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Financial Institutions Inc (NASDAQ:FISI)
Q1 2020 Earnings Call
May 1, 2020, 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. First Quarter Earnings Conference Call. [Operator Instructions]

At this time, I'd like to turn the conference call over to Shelly Doran, Vice President of Investor Relations. Ma'am, please go ahead.

Shelly J. Doran -- Director of Investor and External Relations

Thank you for joining us for today's call.

Providing prepared comments will be President and Chief Executive Officer, Marty Birmingham, and Chief Financial Officer, Justin Bigham. They will be joined by Chief Banking and Revenue Officer, Bill Kreienberg, and Director of Financial Planning and Analysis, Mike Grover, for the question-and-answer portion of the call.

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, 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 intended to supplement and not substitute for comparable GAAP measures. Reconciliations of these non-GAAP financial measures to GAAP financial measures are provided in the 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, May 1, 2020.

I'll now turn the call over to Marty.

Martin K. Birmingham -- President and Chief Executive Officer

Thank you, Shelly. Good morning and welcome to our first quarter call.

Before we turn to a discussion of results, we want to acknowledge that these are incredibly challenging times for everyone and our thoughts remain with those most impacted by COVID-19.

In early March, we invoked our business continuity plan in response to the unfolding crisis. Our guiding principles through this period of uncertainty had been the safety and health of our associates, serving our customers to the highest standards and doing our part to slow the spread of the virus so that the most vulnerable can get the care they need. To protect the health and safety of our associates, performing many of the Company's most critical processes, by mid-March we created a less dense work environment with resiliency through the use of alternative locations and the implementation of work from home for as many associates as possible. We also closed most branch lobbies and implemented nonessential business travel and visitor restrictions that reduced or eliminated in person meetings.

On March 20, New York State enacted PAUSE, its stay in place order. On March 27, the order was expanded and it was mandated that 100% of the workforce must stay home, excluding essential services. While we are exempt from the order, we have taken great steps to protect our workforce, and approximately 65% of associates have been working from home or remotely since mid-March.

We very quickly transitioned from a business as usual operations to our new standard of working together from multiple locations across our footprint. I am so proud of our organization's collective resiliency and acclimation to so many changes. Despite all the challenges, our associates continue to work every day, ready to serve our customers and improve our communities. Across our organization, they are making a difference, from back office personnel to frontline branch staff, relationship managers and associates at Courier Capital, HNP Capital and SDN Insurance. I thank each of them for their ongoing dedication and support during this public health and economic crisis of uncharted proportions.

It is more critical than ever that individuals and businesses continue to have access to their financial institution and the ability to work with their trusted financial advisors. In many ways, through the past seven weeks, we have brought certainty to customers, friends and neighbors dealing with so much uncertainty. Customers can access us through branch drive-throughs, by our web and mobile apps or through our call center, and branch appointments are available as needed.

On March 23, we rolled out a series of solutions to support customers during this difficult time, and we have worked closely with many small business customers to help them with various SBA programs, the most significant of which is the Payroll Protection Program. In the first round, we helped about 600 businesses, obtained more than $200 million in PPP loans and we are processing applications for around two. Applications volume remains consistent with the first wave and funding will be subject to the processing capabilities of the SBA.

We entered this crisis in a position of strength based on our diversified business model, strong levels of capital and liquidity, historically strong asset quality metrics and a disciplined risk management and underwriting process. While we do not know how this crisis will end, how long it will last, how much economic damage it will cause or how fast or slow the recovery will be, we are focused on taking good care of our customers and managing our Company to successfully navigate this crisis.

I'll now turn the call over to Justin for a discussion of the results of the quarter. Justin?

Justin K. Bigham -- Executive Vice President and Chief Financial Officer

Thanks, Marty. Good morning, everyone.

Net income was $1.1 million for the quarter or $0.05 per diluted share. The significant drop in earnings was caused by a higher provision for credit losses of $13.9 million as compared to an exceptionally low provision in the first quarter of 2019 of $1.2 million. The increase in the first quarter provision primarily reflects deterioration in the economic environment due to COVID-19. The after-tax impact of the higher provision was $0.59 per share.

