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First Interstate BancSystem, inc (NASDAQ:FIBK)
Q3 2021 Earnings Call
Oct 27, 2021, 11:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Hello, everyone, and welcome to the First Interstate BancSystem Third Quarter Earnings Conference Call. My name is Harry, and I'll be your operator today. [Operator Instructions]

I will now hand the call over to Lisa Slyter-Bray to begin. Lisa, please go ahead.

Lisa Slyter-Bray -- Executive Assistant

Thanks, Harry. Good morning. Thank you for joining us for our third quarter earnings conference call. As we begin, please note that the information provided during this call will contain forward-looking statements. Actual results or outcomes may differ materially from those expressed by those statements.

I'd like to direct all listeners to read the cautionary note regarding forward-looking statements and factors that could affect future results contained in our most recent Annual Report on Form 10-K filed with the SEC and in our earnings release, as well as the risk factors identified in the Annual Report and our more recent periodic reports filed with the SEC. Relevant factors that could cause actual results to differ materially from any forward-looking statements are included in the earnings release and in our SEC filings. The company does not undertake to update any of the forward-looking statements made today.

A copy of our earnings release, which contains non-GAAP financial measures is available on our website at fibk.com. Information regarding our use of the non-GAAP financial measures may be found in the body of the earnings release and a reconciliation to their most directly comparable GAAP financial measures is included at the end of the earnings release for your reference.

Joining us from management this morning are Kevin Riley, our Chief Executive Officer; and Marcy Mutch, our Chief Financial Officer, along with other members of our management team.

At this time, I'll turn the call over to Kevin Riley. Kevin?

Kevin P. Riley -- President & Chief Executive Officer

Thanks, Lisa. Good morning and thanks again to all of you for joining us on our call today. Again this quarter, along with our earnings release, we have published an updated investor presentation that has some additional disclosures that we believe will be helpful. The presentation can be accessed on our investor website. And if you haven't downloaded a copy yet, I encourage you to do so.

I'm going to start off today by providing an overview of the major highlights of the quarter and then, I'll turn the call over to Marcy, so she can provide more detail on our financials.

During the third quarter, we saw a continuation of positive trends we have experienced this year, most notably, quality balance sheet growth, higher revenue, and disciplined expense management. This resulted in another quarter of strong financial results with net income coming in at $47.1 million or $0.76 a share. This includes $0.08 of merger-related expense and $0.02 of expense related to settlement of legal claims. Excluding these two items, our earnings per share was $0.86 or 25% higher than the prior quarter.

While the quarter had less robust loan growth than we anticipated, we were still able to generate the growth in our operating pre-provision net revenue that we were expecting. Net interest income, excluding PPP, increased at a similar pace as the second quarter. Fee income showed strong sequential increases, and expenses were flat excluding the two items I noted earlier. All in all, it was another solid quarter for us, which is reflective of the underlying strength of our diverse business model.

Despite the supply chain and labor challenges, economic activity in our market remains very healthy, which continues to drive strong inflows of core deposits. Our third quarter is typically our strongest quarter for deposit growth, and this quarter did not disappoint. Total deposits increased $442 million, and close to half of the growth came in non-interest-bearing deposits. These strong inflows have enabled us to continue growing our earning assets and driving increases in our net interest income. As we told you earlier to expect [Phonetic] in July, our net interest income, excluding PPP, was up for the third quarter, and we expect another good quarter to finish out the year.

The healthy economic activity in our market is also having a positive impact on our fee-generating businesses, as most of the major areas were up from the prior quarter resulting in 12% growth in non-interest income. We were able to deliver strong performance despite loan growth coming in below our expectations. Across the organization, we are seeing strong demand and good production with the exception of Wyoming. Excluding Wyoming, our annualized loan growth was over 4% for the quarter.

While our loan pipeline remains healthy, there's three key factors continue to impact both new loan fundings and draws on existing lines of credit. Supply chain disruption and very tight labor market is resulting in more project and planned investments among our commercial clients taking longer to complete or being delayed. The underlying financial strength of our customers in markets, which you see reflected in our stellar credit metrics, is resulting in very little line usage or higher levels of loan payoffs. Competition remains challenging, and we are declining opportunities to extend loan portfolio duration at unprofitable yields.

