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Financial Institutions Inc (NASDAQ:FISI)
Q2 2019 Earnings Call
Jul 30, 2019, 8:30 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning, and welcome to the Financial Institutions Incorporated Second Quarter 2019 Earnings Call. [Operator Instructions]

I would now like to turn the conference over to Shelly Doran, Director of Investors. Shelly, please proceed.

Shelly J. Doran -- Senior Vice President and Director of Investor & External Relations

Thank you for joining us for today's call. Providing prepared comments will be President and Chief Executive Officer, Martin Birmingham; and Chief Financial Officer, Justin Bigham. During the question-and-answer portion of the call, they will be joined by Chief Banking and Revenue Officer, Bill Kreienberg; and Director of Financial Planning and Analysis, Mike Grover.

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 historical SEC filings, all available on our website. For our safe harbor description and a detailed discussion of the risk factors relating to forward-looking statements.

We will also discuss certain non-GAAP financial measures intended to supplement and not substitute for comparable GAAP measures. Reconciliation for these non-GAAP financial measures to GAAP financial measures were provided in yesterday's earnings release, which was filed as an exhibit to our Form 8-K.

Please note that this call includes information that is accurate only as of today's date, July 30, 2019.

I'll now turn the call over to Marty.

Martin K. Birmingham -- President and Chief Executive Officer

Thank you very much, Shelly. Good morning to those participating this morning and welcome to our second quarter earnings call. There was another strong quarter for our company with net income of $11.4 million or $0.69 per share. Pre-tax pre-provision income was $16.7 million, 6.1% higher than the first quarter of 2019 and 9.9% higher than the second quarter of 2018. This represents the highest pre-tax pre-provision income in our company's history for the second quarter in a row.

We continue to execute our long term strategy to achieve sustained incremental earnings. And I'll briefly summarize a few of the measures most relevant to executing our strategy. Our critical relationship based commercial and residential loan portfolios experience strong growth in the quarter. Consumer business loans grew 7.4%, commercial mortgage loans increased 1.7% in residential real estate loans were up 2.1%. In contrast, the consumer in direct portfolios decreased by $27 million or 3% during the quarter. And at quarter end, it comprised 27.8% of our total loan portfolio, down from 31.2% one year ago.

We continue to maintain pricing discipline in our indirect line of business, resulting in lower production. In addition, we took advantage of a strategic opportunity and sold a small pool of $21 million in indirect loans, generating $143,000 gains. Total deposits at quarter end were $37 million lower than the end of the first quarter and $210 million higher than the year earlier period. The decrease from March 31, 2019 was the result of an $86 million decrease in public deposits due to the seasonality of municipal deposits, partially offset by $49 million increase in non-public deposits.

The increase from June 30, 2018 was the result of $27 million increase in public deposits, combined with $183 million increase in non-public deposits, partly as a result of successful business development efforts. Our net interest margin increased by 4 basis points compared to the first quarter for 2019 driven by our balance sheet strategy to redeploy investment securities into loans. The increase compared to the second quarter of 2018 was 12 basis points. We continue to manage expenses in the quarter is reflected by our improved efficiency ratio of 59.79% compared to 60.99% in the first quarter of 2019 and 60.14% in the year earlier quarter.

Another positive outcome for the quarter was a strong increase in our TCE ratio. TCE increased 32 basis points in the quarter to 7.77%. This is the highest TCE where our company since December of 2011.

I'll now turn our call over to our CFO, Justin Bigham, who will provide additional details on results as well as current outlook for the remainder of 2019.

Justin Bigham -- Executive Vice President, Chief Financial Officer and Treasurer

Thanks very much, Marty. Good morning, everyone. I'll begin by writing commentary on a few key items with comparisons to the first quarter of 2019. Net interest income was $32.5 million, up $672,000 from the linked quarter. The increase was driven by growth in average loan balances and then interest margin, combined with the impact of one additional interest accrual day in the current quarter.