We adopted CECL on January 1. So before I address the provision expense for the first quarter, let me take a minute to reconcile our CECL related adjustments. The designated loss driver for our CECL model is the National Unemployment Forecast, which was decidedly different on January 1 than it was on March 31. For our day one adjustment, we saw an increase to the allowance for credit losses for loans of $9.6 million and established a reserve for unfunded commitments of $2.1 million for a total adjustment to our allowance for credit losses of $11.7 million. This adjustment was recorded through retained earnings with an after-tax impact of $8.7 million.

Our day two adjustment incorporated an unemployment forecast that showed significant deterioration, driving $6.9 million of provision through the income statement. Remaining provision expense for the quarter was primarily related to charge-offs, which I will cover in a moment. The coverage ratio at quarter-end was 1.34%, 39 basis points higher than it was at December 31, 2019.

Charge-offs in the quarter were $10.1 million, $8.4 million higher than the first quarter of 2019, primarily due to the partial charge-off of a single C&I loan. This credit has been on our books for more than five years. This was a business that had been in operation for more than 75 years as a distributor of supplies and equipment for the hospitality industry in western and downstate New York. We were monitoring this credit exposure closely for all of 2019. And most recently, we were working with management to consider their acquisition of the company based on a viable business plan and refreshed capital structure, including a combination of equity and senior subordinated debt.

Although the loan was current and paid as agreed at year-end, there were weaknesses in current performance impacting its outlook. After the pandemic shut down the primary markets of this company, hospitality, hotels and restaurants, and eliminated geographic access to the regions they were servicing, including Metro New York, the company announced it was ceasing operations on March 27 due to the impact of COVID-19 and insurmountable economic challenges. This resulted in the partial charge-off of $8.2 million of the $11.9 million loan, pending liquidation of the underlying collateral.

Net interest income for the quarter was $33.1 million, relatively unchanged as compared to the linked quarter. Net interest margin was 3.31%, down 2 basis points from the linked quarter as a result of lower rates due to Fed actions in the latter part of the quarter. The average yield on interest earning assets was 4.15%, a decrease of 7 basis points from the linked quarter. Cost of funds was 84 basis points, a decrease of 5 basis points.

Non-interest income was up $295,000 from the fourth quarter of 2019. The key drivers were, first, insurance income was up $468,000, primarily due to contingent revenue received in the first quarter each year. Second, we incurred a net loss on tax credit investments of $40,000 as compared to a net loss of $528,000 in the linked quarter. As a reminder, the benefit associated with these tax credit investments is recorded below the line as a reduction of income tax expense. These factors were partially offset by lower income from derivative instruments. We had another strong quarter of commercial lending interest rates swap transactions. However, net income from this category was $515,000 lower, primarily because of a credit valuation adjustment associated with our swap portfolio that was driven by the decline in interest rates.

Non-interest expense was $27.7 million, an increase of $954,000 from the linked quarter. The largest contributors to the increase were salaries and benefits, which were $345,000 higher due to investments in personnel and the timing of merit increases. Occupancy and equipment was $310,000 higher, largely due to snow removal expense, which is generally highest in the first quarter each year. Professional services expense was up $346,000 because of the timing of audit fees that are typically highest in the first quarter each year, combined with higher fees in connection with consulting and advisory projects. These increases were partially offset by a decrease of $671,000 in advertising and promotions expense. This expense is typically lowest in the first quarter of each year. In addition, advertising activity was reduced in March due to the COVID pandemic.

Income tax expense was $322,000 in the quarter, representing an effective tax rate of 22.2%.

Moving on to the balance sheet. Growth in total loans was muted in the quarter, with an increase of 0.5% from year-end. Commercial business and residential loans grew 2.9% and 1.3% respectively, while commercial mortgage was relatively flat and consumer indirect continued to decline. Commercial mortgage experienced higher payoffs than the prior quarter, driving the relatively flat linked-quarter performance.

