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Financial Institutions Inc (FISI 3.47%)
Q3Â 2019 Earnings Call
Oct 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 Inc. Third Quarter 2019 Earnings Conference Call and Webcast. [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. Shelly Doran, Director of Investor and External Relations, Executive Vice President and General Counsel. Please go ahead ma'am.
Shelly J. Doran -- Director of Investor and External Relations
Good morning. 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 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 which are available on our website for a 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 that are intended to supplement and not substitute for comparable GAAP measures. Reconciliations of these non-GAAP measures to GAAP measures were provided in the earnings release, which was filed as an exhibit to the Form 8-K. Please note that this call includes information that is accurate only as of today's date, October 30th, 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 and welcome to our third quarter earnings call. We are pleased to report another strong quarter with net income of $12.8 million or $0.78 per share. Pre-tax pre-provision income was $19 million, 13.6% higher than the second quarter of 2019 and 24.7% higher than the third quarter of 2018. Both net income and pre-tax pre-provision income were the highest in Company history. Our results reflect the hard work of our teammates, resulting in effective execution of strategies intended to drive long-term shareholder value.
Outcomes this quarter reflect the continued focus and balance sheet optimization, including the conversion of securities to relationship-based loans, down-scaling the consumer indirect portfolio and building tangible capital while remaining disciplined with the management of expenses, growth in non-interest revenues and maintenance of a robust credit culture. Meaningful progress was achieved in the third quarter related to realizing positive operating leverage and higher return on average assets and return on average equity.
During the quarter, in addition to concluding the redeployment of securities, we took advantage of a market opportunity to convert unrealized gains by selling $65 million of investment securities, generating a $1.6 million gain. Proceeds of $65 million were immediately reinvested into investment securities with intermediate durations. This repositioning was completed without materially impacting portfolio yield. We expect to continue to take advantage of these opportunities when they become available to us.
Growth of total loans was relatively flat during the quarter due to two factors. First, we experienced a higher than typical level of loan payoffs in the quarter, following two quarters of very low pay-offs. A portion of this activity was transactional. For example, one customer was sold, resulting into repayment of a $5.3 million loan, another was a sizable C&I relationship that we strategically participated to another bank, reducing loan outstandings by $6.2 million. Other payoffs were smaller with a few related to construction loan payoffs. Based on what we are seeing today, we anticipate a return to normalize payoff activity in the fourth quarter. Second, we continue to downscale the consumer indirect portfolio by focusing on the profitability of new loan originations. This portfolio decreased by $12.5 million or 1.4% from June 30th. And at quarter-end, it comprised 27.4% of our total loan portfolio, down from 30.4% one year ago. Consumer indirect portfolio yield for the quarter was 9 basis points higher than the second quarter of 2019.
Total deposits at quarter-end were $114 million higher than the end of the second quarter and $101 million higher than the year-earlier period. The increase from June 30th, 2019 was primarily due to public deposit seasonality. Deposit growth from September 30, 2018 was driven by business development and growth in the broker deposit portfolio, partially offset by an approximately $50 million decrease in non-public CDs. We made a conscious decision to lower our CD rate, leading to an approximately $28 million roll-off of high cost non-public CDs in the quarter.
In the third quarter, we experienced an increase in interest rate swap transactions as part of our commercial lending program, resulting in fee income for the quarter of $890,000. This fee-based income category will fluctuate from quarter-to-quarter as it's primarily based on the number and value of interest rate swap transactions. While non-interest expenses were higher, we expected and provided guidance for this. The efficiency ratio was 59.52% for the quarter compared to 59.79% in the second quarter and 62.04% in the third quarter of 2018. Performance ratios for the quarter were strong. Return on average assets was 1.19%, 13 basis points higher than the second quarter of 2019 and 19 basis points higher than the third quarter of 2018. Return on average equity was 11.86% compared to 11.01% in the second quarter and 10.71% in the year earlier period. And our tangible capital equity ratio increased to 7.99%, up 22 basis points from 06/30/19 and up 91 basis points from 09/30/18.