Net interest margin for the quarter was 3.28%, up four basis points from the linked quarter. Margin expansion was primarily driven by a continued improvement in our interest earning asset mix. Our average yield on loans was 4.82% in the current quarter, up five basis points from the first quarter. The average yield on interest earning assets was 4.29%, an increase of 6 basis points from the linked quarter. Our cost of funds increased 2 basis points as compared to the first quarter, which is up to 101 basis points.

Total loans increased by 1.4% from the end of the first quarter as a result of growth in commercial and residential lending, partially offset by the decrease in consumer indirect, as Marty referenced. Provision was $2.4 million in the quarter, up $1.2 million from the first quarter, yet still lower than our historical experience. Net charge offs remained low at $1.2 million $533,000 lower than the first quarter of 2019. Net charge offs to total average loans of 16 basis points was our lowest quarterly level in more than a decade.

Non-performing loans increased by $5.7 million in the quarter because of the downgrade of one commercial credit relationship. Allowance for loan losses to total loans was 1.09% at quarter end up 2 basis points from last quarter, and the allowance for loan losses was 300% of non-performing loans compared to 574% at the end of the first quarter. Non-interest income was up slightly in the quarter at $9.2 million, compared to $9.1 million in the linked quarter. ATM and debit card charges were $296,000 higher, primarily due to higher levels of consumer activity.

The net gain on sale of loans was up $225,000 because of the previously described sale of a small pool of indirect loans combined with higher gains on sale of mortgage loans. Insurance income was $506,000 lower than the first quarter due to the seasonality of this line of business. Non-interest expense in the first quarter was $25.0 million. Relatively flat as compared to the first quarter.

Salaries and employee benefits expense was down $752,000 from the first quarter, primarily due to favorable health claims in the second quarter and higher payroll taxes incurred in the first quarter. Advertising and promotions expense was up $566,000 from the linked quarter due to timing related to the bank's branding campaign. As we stated on the first quarter call, the timing of advertising and promotions expense will vary quarter-to-quarter.

A continued focus on efficiency drove quarterly operating leverage year-over-year. I'll now provide our current outlook for the remainder of 2019. We continue to expect mid-to-high single digit growth in our total loan portfolio for the full year of 2019, driven by commercial and residential loan production. We also continue to expect consumer indirect loan portfolio to decrease to 25% to 27% of total loans by year end. For non-interest expense, we continue to expect a range of $25.5 million to $26.5 million per quarter, with variability, reflecting the timing of incentive compensation, healthcare and marketing costs.

Several other key areas of our outlook from full year 2019 remain unchanged as well. We continue to expect mid single digit growth in non-public deposits. Mid-single digit growth in non-interest income and efficiency ratio within a range of 59% to 60% and an effective tax rate within a range of 20% to 21%. We currently expect full year net interest margin to be in the middle of the previously provided range of 3.25% to 3.35%. Approximately $100 million of securities were converted into loans during the first six months of the year. The securities portfolio totaled $805 million at June 30th. And we believe that by year end it will be between $780 million and $800 million, depending on the seasonality of municipal deposits.

Therefore, we expect to redeploy between $5 million and $25 million of securities into loans in the second half of 2019, ending our redeployment initiative. Regarding provision, we expect a more normalized level of provision for the last two quarters in line with our historical experience. In the first half of 2019, financial institutions delivered very healthy growth in core operating profitability and we expect that to continue through the second half.

I'll now turn the call back to Marty.

Martin K. Birmingham -- President and Chief Executive Officer

Justin, thank you very much. Our organizational -- our organization continually seeks ways to serve our communities because we understand that helping communities support our ability to be successful. Accordingly, we invest in and support the communities we serve through volunteer activities, financial investments and product offerings. We recently published our second community report in which we describe our many [Phonetic] community efforts, including products and services, grants, sponsorships and voluntary.

The report is posted on the Five Star Bank website. Will be posted on the FII Warsaw website shortly and printed copies are available upon request. Over the past 12 to 15 months, we have focused on a few issues impacting the investment community's perception of our company. These include the size of our securities portfolio, the size of our consumer indirect loan portfolio and our lower than many peer tangible capital equity or TCE ratio.