Total loans increased 4.1% from March 31, 2019, led by 11.5% growth in commercial mortgage, 8.4% growth in residential loans and 6.3% growth in commercial business, partially offset by a 6.5% decrease in consumer indirect.

Total deposits at quarter-end were $232 million higher than the end of the fourth quarter of 2019. The increase was driven by $268 million of growth in customer deposits, excluding CDs, partially offset by decreases in customer CDs of $13 million and brokered deposits of $23 million. Customer deposits excluding CDs includes consumer, commercial, municipal and reciprocal deposits. The first quarter growth of $232 million was driven by $175 million of public deposit seasonality.

Total deposits at quarter-end were $278 million higher than March 31, 2019. This increase was driven by $230 million of growth in customer deposits, excluding CDs, plus $112 million of growth in brokered deposits, partially offset by a decrease in customer CDs of $64 million. We increased our brokered deposit portfolio to reduce reliance on FHLB secured borrowings and improve our available committed liquidity.

During a normal call, at this time, I would provide our current outlook in key areas. However, we are not operating in normal times. The COVID-19 crisis is expected to continue and it will have financial impact on our results in the second quarter of 2020 and beyond. As a result of this rapidly evolving situation and high degree of uncertainty, we do not believe we can estimate the impact to financial and operational results with reasonable accuracy. Therefore, we are not providing guidance this quarter and you should not rely on the 2020 guidance we previously provided.

With that said, I'll now turn the call back to Marty for closing remarks.

Martin K. Birmingham -- President and Chief Executive Officer

Thank you, Justin.

While we have been incredibly busy operating in our new temporary normal, addressing a multitude of issues related to COVID, we have also continued to advance several important projects, including our digital banking platform and enterprise standardization project. Five Star Bank digital banking will completely replace our existing digital platform for consumer and commercial customers and significantly improve the user experience across all devices.

COVID-19 is driving even faster changes in the way customers are learning to interact with us, and our digital upgrade will empower them. It is a critically positive development that we believe will position us well in the future as consumer and commercial customers increase their reliance on digital solutions. We were concerned about launching our new digital offerings in the middle of a crisis. So we reached out to several customers and asked if they want us to go ahead with the launch or wait due to the current environment.

Most respondents indicated that they wanted us to move ahead. This, combined with our determination that the benefits offered by the new platform would greatly benefit customers during this time when they need to be able to interact with us digitally more than ever prompted us to move forward. The transition of customers to the new platform will be completed in multiple waves over the course of the next few weeks. We launched the first wave last week and moved 17,000 customers. The process was not without issues, but we saw outstanding teamwork and willingness to help from individuals across the organization to assist with the process and calls from customers. Our vendor advised that results after day four compared favorably to other institutions and we've received numerous customer testimonials about positive experiences. We're proud of these huge wins and look forward to wrapping up the conversion later this quarter.

Our enterprise standardization program is also advancing. We continue to evaluate activities and functions across the organization, focusing on ways to improve operational efficiency while enhancing the employee and customer experience. We expect this program to result in improved efficiencies and enhance profitability, and we are committed to following through on this initiative in the current operating environment.

While we are experiencing many challenges in today's environment, we're seeing some favorable outcomes and trends. Our ability to help customers and potential customers is demonstrating the benefits of local management and decision-making, and we believe customers will move additional business to us and that we will gain new customers. We're using the Paycheck Protection Program as an opportunity to deepen existing relationships and develop new relationships. We believe all of this will in turn aid future deposit growth.

We are seeing significant mortgage origination activity and believe we are lending prudently. This is another important way we can take care of families and our communities. We're reviewing metrics for underwriting and pricing across all of our lending platforms. We are doing it carefully and thoughtfully, weighing risk and reward to maximize profitability while continuing our strategic focus on the importance of credit discipline. Across the banking, wealth management and insurance lines of business, we're staying close to our customer base. Our associates have been reaching out to customers since the beginning of the crisis to find out how we could help, given each unique business circumstance.

