved earnings which is reflective continued improvement and our credit quality.
Earnings improvement was directly and significantly impacted by reduced credit related costs, both provision expense and other real estate expense. So while we indicated in April, we would not expect another quarter with provision expense of $500,000, we were correct that this quarter is even lower with provision expense of $75,000.
I will give you a sense of some of the puts and takes affecting our level of provisioning. First, overall loan growth is modest.
So we aren't having much provision related to loan growth. Second, net charge-offs have been very low for three consecutive quarters and we're getting further away from the quarters in which we experienced our most significant credit losses.
We have also had almost $10 million in recoveries of charged off loans this year. Also the historical loss experience component of our allowance methodology is coming down from historical highs.
Third, we've seen a steady decline in our level of criticized loans which continued again this quarter. And finally, we're seeing improving economic conditions locally with some increases in collateral valuations in our markets.
This is most clearly demonstrated through the consistent gains we're getting upon disposition of our other real estate and the reduced level of additions through other real estate. Just in case you missed the numbers on that were in our written report, our other real estate peaked out at $52 million and today it's down to 10 million.
So it's gone down substantially. In aggregate, these factors indicate that we're well reserved and if current trends continue our level of provisioning should be modest until we see more growth in the loan portfolio.
Our provisions will be lumpy quarter-to-quarter while we continue to resolve the non-performing loans that remain on the books in conjunction with differing levels of recoveries from quarter-to-quarter. The second boost to earnings this quarter was profits on the sale of other real estate versus the normal losses that you have.
This is the strongest evidence we have seen of a recovery in real estate values in our markets. Whereas other real estate costs have been a drain on earnings in the past, we reported $915,000 of net profits this quarter.
The 30% reduction in our other real estate balance from last quarter and over 50% reduction from last year continued the steady downward trend of our bank owned real estate holdings. Residential mortgage lending has been an important product for many years, both to the company and to our customers.
Clearly, residential mortgage lending has been a growing revenue source for the company over the past couple of years. And as mortgage rates are have risen recently, we are starting to see some changing trends.
Although, income from the origination and sale of residential real estate loans was relatively stable from last quarter, there was a clear shift in the purchased home volumes from 33% in the first quarter to 53% in the second quarter. The total volume of closed residential loans for the first six months of this year was flat compared to the first six months of last year.
However, this quarter’s activity is down 6% compared to the second quarter of 2012. With mortgage rates increasing, we are beginning to see a decline in mortgage activity, so depending on how rates settle out over the next couple of months, we believe we will see the total volume of originations for the year reduced from last year’s record levels largely due to a slowing rate of refinance activity.
Although, we’ve seen some very encouraging signs with respect to economic conditions, we are disappointed we’re not seeing higher levels of loan growth. On the positive side, both Ag real estate and Ag operating loans saw modest increases, which would be expected this time of year as both ranchers and farmers are in production mode.
We have also seen some growth in consumer lending, which was mainly the result of an increase in our indirect portfolio. Most of the growth in this portfolio is coming from our Eastern Montana markets.
The residential real estate portfolio has continued to increase, although at a slightly reduced pace from last quarter and last year. As we continue to experience increasing mortgage interest rates, we anticipate less mortgage activity and the growth in the residential mortgage portfolio will naturally taper off.
The commercial loan activity is where things continue to be more difficult. We’re booking new loans, but this activity hasn’t significantly exceeded the pace at which we are experiencing regular monthly loan pay-downs, along with payoffs, charge-offs and foreclosure activity related to the problem loans.
We remain cautiously optimistic we’ll see modest loan growth by the end of the year and by modest, we mean something like 2% to 3%. We continue to be focused on quality first and then margin and are not willing to grow the portfolio at any cost.
Non-performing assets decreased nearly $5 million from last quarter and 62 million from the same quarter last year. We’re pleased with the strides we’re making in resolving our credit quality issues.
As you noticed in our release there was a $5 million increase in non-performing loans this quarter. The largest factor in this increase was an $8 million relationship which was placed in non-accrual.