First, as I mentioned earlier in the call, we have been redeploying investment securities into higher-yielding loans for several quarters. At June 30, our investment securities portfolio totaled $805 million or 18.7% of total assets. This compares to the peak of $1.1 billion at June 30, 2016, when securities comprised 29.5% of total assets. This initiative has had a very positive impact on profitability and as a driving factor for 2019 NIM growth.

Second, we work to right size consumer indirect loan portfolio by reducing loan volumes and increasing yield. We also took advantage of the opportunity to complete a small sale in the quarter. At June 30 consumer indirect loans comprised 27.8% of our total loan portfolio, down from the peak of 35% at December 31, 2013. Third, tangible capital has grown significantly through the retention of earnings and prudent issuance of capital. At June 30, TCE ratio with 7.77% up 161 basis points from 6.16% on March 31, 2017. Over the same period, our common equity assets ratio increased by 140 basis points from 7.99% to 9.39%.

We expect these ratios to continue to grow as we generate capital to the retention of earnings. These actions combined with our management team discipline approach to expense control, resulted in positive operating leverage in the quarter as well as an improved efficiency ratio. Having made significant progress in these areas, we are now about to deploy improvement initiatives to identify and take advantage of opportunities to improve efficiency while enhancing customer and employee experiences. These opportunities include expense savings and/or incremental revenue opportunities. We look forward to providing details on this program later this year.

Before I conclude my prepared remarks. Operator, I want to thank my teammates for their hard work and commitment to the execution of our initiatives, supporting each other, our customers and our communities are mainly [Phonetic] to the strong quarter and the outcomes we have just reported.

Ian, we're ready to open the call for questions.

Questions and Answers:

Operator

We will now begin the question-and-answer session. [Operator Instruction] Our first question comes from Alex Twerdahl with Sandler O'Neill. Alex, please proceed.

Alex Twerdahl -- Sandler O'Neill -- Analyst

Hi, good morning.

Shelly J. Doran -- Senior Vice President and Director of Investor & External Relations

Good morning.

Martin K. Birmingham -- President and Chief Executive Officer

Good morning, Alex.

Justin Bigham -- Executive Vice President, Chief Financial Officer and Treasurer

Good morning.

Alex Twerdahl -- Sandler O'Neill -- Analyst

Just first-off, Justin, I think you're -- I -- kind of missed your margin guidance. Can you repeat that? I think it's in middle of the previously guided range, but with that for the just from the back half of the year? Or is that for the full year margin? And can you just tell us what rate assumptions you have in that guidance?

Justin Bigham -- Executive Vice President, Chief Financial Officer and Treasurer

Sure, that's a full year. I did say it would -- we're narrowing a little bit by indicating we'll be -- we expect to be in the middle of the range, plus or minus, of course, a basis point here or there. And as far as what our assumptions are. You know, we've essentially modeled one decrease in rates tomorrow as part of that guidance to look at what the impact on our margin would be.

Alex Twerdahl -- Sandler O'Neill -- Analyst

It's fair to assume that given that the margin has been 3.24% in the first quarter, 3.28% this quarter, to assume it's can be about 3.30% for the full year that would imply, it should be above 3.30% for the back two quarters of the year. Am I thinking about that right?

Justin Bigham -- Executive Vice President, Chief Financial Officer and Treasurer

You're thinking about that right.

Alex Twerdahl -- Sandler O'Neill -- Analyst

Okay. Great. And then onto the expense guide. We're $25.5 million and $26.5 million unchanged. However, you were below that guidance a little bit in the first two quarters. I know there is some timing issues, but should we expect now that maybe you should be toward the upper end of that range in the back two quarters as some of those things that maybe did not impact the first two quarters can kind of hit in the back of the year.

Martin K. Birmingham -- President and Chief Executive Officer

You know, Alex, it's really hard to sort of take that number given some of the volatility of -- for example, are we -- we mentioned how this particular quarter were lower, which was driven by some of the medical costs. And, you know, it's really difficult to sort of peg that number, which is why we provide that range. You know, from my perspective, we'll start to see some relief in the salary and benefits line from taxes, etc. But we're going to start to see some more seasonal increases on the medical expense side. So and then we've got these sort of volatile advertising and branding campaigns. So it's just difficult to really peg one number within a quarter. So we really just need to stick to know that -- that range that we've provided on a quarterly basis.