We're operating in uncertain times and there are just too many variables to provide guidance on expectations. As the situation develops and we better understand the impacts on our Company, we will continue to communicate with shareholders on our evolving strategies and expectations. As I stated in my opening comments, we remain focused on taking good care of our customers and managing our Company to successfully navigate this crisis.

Notwithstanding CECL and the impact of one credit, our core operating performance in the quarter demonstrated strong fundamentals. We are moving forward with our enterprise standardization program and other strategic initiatives and are focused on driving positive operating leverage for the year. With the assistance of our dedicated associates, I believe we will come through this stronger than ever.

Operator, this concludes our prepared comments and we are ready to open the call for questions.

Questions and Answers:

Operator

[Operator Instructions] Our first question today comes from Alex Twerdahl from Piper Sandler. Please go ahead with your question.

Alex Twerdahl -- Piper Sandler -- Analyst

Hey, good morning.

Martin K. Birmingham -- President and Chief Executive Officer

Good morning, Alex.

Justin K. Bigham -- Executive Vice President and Chief Financial Officer

Hey, Alex.

Alex Twerdahl -- Piper Sandler -- Analyst

First off, it sounded to me, Justin, in your prepared remarks with respect to CECL that really the big driver of CECL for you guys is national unemployment versus things like GDP decline and things like that. I was just wondering if you could kind of share with us what the inputs are to that model right now, what you kind of assuming unemployment goes to, etc., so we can kind of get a better sense for how you're putting it all together.

Justin K. Bigham -- Executive Vice President and Chief Financial Officer

Sure, Alex, happy to do that. So our portfolio is -- the primary driver of our CECL calculation is national unemployment as I stated and as you pointed out. We used our Q2 unemployment figure of approximately 11%, and then it scales down from there for future quarters, and we used a Bloomberg weighted average at quarter-end to do that estimate.

Alex Twerdahl -- Piper Sandler -- Analyst

Okay. And then talk a little bit more about this specific net charge-off. You gave some good details on the type of business and what they're going on. But it sounds to me like the main driver of them becoming a charge-off or that loan becoming a charge-off this quarter was the fact that the business decided to cease operations before the end of the quarter.

Can you just talk a little bit and get us a little more comfortable with the remaining kind of, quote unquote, high-risk exposure that you define here as 12%? Are there any other of those loans that would be on a watch list at similar type of a situation where if they ceased operations, they could result in something similar in the second quarter?

Martin K. Birmingham -- President and Chief Executive Officer

Sure, Alex. It's Marty speaking. The credit we talked about, as you know, watching our performance over the last five or six years, generally we have had credits experienced issues with their industry or the life cycle of their business, etc. And obviously, we've tried to be very thoughtful and transparent with the specific credit that we've talked about in our disclosures.

Otherwise, we have supplemental investor materials and our earnings presentation that we've also posted with our earnings press release. And on slide 17, we talk about the information you're referencing. We have analyzed the situation in terms of what we know today of industries having sensitivity in construction and retail, lodging, restaurants and food and entertainment recreation, auto related, etc. So, those were good credits when we underwrote them. They're good strong management teams. It's consistent with our historic performance. But in the COVID environment where the economy is shutdown, these are the industries and the exposures that we are looking at even more carefully. And depending upon how long the situation goes on for will impact and influence what happens with these credits.

But we remain optimistic with our exposures as we've identified. But we've tried to be, again, transparent with how we're thinking about those industries and the resulting exposure. But we'll know more as this COVID crisis continues to evolve. The other comment I'll make is that we haven't had any similar deterioration with our commercial customers to date.

Alex Twerdahl -- Piper Sandler -- Analyst

Okay. And then when I look at the earnings release, one thing that kind of jumped out at me is the savings accounts and the money market accounts. Their rates actually increased in the first quarter. Is that because of the brokered deposits that you guys put on? Or is there something else going on there?

Justin K. Bigham -- Executive Vice President and Chief Financial Officer

So, Alex, I can take that question. So, as you probably also noticed, our CD portfolio is also starting to run down. So some of what we're seeing is our CD customers. We do have some of the CD customers that are rolling off electing to take advantage of an intro rate on our money market. So I would say that the primary driver of what you're seeing in the rate on the money market there is the intro that the folks are electing to take advantage of as they rotate out of CDs.