One of the highlights this quarter is that the investments we've made in technology over the past few years are coming to fruition. We've hit an inflection point in the growth of our digital mortgage application portal. While currently available across the footprint, in a couple of months, we've rolled out training -- in the last couple of months, we've rolled out training to the front line staff on how to assist clients with this process, rather than channeling all mortgage activity coming into our branches to our mortgage loan originators. As a result, the digital channel is now accounting for roughly 5% of our total mortgage application volume, and it is growing rapidly. Once the training is fully rolled out, it should have an even greater impact on volumes and the overall profitability of our mortgage business.

In addition, our small business digital delivery channel has now been rolled out, and we're seeing the applications coming in across our entire footprint. In this initial phase, we're seeing about 27% approval rate with another 19% of the applications being off-boarded to another credit channel. In the first couple of weeks, it resulted in about 1 million of booked loans at attractive risk-adjusted yields with the average balances of around $50,000. As we get larger, this channel will ensure our ability to continue servicing our small business clients across our footprint.

We're excited about the combination of our digital channels in mortgage, credit card, and now, small business, and expect these capabilities to enable higher levels of productivity out of our retail sales force. Of course, the biggest development in the third quarter was the signing of the transformative merger agreement with Great Western Bancorp. Since the announcement of the merger, we've had the pleasure of hosting town halls in Sioux Falls, Des Moines, Omaha, Fort Collins, and Denver and had the opportunity to meet about 70% of the Great Western employees. The response has been overwhelmingly positive, and we are excited to team up with this group of talented bankers.

The bankers recognize the opportunity to attract new clients and expand existing relationships with the collective resources in support of a $32 billion organization. What was evident throughout our travel was how vibrant these markets really are, which gives us increased confidence in our conservative growth assumptions for the next few years from the Great Western footprint. Longer term, we are confident that our exposure to these attractive markets is going to be the higher levels of organic growth than we have historically generated.

Overall, we've gotten off to a good start in our integration planning. Our senior leadership teams are collaborating very well and creating a smooth transition process for employees and customers, as well as developing plans to effectively leverage the collective strength of each organization to provide a superior banking experience and enhance our business development efforts.

Before I turn the call over to Marcy, just a few comments on the Great Western results, you have all likely have seen by now. In short, we are pleased with the quarter and at this point, we see no changes in our expected financial metrics we announced last month. While ex-PPP loan, balances declined a bit more than we anticipated. Much of the decline resulted from the repayment of several criticized and special asset hotel loans we would have designated as PCD loans in our review. They have continued working through their problem loan portfolio, while booking only $4 million in charge-offs this quarter. Another positive note is that in September, they saw a net positive loan growth. So, that is also encouraging. Overall, it looks like we're off to a good start.

And with that, I'll turn the call over to Marcy to provide some additional details around our third quarter results. Go ahead, Marcy.

Marcy D. Mutch -- Executive Vice President & Chief Financial Officer

Thanks, Kevin, and good morning everyone. As I walk through our financial results, unless otherwise noted, all of the prior period comparisons will be with the second quarter of 2021, and I'll begin with our income statement.

On a GAAP basis, our net interest income increased by $8.1 million, which reflects the growth in our earning assets and a $6.4 million increase in PPP loan income. Accretion income was $200,000 lower on a linked quarter basis. Excluding the impact of PPP income, our net interest income increased by 1.7% from the prior quarter or approximately $2 million, which was in line with what we told you to expect last quarter. The increase was primarily attributable to a higher average balance of investment securities. Looking ahead to the fourth quarter, excluding PPP income, we would expect to see continued growth in net interest income, driven by increases in earning assets.

The higher level of PPP income this quarter resulted in a 9 basis point increase in our net interest margin on a reported basis when compared to the second quarter. Excluding PPP from both periods, our net interest margin decreased by 10 basis points. A couple of basis points of that decline is attributable to the adjustment to our dealer reserve we called out last quarter. The balance is due to a shift in our mix of earning assets toward investment securities along with modestly lower loan and security yields. This was offset by a 1 basis point decline in our cost of deposits, resulting from the continued growth in non-interest-bearing deposits.