Justin Bigham -- Executive Vice President, Chief Financial Officer and Treasurer

I think those are two -- Alex I think those are two good examples, though, that, you know, healthcare. We've been able to migrate the company to high deductible plans and the seasonality of those kicking in when the deductibles are fulfilled, we do expect that.

Alex Twerdahl -- Sandler O'Neill -- Analyst

Okay. And then final question for me, just on the auto sale this quarter, I know it's something you guys had experimented with, on and off 10 years ago or something like that. Now you're seeing a little bit again, it just kind of just threw the reintroduction, some experimentation in terms of what the market would give you for these loans? Or is this going to be a more consistent part of the business just. And is it going to be a tool just to keep the portfolio kind of flat relative to other loan growth? Or do you think at some point it would obviously help you to reduce the portfolio in a more meaningful way?

William L. Kreienberg -- Executive Vice President, Chief Banking and Revenue Officer and General Counsel

Alex, this is Bill Kreienberg. You're right, we hadn't done a sale for nine or 10 years. This process was something where we just wanted to test the market, get the market to evaluate a portion of our portfolio, get appreciation for our credit underwriting and metrics in the portfolio, our pricing, etc., and also see what the market would bear for it. I think it was just part of an overall strategy, as we've said to gradually reduce the indirect auto portfolio as we're able to increase the buckets of residential and commercial, which is our strength point for full relationship banking. So depository relationships, cash management, insurance, wealth management, cross-sell. So it was just something that we successfully completed and now we're going to keep it in the back of our mind as we go forward and continue to analyze the size of the indirect portfolio in our bank.

Alex Twerdahl -- Sandler O'Neill -- Analyst

Okay, but not necessarily something we'll see every quarter, but potentially is kind of you reevaluate things going forward?

Justin Bigham -- Executive Vice President, Chief Financial Officer and Treasurer

That's correct, Alex, not necessarily.

Alex Twerdahl -- Sandler O'Neill -- Analyst

Great. Thanks for taking my questions.

Martin K. Birmingham -- President and Chief Executive Officer

Thanks, Alex.

Operator

Our next question comes from Matthew Breese with Piper Jaffray. Matthew, please proceed.

Matthew Breese -- Piper Jaffray -- Analyst

Hey, good morning.

Shelly J. Doran -- Senior Vice President and Director of Investor & External Relations

Good morning.

Martin K. Birmingham -- President and Chief Executive Officer

Good morning, Matt.

Matthew Breese -- Piper Jaffray -- Analyst

Just thinking about the mix shift, you noted that you're about $100 million of the way through the mix shift and that looking ahead, there's about $5 million to $25 million left to go, which I think puts you at the bottom half of the initial range of $110 million to $160 million of the mix shift. And so I'm just curious, given the positive benefit it had on the margin throughout this timeframe, why not more aggressively pursue it? And what are the limiting factors from continuing down this path?

Martin K. Birmingham -- President and Chief Executive Officer

Yeah, Matt, there's a lot of considerations that we need to take around liquidity and other aspects. You know, from our perspective, you know, we're going to pause when we get to that point. It's not necessarily out of the [Indecipherable] that we might do some more, but it won't be this year. We're going to continue to monitor and assess. As you know, we have a fairly large municipal portfolio and those municipal relationships require us to sort of securitize those deposits with us, with our securities portfolio. So there are some limiting factors to us going much lower. It also puts us at a rate at a percentage of assets that is in line with our peers. And so overall, we think that's sort of the prudent level to get to. Should we see opportunities to go a little bit lower, you know, I certainly think we'll -- explore those. But that's sort of where we're ending up for the year at this point.