Alex Twerdahl -- Piper Sandler -- Analyst

Okay. And then, if I remember correctly, you guys are fairly close to liability sensitive, if not a little liability sensitive. So I understand you're not giving guidance on the margin. But would it be fair to assume that those liabilities are going to reprice fairly quickly over the next couple of months just given what the Fed has done with rates and potentially faster than -- assets will come down and therefore you could get a little bit of margin expansion over the next couple of quarters or at least margin flat?

Justin K. Bigham -- Executive Vice President and Chief Financial Officer

Alex, that is a tough question for us to predict. I mean, so much is driven by not only overall rates, but also the level of change and the dramatic reduction in rates. Everything new that we're booking and everything that's variable on the asset side is repricing down a lot more than it would typically reprice down if the Fed only moved 25 or 50 basis points.

And as I'm sure you know, as rates come down your spread almost automatically -- if they go to zero, your spread almost automatically compresses. It's impossible to get as much out of the liabilities as comes out of your asset book because the asset rate is so much higher. So, as we said we're not really guiding right now, but I'm not sure I would assume an expansion of the margin in this environment.

Alex Twerdahl -- Piper Sandler -- Analyst

Understood. Thank you for taking my questions.

Justin K. Bigham -- Executive Vice President and Chief Financial Officer

And then the other variable, Alex, is the PPP loans. Really difficult to know how much we have and how much is going to be on the books. Those are coming on at 1%. So those are also going to impact the margin.

Alex Twerdahl -- Piper Sandler -- Analyst

Great. Thank you for taking my questions.

Justin K. Bigham -- Executive Vice President and Chief Financial Officer

You're welcome.

Martin K. Birmingham -- President and Chief Executive Officer

Thanks, Alex.

Operator

[Operator Instructions] Our next question comes from Damon DelMonte from KBW. Please go ahead with your question.

Damon DelMonte -- KBW -- Analyst

Good morning, everyone. I hope everybody is doing well during these challenging times. First question, just to kind of follow up on Justin's last comment on the PPP participation. I think you guys noted you did around $200 million in loans in the first round, and you're active here in the second round. On that first $200 million of loans, what's the average fee that you expect to realize from those loans?

Martin K. Birmingham -- President and Chief Executive Officer

So the fees range from 1% to 5% based on the size of the loans. We've done loans as low as $35,000 and up to $10 million. I think our average was around $350,000. So at this point, I think, Justin, we, for planning purposes, have kind of plugged an average of 2.5%. But Justin, I would ask you to comment further.

Justin K. Bigham -- Executive Vice President and Chief Financial Officer

Damon, yeah, Marty is accurate. And we're obviously monitoring this very closely. But I think 2.5% is probably a reasonable assumption of where we're averaging right now. And again, with the second round occurring, we don't know what the average size yet is at that second round. So that could change that variable as well.

Damon DelMonte -- KBW -- Analyst

Okay.

Martin K. Birmingham -- President and Chief Executive Officer

I mean, just to confirm. We did $3,100 -- in terms of the range, it was $3,100 to $10 million. Our median loan size was $84,000, and 81% of the loans that we did were under $350,000. So we'll see how all that math works out.

Damon DelMonte -- KBW -- Analyst

Okay. That 2.5% is a good ballpark figure, just from a modeling standpoint. So thank you. And then with regards to loan modifications, can you give us an update as to either the number of loans and the dollar amounts or maybe a breakout between commercial, consumer or residential mortgages?

Justin K. Bigham -- Executive Vice President and Chief Financial Officer

Marty, I can take that if you'd like. Well, go ahead.

Martin K. Birmingham -- President and Chief Executive Officer

Okay. Go ahead, Justin.

Justin K. Bigham -- Executive Vice President and Chief Financial Officer

So, what we've seen so far is residential mortgage -- or residential, I guess, I should say, forbearance is a little north of 5%, 5.5% or so. Consumer, which is primarily our indirect auto book, is about 6% of their -- this is relative to their own portfolios. Large commercial, about 6.5%; and small business, between 7% and 7.5%.