Having said that, we're encouraged by the fact that yields on new loan production increased by 13 basis points linked quarter to 4.11% and that new money in the investment portfolio is now almost on top of the 1.27% [Phonetic] yields we reported this quarter with a shorter duration. So going forward, we expect our net interest margin to be mostly dictated by the mix of earning assets.

Given the continued growth in the investment securities portfolio, we added another interest rate swap during the third quarter designed to protect our capital and maintain our targeted level of asset sensitivity. Using a laddered approach to managing our interest rate risk, the new swap has a longer maturity than the swap added in the second quarter. More details around this were included in the earnings release. At the end of the third quarter, the duration of the securities portfolio was 3.9 years compared to four years at the end of the second quarter.

Our non-interest income increased $4.4 million quarter-over-quarter to $39.7 million, with most of our fee-generating areas contributing to the increase. Payment service revenues increased by approximately $800,000, due primarily to higher business credit card volume, which reflects the strong economic activity we're seeing in our markets. Mortgage banking revenues increased by $2 million as we've returned to more historic levels of selling our mortgage production into the secondary market during the third quarter.

Looking ahead, we do expect seasonally lower mortgage banking revenues in the fourth quarter, but for the first time in a while, we're beginning to see some positive momentum in our swap [Phonetic] business and should also continue to realize the benefits of a strong equities markets in our wealth management business. We expect non-interest income to be strong for the fourth quarter, but down roughly mid-single-digits from our third quarter high. This guidance assumes no changes in our mortgage servicing rights valuation.

Moving to non-interest expense. We recorded $6.6 million in acquisition expense in the third quarter, as well as $1.2 million for the settlement of legal claims. The legal claims were related to two class action lawsuits that many other financial institutions have also settled in recent years relating to the overdraft and insufficient funds fees. Excluding these two items, our non-interest expense was $98.1 million. This was approximately $1 million lower than the prior quarter, which is right on the target we provided. As such, we continue to expect normal operating expenses to be up approximately 1% year-over-year.

Moving to the balance sheet, our loans held for investment decreased $212 million from the end of the prior quarter, due to a net decline in PPP fees -- PPP loans, excuse me, of approximately $265 million. Excluding PPP loans and deferred fees, total loans held for investment were up $53 million from the end of the prior quarter. Most of the growth came in our commercial real estate portfolio, partially due to the transfer of construction loans into this portfolio. The increase was partially offset by declines in C&I and consumer loans, primarily due to the supply chain and labor issues that Kevin discussed earlier.

As of September 30, we still had approximately $281 million of PPP loans on our balance sheet, net of $13.1 million of associated deferred loan fees remaining. On the liability side, our total deposits continued to increase and were up $442 million from the end of the prior quarter with $201 million of the growth coming in non-interest bearing deposits.

Moving to asset quality, our portfolio continued to perform exceptionally well. We had small declines in non-performing loans and non-performing assets and a $22 million decline in criticized loans as a result of upgrades and pay-offs. Credit losses were very low with only $600,000 of net charge-offs, representing just 2 basis points of annualized average loans in the quarter.

Given the stable asset quality and low level of growth in the portfolio, we did not record any provision expense again this quarter. This kept our allowance as a percentage of loans held for investment relatively stable at 1.4% at September 30. Excluding PPP loans, our allowance represented 1.45% of loans held for investment at the end of the quarter.

With that, I'll turn the call back to Kevin.

Kevin P. Riley -- President & Chief Executive Officer

Thanks, Marcy. Nice job. I'll wrap up the call with a few comments about our outlook. Heading to the end of the year, we expect to deliver another strong quarter. Well, it's difficult at this point to say when the supply chain and labor market issues impacting loan growth might abate. We should be able to continue generating higher levels of net interest income as a result of higher balances of earning assets.

In regards to loan growth, we are well positioned to meet the loan demand within our markets, and we are confident in the ability to continue delivering strong financial results without compromising our pricing and underwriting criteria. We also continue to make progress on our integration planning for the Great Western merger. Again as you have probably seen with Great Western's earnings release, they continue to make progress working through the disposition of loans that we expected to run off after the closing. While that impacts their overall loan balances this quarter, this is just a difference in the expected timing and the progress they are making prior to closing. This is very encouraging to us.