We do have a workout plan in place with the borrower and have adequately reserved for the credit. Although, there was a net increase in non-performing loans this quarter, we don’t believe this changes our outlook as we’re still seeing significant resolutions of our non-performing loans as we head into the third quarter.
We’re targeting total non-performing assets to be below 110 million by the end of the year. At this time, I’d like to turn the call over to Terry Moore for a more granular look at earnings for the quarter.
As you probably saw earlier this month, Terry is retiring as CFO in the middle of August, although, he’ll remain in a consultative role until next June. Terry has been with the company for 35 years and he has been into real part of the company and our growth and success over the years.
And I’m going to speak to that a little bit more later when we wrap up. So, Terry, go ahead.
Terrill Moore
Thanks Ed. It’s great to report such a strong quarterly earnings of 21.5 million and $0.49 earnings per share on my final call.
As Ed indicated, our improved results are due to a number of factors, but obviously reduced credit costs were the primary drivers. Since we talked in detail last quarter about the factors impacting provision expense, I won’t repeat that conversation but will be glad to address any questions you might have at the end of the call.
It was encouraging to see the net interest margin improved one basis point quarter-over-quarter to 3.56% for this latest quarter, exclusive of recoveries of charged off interest we saw a four basis point improvement in net interest margin from Q1. The improvement in margin was a result of an increase in average loan balances outstanding along with the reduction of cash balances that we’re earning only 25 basis points.
It was further aided by a further reduction in cost abundance of three basis points. The yield on earning assets declined just two basis points from last quarter to 3.87%.
Our investment strategy has remained unchanged. However, the increase in the yield curve passed an unexpected extension in the duration of our investment portfolio; of about one year, from 2.7 years last quarter to 3.6 years at the end of June.
A gradual upward movement in the yield curve should help us, and could help mitigate some of the decline we would otherwise expect in the net interest margin. If we look out over the next year, we have over $300 million of our investment portfolio that will roll on, which we hope to redeploy and part in the loan portfolio.
However, even if the loan growth is limited we should be able to reinvest at a higher rate in the investment portfolio than we have seen over the previous 12 months. Non-interest income remained steady at 33% of total revenues.
This was aided by strong debit and credit card revenues along with proceeds from a company owned life insurance settlement. We have had a long term commitment to providing card based services to our consumer and business customers.
Credit card and debit card revenues had been consistent and strong as we market it to our customer base in our market areas. For the first six months of this year compared to last year credit card revenues had increased 8.6% and now top $5 million.
Debit card revenues had been consistent year-over-year at around $6 million for the first six months. Although mobile banking fees are nominal at this point, the adoption and utilization of mobile banking by our customers has been exceptional.
Currently over 15000 customers are using mobile banking services regularly with the average customer accessing one of our mobile banking services 17 times per month. Total non-interest expense was down $1.7 million from last quarter.
This was mainly a result of the swing and other real estate activity Ed discussed earlier from the typical net expense to net revenue for the quarter. However there are a couple of other not worthy items.
First, salary expense remained relatively flat again this quarter as reduced overtime and commissions were offset by an increase in the incentive bonus accrual. Second, employee benefits decreased due to a $500,000 reversal of group health insurance expense.
We have experienced lower medical claims in the last year than expected, in part due to the focus on wellness and fewer larger claims. Third, the other expense category increased due to additional advertising cost recorded this quarter and the $616,000 write down of the value of banking facilities being held for sale.
I would like to talk about capital and the impact to the market-to-market adjustment on our available for sale or AFS securities along with Basel III implications. First let’s discuss the market-to-market adjustment.
With the rise in the yield curve in the second quarter net unrealized gains in the AFS portfolio was $14 million as of March 31, to net unrealized losses of $7 million in the end of June. Due to the shorter duration of our portfolio along with our asset classes we are impacted most by the five year part of the treasury curve which went from 76 basis points at the end of March to a 139 basis points at the end of June.
