First Interstate BancSystem - Q2 2023

Transcript

Operator (participant)

Listeners to read the cautionary note regarding forward-looking statements 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 in 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.

Kevin Riley (President and CEO)

Thanks, Andrea. Good morning. Thanks again to all of you for joining us on our call today. 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 relations website, and if you haven't downloaded a copy yet, I encourage you to do so. I'm going to start today by providing an overview of the major highlights of the quarter, and then I'll turn the call over to Marcy to provide more details on our financials. We performed well in a difficult environment during the second quarter, reflecting the strength of the franchise we've built. While we've seen pressure on deposit costs, balances performed as expected, benefiting from the strength of our markets and the diversity of our client base.

We have not had to take any extraordinary measures around liquidity. Credit continues to perform well, our capital is strong, and importantly, we are beginning to see some stabilization in our net interest margin, which has remained flat around 3% for May, June and July. Though we expect the environment to remain challenging for the banking industry for the remainder of the year, we are well positioned to play offense. We generated $67 million in net income, or $0.65 per share in the second quarter, which includes $0.01 of severance expense, primarily related to the strategic repositioning of our home lending business, which we will discuss later in the call. As we indicated on our last earnings call, we did not see any meaningful disruption in customer behavior following the bank failures in March.

During the second quarter, it was very much business as usual in what we would characterize as a relatively normalized operating environment. We continue to see healthy economic conditions throughout many of our markets, and most notably in tourism and in the agricultural industries, where clients are performing well. In particular, Yellowstone is having a very strong tourist season, with a number of visitors to the park up 19% compared to the first six months of last year. We've seen sufficient moisture over most of our footprint, which bodes well for our ad clients. While deposits declined about 2% in the second quarter, this result was very much in line with the expectations we spoke to in April. Importantly, throughout the quarter, balances expressed very normal seasonality. We saw expected outflows in the first half of the quarter, with broad seasonal strength into the end of June.

For the month of June, total balances grew $375 million, or 1.6%, which is partially a result of our success in new client acquisition. It is worth noting that we continue to have no brokered deposits on our balance sheet. Our non-interest-bearing deposits showed resiliency, and while down for the quarter, balances ended June modestly higher than April. Given the strength of our balance sheet and the reputation we have developed for providing superior level of service, we have been able to effectively capitalize on the current environment. Given our advantageous loan-to-deposit ratio, we have strategically raised our rates to provide a competitive value proposition to our current clients, which we believe is the right thing to do.

At the same time, we are selectively raising rates and adding products to support new business development efforts, targeting new clients where we have the opportunity to develop deeper, more profitable relationships over the long term. As we indicated on prior calls, we continue to be thoughtful regards to new loan production, maintaining strong underwriting criteria and discipline in our pricing. As we expected, this resulted in a lower level of loan growth in the second quarter, but with improved risk-adjusted yield. We expect both trends to continue for the balance of the year. Excluding draws on construction lines, the average yield on new loans fundings in the second quarter was up about 80 basis points from the prior quarter to 7.1%. Asset quality also remains strong.

Although we saw a modest increase in non-performing and criticized loans this quarter, those balance make up just 51 basis points and 350 basis points of loans held for investments, respectively. Looking forward, based on our current evaluation of the loan portfolio, we anticipate a reduction in criticized balances over the remainder of the year. Charge-offs increased to $11.4 million this quarter, with about 85% coming from the restructuring of a single metro office construction property that we've discussed in the past. With the recent restructure, we expect this credit to perform going forward. Outside of this one credit, losses were negligible. With that, I'd like to turn the call over to Marcy to provide some additional details around the second quarter results. Go ahead, Marcy.

Marcy Mutch (CFO)

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 first quarter of 2023, and I'll begin with our income statement. Our net interest income decreased by $20.5 million, which was primarily due to an increase in our interest expense, resulting from higher rates on interest-bearing deposits and a shift in our funding mix toward higher cost, short-term borrowings, and interest-bearing deposit accounts. Purchase accounting accretion was also $600,000 lower quarter-over-quarter. Our reported net interest margin decreased 24 basis points from the prior quarter to 3.12%.

Excluding purchase accounting accretion, our adjusted net interest margin also decreased by 24 basis points to 3.05% from the prior quarter, as the 9 basis point increase in the average yield on earning assets was more than offset by the increase in our total cost of funds. Looking to the balance of the year, given the recent trend in our deposit costs, we are now expecting our interest-bearing deposit beta to reach the low to mid-30% range by the end of the year. This outlook assumes one additional 25 basis point rate hike in the second half of 2023. As Kevin noted, in June and July, our net interest margin was around 3%.