To wrap it up, our house is in good order. Our people are engaged and excited about the future. Our processes and technologies are working well. Our balance sheet is well positioned for this environment, and our capital levels are robust. We have a proven track record of enhancing the value of our franchise through acquisition, and our shareholders have been rewarded for their support as we've executed on our strategy. We are confident they will continue to be rewarded as we realize the substantial long-term benefits from the combination with Great Western.

So with that, I'll open the call up for questions.

Questions and Answers:

Operator

Thank you, Kevin. [Operator Instructions] And our first question comes from Jeff Rulis from D.A. Davidson. Jeff, your line is now open if you'd like to proceed.

Jeffrey Rulis -- D.A. Davidson & Co. -- Analyst

Thanks. Good morning. Kevin, just wanted to follow up on the Great Western results. Again further credit progress in the most recent quarter, and I just wanted to -- to the degree that that expected run-off is occurring or what you had anticipated following the close if that continues to clean up. I guess, I just wanted to circle back to your expectations. I think you mentioned that those haven't altered much given the latest results, but you did mention it as the conservative outlook in terms of the growth. So, it's either the credit work you've got to complete and then, the kind of the flip to growth which they saw a little bit in September. Just an update on that conservative outlook, if you wanted to kind of further discuss that Kevin would be helpful.

Kevin P. Riley -- President & Chief Executive Officer

Well, I think when we announced the transaction, we talked about that we would have to kind of run off some of those maybe problem assets as we move forward and that would have a drag on maybe our organic loan growth in the years to come. If they're able to clean up a lot of that earlier, then we probably will have earlier organic loan growth upon the completion of the acquisition.

Jeffrey Rulis -- D.A. Davidson & Co. -- Analyst

And just to kind of reengage with that milepost, I think the standard growth rates were sort of mid-single -- low-to-mid single-digit for the first year following conversion. Could you just kind of update us back to what those mileposts were?

Kevin P. Riley -- President & Chief Executive Officer

Yeah. They were mid-single-digits with the offset being taken care of some of their criticized assets. So, if that is taken care of prior to the closing, which I don't think all of it's going to be done. I think they're doing a great job and that their management team should actually be commended for the efforts that they're putting, but -- which would have less of an impact on that mid-single-digit growth number.

Jeffrey Rulis -- D.A. Davidson & Co. -- Analyst

The last question related to the Great Western. The timing of that close, are you getting any more visibility in terms of the first quarter? Is that early, middle, late? Too early to tell so?

Kevin P. Riley -- President & Chief Executive Officer

It's kind of too early, but I'll tell you, there appears to be a little bit of delay on some of these acquisitions being approved. I think you saw one today, they announced a little bit of a delay. What we're hearing and this is just anecdotal -- what we're hearing on the Street is that the Fed is really not making many decisions right now or approving transactions until there is a decision on the leadership changes that might occur in the Fed. So, I think once that is cleared up, that logjam will be also cleared. So, it may might delay us but again, the sooner that announcement happens, the quicker this could be approved and moved forward. So, we are still expecting the first quarter. However, if it falls in the beginning of the second quarter, it's really not going to change much of the metrics of the deal.

Jeffrey Rulis -- D.A. Davidson & Co. -- Analyst

Got it. And last one is jumping to the fee income line items. Just your thoughts on gain-on-sale and the payment services showed a little light in the quarter and granted some seasonality there. But if we wanted to kind of extend that into '22, high level expectations for those line items?

Marcy D. Mutch -- Executive Vice President & Chief Financial Officer

We're kind of in that process right now, doing our budget, Jeff. And so, I would expect us to continue to grow those line items, as we go into 2022, especially, if we see any changes in supply chain issues or labor issues. As people have the ability to spend more because the goods and services they want are actually out there, I think we'll see some increases in those line items.

Jeffrey Rulis -- D.A. Davidson & Co. -- Analyst

Okay. And Marcy, while I have you, the non-interest expense guide, the 1% growth is off of the $98.1 million [Phonetic] core or what was that again, just what the 1%...