I'll now turn the call over to our CFO, Justin Bigham who will provide additional information on results as well as our current outlook for the fourth quarter.
Justin K. Bigham -- Executive Vice President, Chief Financial Officer and Treasurer
Thanks, Marty. Good morning, everyone. I'll be providing commentary on a few key items with comparisons to the second quarter of 2019. Net interest income was $32.5 million, flat compared to the linked quarter. This was the result of lower average interest earning assets in the quarter, offset by the impact of net interest margin expansion.
During the third quarter, as Marty discussed, we sold and immediately reinvested $65 million of securities, realizing a gain of $1.6 million. That transaction had an immaterial impact on our NIM. Additionally and in line with our guidance, this quarter we concluded our balance sheet strategy of redeploying investment securities into higher yielding loans. Going forward, we expect the securities portfolio to float within a range of $780 million to $800 million, depending on the level of municipal deposits. The decrease in securities was greater than the increase in loans during the quarter, resulting in lower average interest earning assets for the period. The timing of loan growth in the third quarter of 2019 resulted in a temporary deployment of a portion of investment securities proceeds for other purposes.
NIM for the quarter was 3.29%, up 1 basis point from the linked quarter. Margin expansion was positively impacted by the repositioning of the balance sheet as loans became a higher percentage of earning assets. Our average yield on loans was 4.77% in the quarter, down 5 basis points from the second quarter. The average yield on interest earning assets was 4.29%, unchanged from the linked quarter. Our cost of funds decreased by 1 basis point as compared to the second quarter to 100 basis points. Total loans increased by 0.2% from the end of the second quarter as a result in growth in commercial mortgage and residential real estate of 2.5% and 2.3% respectively, offset by decreases in commercial business and consumer indirect portfolios. Provision for loan losses was $1.8 million in the quarter, down $510,000 from the second quarter. Provision for the quarter was impacted by a few factors. First, loan growth was lower, therefore less reserve was required. Second, as the consumer indirect portfolio decreases, less reserve is necessary. And lastly, we continue to experience good credit quality.
Net charge-offs were $4.6 million compared to last quarter's $1.2 million. The increase is primarily attributable to the partial charge-off of $3 million of the commercial credit downgraded last quarter. Approximately $2.2 million of that credit remains classified as non-performing commercial mortgage loans. Non-performing loans were $9.8 million in the quarter, down $1.7 million as a result of the $3 million commercial mortgage charge-off, partially offset by a few commercial business credit downgrades in the quarter. Allowance for loan losses to total loans was 1% at quarter-end, down 9 basis points from last quarter and the allowance for loan losses was 324% of non-performing loans compared to 300% at 06/30/19. Non-interest income was up $3.1 million in the quarter as a result of the following. Insurance income was up $567,000, primarily due to the timing of renewals and business development, income from derivative instruments was up $935,000, primarily due to new interest rate swap transactions and we benefited from the investment security sale and reinvestment, generating $1.6 million of gain. Non-interest expense was $25.9 million, an increase of $883,000 from the second quarter.
Salaries and employee benefits expense was up $1.2 million because of new hires and replacement personnel, higher commissions related to higher revenue and an increase in healthcare claims. You'll recall that in the second quarter, we experienced favorable healthcare claims and indicated that we expected them to be higher in the third quarter. Professional services expense was $596,000 higher than the second quarter due to consulting and advisory projects. These increases were partially offset by lower FDIC assessments as we benefited from FDIC assessment credit of $482,000 in the quarter and lower advertising and promotion expense as a result of the timing of expenses related to the bank's branding campaign. While non-interest expense was up in the quarter, it was in line with our expectations and guidance. Our continued focus on revenue and efficiency resulted in another quarter of positive operating leverage year-over-year.