Of course this market-to-market adjustment has no impact on this quarter’s, or future quarter’s earnings, nor any regulatory ratios, capital ratios. While a $21 million swing and accumulated other comprehensive income does not have significant impact to our strong capital base.
I would like to discuss the potential impact of further increases in the treasury yield. Although, hard to imagine, yet a further immediate 300 basis point parallel shock to the yield curve would only extend the duration of the investment portfolio to about five years because of the solid structure of estimated lives of the underlying securities.
Additionally, we have the intent to hold the AFS securities to maturity and so we don’t anticipate a situation where we’d recognize losses on the disposition of these securities. As you know the regulators finalized Basel III capital requirements earlier this month and final rules resulted in good news for community banks.
One key win was the ability to hop out of including the unrealized gains and losses on AFS securities on our regulatory capital ratios. Additionally, clarifications that are trust preferred securities are grandfathered and will remain a component of tier one, and tier two capital is a second outcome worth noting.
So we are confident we’ll meet all well capitalized requirements under the proposed fully implemented Basel III rules today. I’ll wrap up by saying I have enjoyed an awesome career at First Interstate.
While I miss the First Interstate team and these opportunities to communicate with the investment community, I also look forward to this next chapter in my life. I have full confidence that Kevin Reilly will serve the company well for years to come and I look forward working closely with him to a transitional period.
With that I’ll turn it back to Ed.
Ed Garding
I’ll wrap up the financial part by saying, it was a great quarter. While our earnings have improved substantially over the last year, we do have our challenges ahead of us.
(Inaudible) working hard to make loans and as always we have our eye on ways to increase non-interest income. We have a long history of controlling expenses and won’t let up on that focus either.
But back to Terry’s retirement for a minute, though I did mention briefly that he had announced his retirement, he actually announced over a year ago and gave us lots of time to plan and he is going to stay with us for almost another year so that we have a very smooth transition and we are happy about that and Terry has (inaudible) that he will find the balance between being available and not looking over Kevin’s shoulder and I think that we will have good transition and I wanted to mention more about Terry’s retirement because he and I literally grew up together in this company. When we started, we were young men in our twenties who didn’t know the first think about banking and now we are mature men in our sixties, who don’t know the first thing about banking.
But we are still here nevertheless. And then finally, we are excited to welcome Kevin Reilly who is in the room with us this morning and if you’ve read the release, you have realized that Kevin is well qualified to take on the role of CFO, 27 years of banking experience with several different companies, actually it’s not several just a few but that does make him well qualified and another thing I would mention about Kevin is that he started at the beginning of last week and we spent the week just allowing him to get to know us and the surprising thing is that he came back this week and so we were pleased to see that.
So with that I will open up for questions.
Operator
(Operator Instructions) Our first quarter comes today from Jeff Rulis with D.A. Davidson.
Please go ahead.
Jeff Rulis - D.A. Davidson
Thanks, good morning. Ed, I just wanted to clarify that I missed the loan growth number you said for the rest, it was a 2-3% for the full year or the remainder of the year, what's that figure?
Ed Garding
That would be for the full year.
Jeff Rulis - D.A. Davidson
And then, more on the capital side, I guess as you've got, you've received some clarity on Basel and continue growing earnings I guess questions on capital deployment, you know, whether alternative uses on the dividend front and/or if you could give us an update on any potential sort of M&A discussions if that in general has picked up in your view.
Ed Garding
Well as you know I have to be very general on that, and so, certainly we'll continue to pay dividends and certainly we continue to be open to acquisition. We're not visiting seriously with anyone at the moment, we still think that we would like to spend time identifying the locations we'd like to be in and who we'd like to partner up with in those locations and we're also open to reactive type acquisitions if someone contacted us, but there isn't anything going on today.
Operator
Our next question comes from Brad Milsaps with Sandler O'Neill.