Matthew Breese -- Piper Jaffray -- Analyst

Okay. And then just continuing, you know, the margin expansion because of the mix shift has been a you know, certainly a tailwind for you. Just thinking about the fundamentals of the book and with the Fed cutting, you know, if the mix shift were to stop and we were to get a Fed cut, you know how does the margin react to that? Is there more -- is there compression, you know, from a Fed cut, if we were to get Fed cut in December. Right. And the mix shift is paused. What is the initial reaction from the margin?

Martin K. Birmingham -- President and Chief Executive Officer

So our initial reaction to a Fed cut is relatively neutral to slightly favorable.

Matthew Breese -- Piper Jaffray -- Analyst

Okay. And then maybe just one step further on that. You know, what is the percentage of the loan portfolio that is exposed to either prime or LIBOR.

Justin Bigham -- Executive Vice President, Chief Financial Officer and Treasurer

About 30% of our loan portfolio is prime or LIBOR exposed.

Matthew Breese -- Piper Jaffray -- Analyst

Got it. Okay. And then, I didn't want to learn more about the course of credit that was downgraded this quarter. What was the nature of that credit? Can you give us any idea of collateral support where we are in the workout process and thoughts on resolution?

Martin K. Birmingham -- President and Chief Executive Officer

So that was a legacy credit in our southern tier market it was a long-term customer -- customer, been on the books for quite some time. Downgrade itself was precipitated by one of the guarantors bankruptcy, which had been triggered by unrelated financial issues to this project. We have improved in workout and meeting with management, working out a plan of reorg, rehabilitation and recovery. We're also exploring a lot of options relative to this credit. And I think in conjunction with our finance and risk teams, we've appropriately reserved for loans. But that's, that's really the extent of my comment now.

Matthew Breese -- Piper Jaffray -- Analyst

Okay. And then my last one is just, you know, the drop in insurance revenues this quarter. I know it's a seasonally weak quarter, but when it compared to even year-over-year, it's down quite a bit. First, you know what happened, what drove, you know, such a significant decrease year-over-year. And then secondly, is there how should we be? Does this set a new bar on what we should be expecting out of that business line? Is it more like, you know, $4 4 million versus the $5 million we've been historically running at?

Justin Bigham -- Executive Vice President, Chief Financial Officer and Treasurer

So good question, Matt. Couple of comments relative to the insurance line. So we've been going through this change to a bank on agency, which we describe in a couple of our calls. This particular quarter has seasonality in to that, due to inconsistency in profit sharing, which is a little bit lumpy year-over-year also, a year ago in this quarter, we had a kind of a one-time transactional commission on a construction project, which when measured against this quarter, obviously showed a decrease. I'd say overall we've now take a lot of the variability out of your book. In 2018, our top 10 customers comprise only 15% of the total agency revenue so our overdependence on which was present when we bought the agency in 14%, where the top 10 customers comprise 30%, as we note down, we're also seeing a great deal of synergy with our commercial lines, with our residential mortgage lines in terms of cross-sell. So our pipeline is good in this business. We have quite a bit of sales activity happening.

We also have additional incentives that we're working on with our commercial and residential wealth teams to support the insurance business. One of the other factors, if you take what we talked about a few minutes ago with the indirect book, our agency does provide insurance coverage for indirect loans, VSI, etc. So as that portfolio goes down and the number of loans we originate goes down, it does cause a drop in that portion of the insurance agency's revenue. But to conclude, I'm very pleased with the direction of the agency. We've got a lot of good things going and it's very profitable and we're not ready to change the thought on where we're headed to this year.

Matthew Breese -- Piper Jaffray -- Analyst

Okay. So we shouldn't put too much emphasis on this quarter's results versus the year ago.

Justin Bigham -- Executive Vice President, Chief Financial Officer and Treasurer

No. I would agree with that statement, I would nor.

Matthew Breese -- Piper Jaffray -- Analyst

Okay. All right. That's all I had. Thanks for taking my questions.

Martin K. Birmingham -- President and Chief Executive Officer

Thanks, Matt.

Justin Bigham -- Executive Vice President, Chief Financial Officer and Treasurer

Thanks, Matt.

Operator

Our next question comes from Joe Fenech with Hovde. Joe, please proceed.