I'll now provide our current outlook for the remainder of 2019. We expect mid-single digit growth in our total loan portfolio for the full year, which is at the low-end of the guidance range provided last quarter. This takes into account the higher level of commercial loan payoffs received in the third quarter as well as the continued down-scaling of our consumer indirect loan portfolio. We expect the consumer indirect portfolio to end the year near the high-end of the range previously provided of 25% to 27% of total loans. In light of the favorable run-off of higher cost CDs experienced to-date and expected in the fourth quarter, we are changing our guidance for non-public deposits to low single-digit growth for the full year.
We continue to expect mid-single digit growth in non-interest income, excluding gains on investment securities for the full year. Non-interest expense guidance remains within a range of $25.5 million to $26.5 million for the fourth quarter. Expenses may be closer to the high-end of the range due to professional fees incurred in connection with improvement initiatives Marty announced in our second quarter call. As our efficiency ratio was 60.09% for the first nine months, we believe the ratio for the year will be slightly higher than the 59% to 60% range previously provided.
We expect modest expansion of the net interest margin in the fourth quarter. For the full year, we anticipate a zero to 1 basis point increase in the 3.27% net interest margin achieved in the first nine months. As noted in the earnings press release, our effective tax rate of 25% for the third quarter includes a one-time true-up of estimates related to the Tax Cuts and Jobs Act recorded at December 31, 2017. We expect to return to an effective tax rate of approximately 21% in the fourth quarter. And regarding provision for loan losses, we anticipate a more normalized level of provision for the fourth quarter, in line with our historical experience. We are currently in the process of developing our 2020 budget and expect to provide guidance in late January after we've obtained Board approval.
I'll now turn the call back to Marty.
Martin K. Birmingham -- President and Chief Executive Officer
Thank you, Justin. Before we open the call for questions, a few concluding comments. During last quarter's call, I commented that we were about to deploy improvement initiatives to identify and take advantage of opportunities, to improve efficiency while enhancing customer experience and employee experiences. We continue to pursue opportunities to maintain expense discipline, improve operational efficiency, and automate low value, repetitive activities using robotic process automation.
Our executive management team and senior leadership supported by capable improvement advisors who specialize in near term self-funding business process improvement have initiated a program to improve company operations across the enterprise, also to deliver enhanced customer experience and improve operational efficiency, to create incremental capacity and more effectively leverage our costs. [Indecipherable] 2020 guidance, we will -- that will be communicated during the call at year-end in January, we intend to provide more details on the cost and benefits of this substantive strategic opportunity.
Irene, this concludes our prepared comments.
Questions and Answers:
Operator
Thank you, sir. We will now begin the question-and-answer session. [Operator Instructions] Our first question is from Damon DelMonte of KBW.
Damon DelMonte -- Keefe, Bruyette & Woods, Inc. -- Analyst
Hey, good morning everyone. How is it going today?
Martin K. Birmingham -- President and Chief Executive Officer
Good morning, Damon.
Shelly J. Doran -- Director of Investor and External Relations
Hi, Damon.
Justin K. Bigham -- Executive Vice President, Chief Financial Officer and Treasurer
Good morning.
Damon DelMonte -- Keefe, Bruyette & Woods, Inc. -- Analyst
Good morning. So just first question, if you can just kind of talk a little bit about the margin. I think, Justin you said that you look for a little bit of modest expansion here in the fourth quarter. Can you just talk a little bit about your rate expectations by the Fed as far as cuts coming this year into next year and kind of how that plays into your outlook?
Justin K. Bigham -- Executive Vice President, Chief Financial Officer and Treasurer
Yeah. Sure, Damon. So that outlook has a cut today and does not assume anything more than the cut that's going to happen -- that we anticipate will happen today.
Damon DelMonte -- Keefe, Bruyette & Woods, Inc. -- Analyst
And if there were to be another cut in December or one in March, how is the margin positioned to handle that?
Justin K. Bigham -- Executive Vice President, Chief Financial Officer and Treasurer
Well, we continue to be very slightly liability sensitive. And so what my -- I would anticipate that a rate cut in December would have only marginal impact on our margin.