Brad Milsaps - Sandler O'Neill
Terry, just a question about the balance sheet I know you guys have benefited the last three quarters from reducing the securities portfolio and more importantly the FED funds position, just your thoughts on how much more room you have to reduce FED funds there and I appreciate the color on 2% to 3% loan growth. I guess if you had to subdivide that by category I know most of it has come out of the residential real estate bucket.
What would your outlook say for you know, for may be more asset sensitive commercial type loan growth.
Terrill Moore
Yes, on the FED fund, Brad, we would see, we have reduced that level down to in the mid $200 million range and we would see that as kind of a normal operating run rate and are comfortable with that particularly at this season of the year which would typically be when we would see the tightest amount of liquidity. So we'd see that more comfortable and more sustainable than the FED fund levels that we operated in over the last 2 to 3 years, in more uncertain times and changing times so I think that might, where we're at today would be more typical.
You want to cover the loan side?
Ed Garding
You're asking for categories and we're optimistic about commercial and commercial real estate and when I say commercial real estate really more specific to construction because we are seeing the home builders gearing up again in literally all of our territory and so we think that we'll see a little growth on that side. We know that we'll continue to see a little growth in that indirect portfolio because we've opened up with some new dealers that we weren't purchasing contracts from before, and as I said earlier we think that that residential piece will probably level off.
Brad Milsaps - Sandler O'Neill
Just kind of a small follow up question, Terry you mentioned some insurance proceeds during the quarter, I assume that's not necessarily repeatable but just curious kind of what the size of those proceeds were that helped you out in the second quarter.
Terrill Moore
It was a little over 600,000 Brad, and we are also hopeful that it would be non-occurring again next quarter.
Operator
Our next question comes from Brett Rabatin with Sterne Agee.
Brett Rabatin - Sterne Agee
I wanted to ask about the margin and just kind of thinking about loan pricing and just until the short end of the curve lifts, maybe if you guys could talk a little about if the margin from here might be under some pressure just kind of given the loan yields continuing to abate and I know you’re still thinking about the cost of funds but we would assume that if margin drifts down can you give any additional color on that maybe for the next few quarters?
Ed Garding
We can and I am going to ask Terry Moore to address that.
Terry Moore
Yeah Brett just really the color hasn’t changed too much from where we’ve been there has been margin compression in the last several years with this near zero interest rate. And I think the outlook will still continue to be some compression it might be mitigated a little bit to the extent that the yield curve is steeper going forward than it has been in the last couple of years.
I might make a brief comment certainly there is pressure on loan pricing from a competitive perspective which continues. And we are no different than any other bank in that regard when you look at linked quarter and we look like we are down about 17 basis points on the loan portfolio some of that is the growth of residential which was less than the average portfolio yield but some of it was that charged-off’s interest in perhaps upwards of about a third of that decline is just attributable to the timing differences of when we collect interest on charged-off loans.
Brett Rabatin - Sterne, Agee
Okay. And then just going back to the loan growth question and the guidance that you gave 2% to 3% for the year, I mean that kind of implies that back half is pretty flattish and I guess I am just, I know you’re talking about mortgage not being as strong in the back half of the year.
But just trying to kind of figure out, the back half of the years is that a function of pay-offs maybe happening to offset some of the growth you’re seeing or why kind of the flattish back half outlook?
Ed Garding
We’re basing our prediction on what we’re seeing in regards to loan requests. And again we’re not seeing enough requests to offset the payment stream that just continues to come in we’re very happy that that payment stream comes in but you have to make a lot of loans to stay ahead of that and then secondly we are a bit of a seasonal company because of the geography we’re in and so agriculture at this time of the year tends to grow.
And then in the fall obviously with the sale of crops and live stock it comes back down and in some ways the retailers do that too that’s somewhat of a summer time season for many of our retailers.
Brett Rabatin - Sterne, Agee
Okay, fair enough good color and then maybe just one last quick one was just thinking about ORE and you mentioned pricing getting better I was just kind of curious if you thought you might have some additional gains in some of the properties that you are trying to market?