Under the repricing assumptions just noted, and assuming deposits remain stable through the end of the year and average earning assets approximate $28 billion, we would now expect this to approximate the net interest margin for the balance of the year. Our total non-interest income increased $27.7 million quarter-over-quarter, primarily due to the $23.4 million loss on investment securities and the $1.9 million net write-down to the fair value of loans held for sale recorded during the first quarter. Excluding these items, non-interest income increased about 6% from the prior quarter. This was primarily due to higher levels of payment services revenue, as we saw the impact of greater transaction volume driven by normal seasonality in our markets, as well as modestly higher mortgage banking revenue and service charges on deposit accounts.

Based on the first half of the year and the trends we're seeing, we expect quarterly fee income for the balance of the year to increase low to mid-single digits from the reported second quarter. This outlook is in line with the improvement in the second half of the year we have been expecting. Moving to total non-interest expense, we saw a continued decline as we remained vigilant to control expenses, with operating expenses down $1.9 million from the prior quarter. Results in the second quarter included $1.9 million in severance expense, mostly related to the restructuring of the mortgage business. Excluding this item, expenses declined 2% from the prior quarter to $162 million. At this point, we would expect this to be a good approximation for the run rate over the rest of the year.

This run rate does not include any impact from the FDIC special assessment. Moving to the balance sheet, our loans held for investment increased $18 million from the end of the prior quarter, with growth in the commercial real estate and ag portfolios offsetting slight declines in the commercial and consumer portfolios. The securities portfolio declined about $250 million in the quarter, partly due to higher unrealized losses, but also from normal monthly cash flow that is not being reinvested. We would expect the portfolio to continue to decline and have provided a new disclosure related to the expected quarterly cash flows on slide 18 of the investor deck. On the liability side, our total deposits decreased $528 million.

We saw declines in most categories, which were partially offset by increases in our balances of time deposits as we see more customers taking advantage of attractive CD rates. Again, as Kevin noted, we have no broker deposits on the balance sheet. Short-term borrowings also declined from the prior quarter end. Moving to asset quality, non-performing assets increased $8.5 million, and criticized loans increased $20 million from the prior quarter, which was partially attributable to problem loans moving through the credit administration process. Outside of these loans, the remainder of the portfolio continues to perform well. Based on current projections, we expect to see asset quality improvement for the balance of the year.

Our net charge-offs were $11.4 million, or 25 basis points of average loans in the quarter, driven primarily by the one charge-off on a metro office property that Kevin discussed earlier. Our provision covered our net charge-offs this quarter, and with total loans being relatively flat, our allowance for credit losses percentage remained relatively unchanged at 1.23% of total loans held for investment. Lastly, while AOCI offset the growth in retained earnings this quarter, which resulted in modest reductions to book value and tangible book value, our regulatory capital ratios all strengthened as we are proactively managing our risk-weighted asset exposure while continuing to support the strategic growth of the company. With that, I'll turn it back over to Kevin. Kevin?

Kevin Riley (President and CEO)

Thanks, Marcy. I'll wrap up with a few comments. Given the relative stability in our outlook from here, the strength of our balance sheet and the strength of our footprint, we continue to believe First Interstate is well positioned to play offense. As such, we are moving forward with several initiatives to further strengthen the franchise and improve our ability to generate long-term profitable growth. One of these initiatives is a shift in our mortgage business away from a mortgage loan originator model. We have implemented a new digital loan origination system, enabling us to push the sourcing of loans across our branch network, while the underwriting and the fulfillment is now fully centralized.

Not only will this improve our operational efficiencies for the benefit of our people and our clients, but it's much more cost-effective delivery mechanism for the company, allowing this product to be more profitable and more scalable in the future. As part of this restructure, we have eliminated most of our MLO positions, which contributed to the severance expense this quarter that Marcy mentioned earlier. Going forward, we will look to leverage our network of more than 300 retail branches to generate referrals for our digital mortgage loan origination platform, and we will incent our retail staff for leads they generate. We have just launched this program, but the initial results are encouraging, and we are excited about the possibilities.

In August, we will be introducing our new suite of consumer credit cards, which will offer a more robust set of benefits and a more competitive and user-friendly rewards program. We believe this new suite of cards, along with our marketing initiatives, will help us achieve our goals of growing our customer base and expanding existing customer relationships, particularly in our new markets. We are also strengthening our commitment to being a good corporate steward and reducing our carbon footprint through the investment in two solar projects, one in Iowa and one in Oregon. The electricity generated by these two projects will offset a good portion of the Scope 2 emissions from our operations in these two states. Heading into the second half of the year, we will continue to prioritize prudent risk management and expect to deliver solid financial performance.