Damon DelMonte -- Keefe, Bruyette & Woods, Inc. -- Analyst
Got it. Okay. All right. Great. And then with regard to the outlook for loan growth, could you guys just give a little bit of color on what you're seeing throughout your footprint and where the best opportunities are for that growth and kind of what you're targeting over the next handful of quarters?
William L. Kreienberg -- Executive Vice President, Chief Banking and Revenue Officer and General Counsel
Well, I think, Damon, this is Bill Kreienberg. We've given our guidance as to where we think we'll end up overall. From the indirect portfolio, we've commented on our conscious efforts to reduce the [Indecipherable] portfolio, but from a commercial point of view, our pipelines remain pretty full. We are seeing a lot of very good opportunities and going through our normal process. So we haven't seen any what we would call economic weakening in our footprint and we remain confident about our ability on the commercial side to deliver the loan growth.
Damon DelMonte -- Keefe, Bruyette & Woods, Inc. -- Analyst
Okay, great. Thanks. And then just one final question on expenses. The FDIC credit that you guys received this quarter, are you expecting to begin to accrue again next quarter or how should we model that out?
Justin K. Bigham -- Executive Vice President, Chief Financial Officer and Treasurer
We will have enough credits to see FDIC costs similar to this quarter, next quarter as well.
Damon DelMonte -- Keefe, Bruyette & Woods, Inc. -- Analyst
Okay, great. That's all that I had for now. Thank you very much.
Martin K. Birmingham -- President and Chief Executive Officer
Thank you.
Operator
Our next question is from Alex Twerdahl of Sandler O'Neill.
Alexander Twerdahl -- Sandler O'Neill + Partners, L.P. -- Analyst
Hey, good morning.
Martin K. Birmingham -- President and Chief Executive Officer
Good morning, Alex.
Justin K. Bigham -- Executive Vice President, Chief Financial Officer and Treasurer
Good morning, Alex.
Alexander Twerdahl -- Sandler O'Neill + Partners, L.P. -- Analyst
First off, just wanted to ask a follow-up on the expense initiatives that you were talking about [Indecipherable], Marty. Is there a specific objective or target that you have in mind in terms of efficiency ratio or ROA or anything like that that you're kind of -- there you kind of have in the back of your mind as you look at these expense initiatives?
Martin K. Birmingham -- President and Chief Executive Officer
So I anticipate that we will be much more definitive in January with you, but I think we have a material opportunity to think constructively and critically about the operations of the Company. And as I said Alex, it's an enterprisewide initiative. We are being supported by capable consultants who are going to support our ability to execute a project in a very definitive and timely manner.
Alexander Twerdahl -- Sandler O'Neill + Partners, L.P. -- Analyst
Okay. And is it mostly going to be targeting expenses or is it going to be looking to spend more in order to make a lot more?
Martin K. Birmingham -- President and Chief Executive Officer
Right now, we're looking at process improvement and efficiency. If there are ideas relative to revenues, we will be open to those, but as I said, we will communicate the cost and our anticipated benefits of the program. I think reengineering has gone through -- general business certainly has gone through the banking industry over the course of last 20 or so years and we have that opportunity available to us and we're going to take advantage of it.
Alexander Twerdahl -- Sandler O'Neill + Partners, L.P. -- Analyst
Great. And then just kind of to elaborate on the margin commentary. Given that you guys are kind of a little bit on the liability sensitive side and now we've had two probably three later today cuts, it doesn't look like we're going to get any increases anytime soon. I mean, would it be fair to say that the margin at kind of 3.29%, that's kind of like a sort of a low-end for where the margin will be over the next, call it four to five quarters?