Ed Garding
Well as long as you brought that up first I want to mention that I had said that our other real-estate peaked out at 52 million and is now down to 10 and I miss spoke there, what I meant to say is it’s down another 10 million to a total of 23 but our Chief Credit Officer, Bob Cerkovnik is here with us so I am going to ask him to speak to is there some gains to be had in that remaining 23 million.
Bob Cerkovnik
We don’t expect to see that larger gains in the future and it just goes to as we look across our portfolio overall we are realizing some smaller gains on that but anything that’s significant that we just experienced is we don’t expect that but we do feel we have everything written down to the for what we considered realizable value.
Brett Rabatin - Sterne, Agee
Okay, fair enough thanks for all the color.
Operator
Our next question comes from Matthew Keating with Barclays.
Matthew Keating - Barclays Capital
I will add my congratulations there I think just for you, I guess just going back to NIM though briefly I think last quarter you talked about securities purchases with an average yield of about 1.26% during the quarter. Hoping you could provide an update on how that kind of trended in Q2?
Thanks.
Terrill Moore
Matthew we acquired about 200 million of additional securities in the second quarter had a comparable yield around one in a quarter and estimating on that but, so we would anticipate, what was that?
Matthew Keating - Barclays Capital
So some benefit but not that much if compared to this quarter given is been moved along into the (quarter).
Terrill Moore
That is correct.
Matthew Keating - Barclays Capital
Separately on expenses, it sounds to me as well mortgage banking trends maybe accelerate a bit in the second half of the year. I know you typically run a pretty meaning operating in terms of your mortgage banking operation but are there any offsets on the expense side there to the extent that revenues in our business do decline.
Thanks.
Terrill Moore
Yes. That’s the short answer.
We have, I’m guessing here about 70 mortgage originators across the company and most of them are paid impart based on the volume of what they are doing. And so that I think we classify this commission income even though it’s not all actually commission, anyway that that would go down correspondingly with the volume.
Matthew Keating - Barclays Capital
Okay. That’s helpful.
I think, rest of my questions are been addressed already. Thanks very much.
Operator
(Operator Instructions). Our next question comes from Jackie Chimera with KBW.
Jackie Chimera - KBW
I just wanted to clarify a number that purchase volume, was that 43% or 53% in the quarter?
Terrill Moore
53% for the quarter, so we were pretty happy to see that.
Jackie Chimera - KBW
And then for the extension, you spoke about for the indirect audio portfolio, is the growth in that fairly due to the extension or is part of that tends up demand from a better performing economy?
Terrill Moore
I think it’s a little of both. I mean there is no question that we picked up some dealers that we haven’t been doing business with before but we also have some dealers especially in Eastern Montana with that those volume, is reached all time highest.
Jackie Chimera - KBW
And then how is the economy varying in some of the resort town, is that expected to be a good season this year.
Terrill Moore
Yes. From the standpoint of tourism numbers they’re looking for need of record number of people.
One thing we’ve seen in the last few years those is the while they’re showing up they may not be spending as much as they use to while they are in town, so to speak. But we’re pretty optimistic about another season is shaping up and of course we’re halfway through it right now.
So, we’ve got a little bit data to prove that this season is going to be a good one.
Jackie Chimera - KBW
And so hotel occupancy is looking good maybe up a little bit year-on-year.
Terrill Moore
No. Looking good not up year-over-year because they were pretty good last year.
Jackie Chimera - KBW
Okay. So, kind of its continuation of the trend and more...
Terrill Moore
Yes.
Operator
(Operator Instructions). We do have another question from James West with UBS.
Go ahead.
James West - UBS
I just want to compliment Terry on hell of a job well done.
Terrill Moore
Thank you.
Operator
There proves to be no further questions at this time. So, I’d like to turn the conference back over to management for any closing remarks.
Terrill Moore
Thank you and thanks for your interest in First Interstate today as always you can contact us through investor relations on our website and we’ll be glad to respond to any follow-up questions. Thanks for your time and goodbye.
Operator
Thank you very much. The conference is now concluded.
Thank you for attending. You may now disconnect.