Expect us to remain thoughtful regarding new loan production, which will likely result in a full-year loan growth being in the low single-digit range. Finally, we are pleased to announce that the board has approved a $0.47 dividend for the third quarter. Given the strength of our balance sheet, the prospective earnings power of the company, and our high and growing capital ratios, we are well positioned to maintain our dividend at the current level, which is an important component of the total return that we deliver to our shareholders. With that, we'll open the call up for questions.

Operator (participant)

Thank you. Ladies and gentlemen, should you have a question, please press the star followed by the one on your touchtone phone. If you'd like to withdraw your question, please press the star followed by the two. If you're using a speakerphone, please lift the handset before pressing any keys. One moment, please, for your first question. Your first question comes from Jared Shaw from Wells Fargo. Please go ahead.

Jared Shaw (Senior Equity Analyst)

Hey, good morning, everybody. Can you hear me? Hello? Hello. Hello.

Marcy Mutch (CFO)

Can you hear me, Jared?

Jared Shaw (Senior Equity Analyst)

Hello? Can you hear me, Marcy?

Marcy Mutch (CFO)

Can you hear us?

Jared Shaw (Senior Equity Analyst)

I can hear you.

Kevin Riley (President and CEO)

Okay.

Jared Shaw (Senior Equity Analyst)

Maybe starting with deposits. Do you think we're at a floor for dollars of DDA here, or is there, yeah, still more pressure on sort of the dollars of DDA?

Kevin Riley (President and CEO)

Non-interest bearing, you're talking about, Jared?

Jared Shaw (Senior Equity Analyst)

Yes.

Kevin Riley (President and CEO)

Well, we've seen some stabilization in that, but we're still projecting that there'll be some deterioration as we move through the remainder year, but we are seeing some stabilization in that.

Marcy Mutch (CFO)

Jared, by the end of the year, we're thinking, you know, non-interest bearing should be about 25% of total deposits.

Jared Shaw (Senior Equity Analyst)

25% with the overall balance of deposits still following those trends in June, still seeing an upward bias as we go through the year?

Marcy Mutch (CFO)

Yeah, flat deposits through the balance of the year.

Jared Shaw (Senior Equity Analyst)

Okay, then on the loan yields, it's, thanks for the color on loan yields, ex construction. What's the balance of remaining construction loans that could be funded? Should we be what's the timing of the funding of those loans?

Marcy Mutch (CFO)

There's still about $1.1 billion to be funded. They spend around $75 million a month.

John Heyneman (Shareholder)

Jared, it's John. The yield on the funding commitments is just over 5.3%. As we roll forward, that yield drag that we were referencing, that will lessen as the year goes on. It's about $75 million a month, as Marcy mentioned, but the funding, you know, kind of picks up as the year progresses.

Jared Shaw (Senior Equity Analyst)

Okay. Okay, that's good. Thanks. When we look at the securities cash flow slide, should we just assume that you use that to pay down FHLB? As we move forward, should we assume that securities are smaller as a percentage of assets and that wholesale funding goes lower?

Kevin Riley (President and CEO)

Yeah. I use it for loan growth, we'll be paying down our funding.

Marcy Mutch (CFO)

We expect loan growth to be pretty modest into the back of the half of the year.

Jared Shaw (Senior Equity Analyst)

Okay. Thanks. I guess just finally, for me, you know, when you look at the rollout of cards that you're talking about, how is the proposed legislation, the proposed Durbin legislation on interchange, does that impact your timing or your enthusiasm for that, for that product?

Kevin Riley (President and CEO)

No.

Marcy Mutch (CFO)

No.

Jared Shaw (Senior Equity Analyst)

If for some reason that went through, that wouldn't change the economics of rolling that out?

Kevin Riley (President and CEO)

The thing is, is that, first of all, I'll be honest with you, I am not fully aware of the new amendment or law you're talking about, because Durbin usually is on debit cards, it wasn't on credit cards. you know, if they're going toward credit card, it is going to hurt the economics of the product.

Jared Shaw (Senior Equity Analyst)

Okay. Yeah, there's a proposed legislation to have the interchange impact credit cards as well. It feels like it's a long shot, but it seems like they're trying to sneak it in on must-pass legislation.