Marcy D. Mutch -- Executive Vice President & Chief Financial Officer

It's off of last year's, so -- yeah, it's off of last year's numbers, but I would expect our expenses to come in fairly consistent with this quarter rate -- operating run rate.

Jeffrey Rulis -- D.A. Davidson & Co. -- Analyst

Got it. Okay. Thank you.

Operator

Thank you, Jeff. And our next question comes from Jared Shaw from Wells Fargo Securities. Jared, your line is now open. So, please proceed.

Jared Shaw -- Wells Fargo Securities -- Analyst

Thanks. Good morning, everybody.

Kevin P. Riley -- President & Chief Executive Officer

Good morning, Jared.

Jared Shaw -- Wells Fargo Securities -- Analyst

I guess, hey, just looking at the liquidity here, you're continuing to see really good deposit growth. You're growing cash balances even as you're growing the securities book. How should we be thinking about cash going into the deal? And then, do you have a target for cash as a percentage of assets sort of coming out of the deal, if we're still on this similar rate environment?

Kevin P. Riley -- President & Chief Executive Officer

Jeff, that -- every time we think we're making progress and putting our cash to work more rolls in. So, we're going to continue working that down as we move in toward the deal. So, we're not going to rush into it, but we are slowly going to make points because again, I never like to pick the market of when you want to invest cash. So, we're going to continue working that down. It's there and [Indecipherable] got a lot of it, but deposits keep on flowing in and PPP loans keep on getting forgiven and cash keeps rolling in. So, we're trying to put it to work in a very prudent manner. And we'll continue to work that down. So, do I like to see $2 billion of cash on the balance sheet? Not really. So, we're going to continue working that down in the most prudent manner possible.

Jared Shaw -- Wells Fargo Securities -- Analyst

Okay. Thanks. And then, looking at loans this quarter, saw some good growth in the average balances. I know that there is sort of the impact of paydowns and payoffs that could potentially happen at the end of the quarter. But as we look forward into fourth quarter, should we still -- should we be expecting growth in average loans ex-PPP?

Kevin P. Riley -- President & Chief Executive Officer

Yes.

Jared Shaw -- Wells Fargo Securities -- Analyst

Okay. So -- OK, that's good. And then, finally for you just on the allowance ratio, what's sort of the thinking about the timing of being able to approach day one levels and does the timing of the deal impact your thoughts around allowance and qualitative reserves at all?

Marcy D. Mutch -- Executive Vice President & Chief Financial Officer

So, the timing of the deal does not impact our thoughts on that, but now that we're seeing some consistency in unemployment rates nationally and they're aligning with our markets, and we're seeing improvement in our economies, we are going to need to be able to look at those qualitative factors and perhaps adjust them to begin to release additional allowance, if we don't see the loan growth to absorb that. So, yeah, it's something that's on our radar, and I think you'll begin to see that start to come down toward day one levels.

Jared Shaw -- Wells Fargo Securities -- Analyst

Okay.

Marcy D. Mutch -- Executive Vice President & Chief Financial Officer

As we go forward.

Jared Shaw -- Wells Fargo Securities -- Analyst

Great. Thanks for the answers and we will talk to you soon.

Kevin P. Riley -- President & Chief Executive Officer

All right, Jared. Thank you.

Marcy D. Mutch -- Executive Vice President & Chief Financial Officer

You bet. Thank you.

Operator

Thank you, Jared. [Operator Instructions] And it appears we have no further questions. So I'll hand back to Kevin.

Kevin P. Riley -- President & Chief Executive Officer

Thanks, Harry. Thank you all for, again, all your questions and joining us on the call today. As always, we welcome calls from our investors and analysts. Please reach out to us, if you have any follow-up questions. Thank you for tuning in today. Goodbye.

Duration: 27 minutes

Call participants:

Lisa Slyter-Bray -- Executive Assistant

Kevin P. Riley -- President & Chief Executive Officer

Marcy D. Mutch -- Executive Vice President & Chief Financial Officer

Jeffrey Rulis -- D.A. Davidson & Co. -- Analyst

Jared Shaw -- Wells Fargo Securities -- Analyst

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