Justin K. Bigham -- Executive Vice President, Chief Financial Officer and Treasurer
Alex, that's a great question. Very difficult to sort of project out that far. As you can imagine, it depends a lot on the shape of the curve, not just overall that funds target rate and the shape of the curve was to change materially, it could have a material impact on the margin. I guess the way that I would think about it is, our slightly liability sensitive commentary is really more of a one-year kind of view. And as you get to year two and year three and year four, obviously at some point if rates continue to decline, you're not able to continue to reprice your liability side as low as your asset side can continue to come down. So it's just not as simple of an answer of that, but I can tell you that we will provide very specific ranges for 2020 in our call at the end of the -- in January.
Alexander Twerdahl -- Sandler O'Neill + Partners, L.P. -- Analyst
Okay. And then just kind of as I sort of think and I haven't done the exact math on this, but just based on the securities kind of reaching the end of the transformation and then loan growth being a little bit lighter this quarter and average earning assets being a little bit lighter, does that imply that there should be a little bit more of a margin impact as loans, [Indecipherable] loans come out in the fourth quarter?
Martin K. Birmingham -- President and Chief Executive Officer
I think that's a fair way to think about it. And I guess the other thing I'd point out to Alex is, we talked about a pretty significant reduction in our CD portfolio and one of the things that we also saw this quarter was a significant increase in our retail and commercial deposit portfolio excluding CDs and so we are generating and doing a really nice job, generating strong deposit growth and it's primarily on the commercial side where we've seen that growth. So from my perspective that's also sort of a good guy if you will relative to how we think about the margin going forward. And I think your commentary about the asset side is also accurate.
Alexander Twerdahl -- Sandler O'Neill + Partners, L.P. -- Analyst
Great. And then just one final question from me. Saw a little bit of M&A in your backyard announced last week that you guys were talking about doing, maybe you can kind of update us [Technical Issues] Can you hear me?
Martin K. Birmingham -- President and Chief Executive Officer
Go over again. That would be good. We couldn't catch all of it.
Alexander Twerdahl -- Sandler O'Neill + Partners, L.P. -- Analyst
[Technical Issues] What's going on here. I was just asking about M&A, had a deal announced in your backyard last week and just kind of curious of M&A is still something that's a consideration for you guys or and if it is, what the criteria if you could remind us what that might be?
William L. Kreienberg -- Executive Vice President, Chief Banking and Revenue Officer and General Counsel
So Alex, we obviously saw the same thing you saw relative to a small bank based in the Southern tier in Upstate New York. From our perspective, we are focusing on the continued execution of our strategic plan, which is driving organic growth, which we continue to build on our track record there to the extent opportunities are available, we're ready and willing to consider them. But at this point, we want to make sure we remain very disciplined in terms of the execution of our plan as well as with the increased volatility in the world, whether it's political or the international pressures, the economic outlook, we want to make very sure that we're not stretching both in the execution of our plan as well as on strategic opportunities.
Alexander Twerdahl -- Sandler O'Neill + Partners, L.P. -- Analyst
Understood. Thanks for taking my questions.
Operator
[Operator Instructions]
Martin K. Birmingham -- President and Chief Executive Officer
And so Irene, it looks like there is no further questions and we also experience a little technical difficulty there. So at this point, hearing no further questions, I think we're ready to conclude the call and we look forward to reconnecting in January with our investors.
Operator
Thank you, sir. We do not have any further questions. Do you have any other closing remarks?
Martin K. Birmingham -- President and Chief Executive Officer
No. Thank you very much. Irene, we're ready to conclude the call.
Operator
[Operator Closing Remarks]
Duration: 27 minutes
Call participants:
Shelly J. Doran -- Director of Investor and External Relations
Martin K. Birmingham -- President and Chief Executive Officer
Justin K. Bigham -- Executive Vice President, Chief Financial Officer and Treasurer
William L. Kreienberg -- Executive Vice President, Chief Banking and Revenue Officer and General Counsel
Damon DelMonte -- Keefe, Bruyette & Woods, Inc. -- Analyst
Alexander Twerdahl -- Sandler O'Neill + Partners, L.P. -- Analyst