Joe Fenech -- Hovde -- Analyst

Good morning, everyone.

Martin K. Birmingham -- President and Chief Executive Officer

Hi, Joe.

Shelly J. Doran -- Senior Vice President and Director of Investor & External Relations

Good morning.

Justin Bigham -- Executive Vice President, Chief Financial Officer and Treasurer

Hi, Joe.

Joe Fenech -- Hovde -- Analyst

Okay, guys on capital, you certainly seem to have moved past the point where you get questions about your comfort level of capital. You know, you get the 8% TCE ratio in sight. Can you rewrite for us the stack of capital management priorities as capital continues to build, you know, two higher dividends moved further up the priority list as a share repurchase, you know, M&A organic growth. Just give us a sense for how you're thinking about your options there as you know, your capital situation changes.

Martin K. Birmingham -- President and Chief Executive Officer

But Joe, I just would emphasize that, you know, we have been carefully listening and communicating to folks like yourself, shareholders and investors, and this has been our key issue of discussion. So, you know, in terms of how we managed our capital account and continue to build it through the retention of earnings. You're right, we're pleased in terms of how close we can, we're coming to the 8% level which for us, as I said was a record level since 2011. So we still have, as you all know, significant growth opportunities and you know as we continue to grow our loans, which is a capital intensive activity that certainly will provide capacity for that as a priority. The dividend has always been something that's been important from a total shareholder experience perspective at our company. And beyond that -- you all have seen we've made some strategic investments to expand and enhance our business model in terms of our wealth management insurance, investments and share buyback as would be the lowest of those priorities at this point in time.

Joe Fenech -- Hovde -- Analyst

Okay. That's helpful, Marty. And then just a follow up question on the Auto Web [Phonetic] loan sale. Not asking for specifics, but just looking for the profile the buyer, was that another bank? Is it private equity or some other party?

Martin K. Birmingham -- President and Chief Executive Officer

Joe, I appreciate the question. We're really not providing any information relative to that.

Joe Fenech -- Hovde -- Analyst

Okay. Fair enough. And then back to the prior question, is part limiting constraints and thought process on the auto book is that, over the longer term, you guys just feel like it's a product that's in demand in your market, you're good at it, you've got the expertise. And so we'll probably more likely to see you prune around the edges once you get to your stated targets rather than further reduce it sharply from that point. Is that a fair assessment?

Martin K. Birmingham -- President and Chief Executive Officer

It is, Joe. We've always been very pleased with our indirect auto line of business. It's very well run. We have people that have been in this business for 30 years in this market, you know the market, you know dealer body. So as we contract, I still think the plan for us strategically is to have this as one of our core offerings and core line of business. I am going to absolutely agree with that, Joe. And Joe, again, this is a consistent theme that we've been working on as a management team, listening to the feedback. This is a great business. We still stand by that and we look forward to continuing to manage it appropriately from a balance sheet perspective. We're very pleased with the opportunity we were able to capitalize on in terms of all what that is required to conduct a successful sale, that infrastructure is in place, that option is available to us as we continue to go forward.

Joe Fenech -- Hovde -- Analyst

Got it. Thank you.

Operator

[Operator Instructions] This concludes our question-and-answer session. Now I'd like to turn the conference back over to the President and CEO, Mr. Marty Birmingham for any closing remarks.

Martin K. Birmingham -- President and Chief Executive Officer

Ian, thanks very much. Thanks all for attending the call. We'll look forward to our next quarterly call.

Operator

[Operator Closing Remarks]

Duration: 32 minutes

Call participants:

Shelly J. Doran -- Senior Vice President and Director of Investor & External Relations

Martin K. Birmingham -- President and Chief Executive Officer

Justin Bigham -- Executive Vice President, Chief Financial Officer and Treasurer

William L. Kreienberg -- Executive Vice President, Chief Banking and Revenue Officer and General Counsel

Alex Twerdahl -- Sandler O'Neill -- Analyst

Matthew Breese -- Piper Jaffray -- Analyst

Joe Fenech -- Hovde -- Analyst

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