Damon DelMonte -- KBW -- Analyst

Got it. Okay. That's great. Thank you. And then I guess the last question was with regards to that [Indecipherable] the slide number 17 with the higher risk asset classes, that's very helpful. Thank you for that. Just wondering if you could maybe just dig a little bit deeper than that. And are there any notable size loans, particularly in the hotel, motel and lodging or in the restaurant size? Like what's the average size those loan buckets?

Martin K. Birmingham -- President and Chief Executive Officer

We have previously talked on these calls that we try to maintain discipline relative to concentrations and exposures. And I think that still holds true here relative to how we have organized the information on page 17 in terms of the granularity of the portfolios that are represented here. Justin, if you have additional comments I would ask you to jump in.

Justin K. Bigham -- Executive Vice President and Chief Financial Officer

No, I don't really have additional comments there. I mean, Damon, we're not given the size of our organization. Our average loan sizes are not typically as large as the credit that we spoke about earlier in our prepared remarks. So I wouldn't anticipate or I wouldn't make an assumption that we have a whole lot of those in our portfolio. I don't have the current sizes with me at this time. We can certainly follow up with you if necessary. But the thing that I will point out is that our hotels and motels are probably somewhere in the ballpark of 5% or so, which is a pretty small portion of the overall portfolio.

Damon DelMonte -- KBW -- Analyst

Got it. Okay. That's helpful. That's all that I had. Thanks and stay well, everybody.

Martin K. Birmingham -- President and Chief Executive Officer

You too. Thank you.

Justin K. Bigham -- Executive Vice President and Chief Financial Officer

Thanks.

Operator

[Operator Instructions] And we do have an additional question. This comes from Kevin Parks from Parkey [Phonetic] Capital. Please go ahead with your questions.

Kevin Parks -- Parks Capital -- Analyst

Hey, everyone. How is it going?

Martin K. Birmingham -- President and Chief Executive Officer

Good, Kevin.

Justin K. Bigham -- Executive Vice President and Chief Financial Officer

Good morning.

Kevin Parks -- Parks Capital -- Analyst

So sticking with slide 17, the last bullet point, the net revolver draws. Are those draws within those kind of high impact categories? Are those on a portfolio wide basis?

Justin K. Bigham -- Executive Vice President and Chief Financial Officer

Those are on a portfoliowide basis.

Kevin Parks -- Parks Capital -- Analyst

Got it. And I guess, kind of maybe shifting gears a little bit. It wasn't really mentioned expressly in the press release or in general comments. At what point does you guys kind of as a management team or Board start thinking about the dividend policy?

Martin K. Birmingham -- President and Chief Executive Officer

Well, we talk about the dividend with our Board consistently every quarter and, ramping up to declaring a dividend, have a very thoughtful process in terms of our capital allocation strategy, etc., looking at our capital plan and the demand on capital. The dividend has always been an important part of our shareholder experience. So, given where we are with our capital levels today and what we know today we remain comfortable with the dividend as it currently stands.

Kevin Parks -- Parks Capital -- Analyst

Great. Thanks, everyone.

Operator

And ladies and gentlemen, at this point it's showing no additional questions. I'd like to turn the conference call back over to management for any closing remarks.

Martin K. Birmingham -- President and Chief Executive Officer

Thank you, Jamie, and thanks to all who have joined us this morning on this call. We appreciate the opportunity to discuss our results with you, and we look forward to building on the conversation as the year unfolds and hopefully as we continue to move forward in a positive way with the management of the COVID healthcare crisis and getting on with its impact on the economy, our industry, our Company and the future. So we'll look forward to talking to you at the end of the second quarter. Thank you.

Jamie, that concludes our call.

Operator

[Operator Closing Remarks]

Duration: 35 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 and Chief Financial Officer

Alex Twerdahl -- Piper Sandler -- Analyst

Damon DelMonte -- KBW -- Analyst

Kevin Parks -- Parks Capital -- Analyst

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