Kevin Riley (President and CEO)

That will have an impact on us and every other bank.

Jared Shaw (Senior Equity Analyst)

Yeah.

Kevin Riley (President and CEO)

Yeah.

Jared Shaw (Senior Equity Analyst)

Okay. All right. Thanks, guys.

Operator (participant)

Your next question comes from Brody Preston from UBS. Please go ahead.

Brody Preston (Equity Analyst)

Hi. My question is on the NII guidance. If I'm looking at that, it kind of implies a flattish NII on the back half of the year. I was just curious if there are any factors or any levers you could pull that would cause it to be either above or below that?

Kevin Riley (President and CEO)

The only factors would be, is really, as we've touched back in the past, it's really based on, you know, our assumption on deposits right now. You know, deposits balances have been stable since the end of April to date. If deposits continue to perform the way we think they're going to perform seasonally through the remainder of the year, or grow, then that should be stable.

Brody Preston (Equity Analyst)

Gotcha. Then just on the Metro Office construction project, I was just hoping for a little more color on that. Like, what Metro was it in? Yeah, any details you can give on that one. Plus, are there any updates on the two CRE NPLs from last quarter?

Kevin Riley (President and CEO)

The metro office that we talked about today was the one that was in Seattle we talked about, and we have a qualified new tenant going into that. We took a charge off, brought it down to the level, and we get some more equity coming from the investor. From this point forward, we're looking at that one should perform, going well going forward, but it did cost us a little bit to get it into that position.

Marcy Mutch (CFO)

That was the one that we talked about last quarter. So it should be resolved, the one in Seattle.

Brody Preston (Equity Analyst)

Understood. Thank you. Just the last one from me. On the expense base, is there any other opportunities to rationalize that outside of the mortgage that you guys announced this quarter?

Kevin Riley (President and CEO)

We continue to look at that as their staff turnover, we continue to look at the fact, you know, are they needed? Part of the goal we had this year at First Interstate, we're working on, and we don't have any kind of estimates on that, is that we're looking at processes to automate some manual processes in the back room. You know, where there's a number of processes that are done, and then re-entered into the operational group. We're looking to automate that so it flows straight through. There are some possibilities to eliminate some staff and operations as we modernize some of the processes.

Brody Preston (Equity Analyst)

Great. That's it for me. Thanks for taking my questions.

Kevin Riley (President and CEO)

Thanks.

Operator (participant)

Your next question comes from Chris McGratty, from KBW. Please go ahead.

Nick Moutafakis (Assistant VP of Equity Research)

Hi, this is Nick Moutafakis is on for Chris McGratty. Good morning, guys.

Kevin Riley (President and CEO)

Good morning, Nick.

Nick Moutafakis (Assistant VP of Equity Research)

Maybe just on the, on the deposits, just on going back to the NIBs, are you seeing primarily outflows from the commercial side on the NIB mix? Is there any, you know, catch up in the retail, you think, on a go-forward basis?

Kevin Riley (President and CEO)

Actually, seasonally, we're seeing, commercial grow and, the downward trend is a little bit more on the retail side. Seasonally, that's what we're expecting, and we are seeing that our commercial balances are growing.

Nick Moutafakis (Assistant VP of Equity Research)

Okay. maybe just on the, on the CDs, what's the, the duration on that, portfolio now? Is it relatively short or?

Kevin Riley (President and CEO)

Most of the CDs that we're putting on is like 12 months or less. The duration is pretty short.

Nick Moutafakis (Assistant VP of Equity Research)

Okay. Just trying to get a sense, you know, if the forward curve plays out and we start to get cuts in 2024, just if you can make a comment on how you think the margin reacts to rate cuts on the way down?

Kevin Riley (President and CEO)

Right now, we would characterize ourselves as slightly liability sensitive, and that, we would benefit on a downward rate cuts.

Nick Moutafakis (Assistant VP of Equity Research)

Okay. Thanks, guys.

Kevin Riley (President and CEO)

Thank you, Nick.

Operator (participant)

Ladies and gentlemen, as a reminder, should you have a question, please press the star followed by the one. Your next question comes from Jeff Rulis from D.A. Davidson. Please go ahead.

Jeff Rulis (Managing Director and Senior Research Analyst)

Thanks. Good morning. Question on the criticized loan balance increase, that $20 million. What, you know, segments was that in? Was that acquired or legacy credits? Just looking for a little color.

Kevin Riley (President and CEO)

It was acquired loan. It's in Arizona. It's a commercial-

Marcy Mutch (CFO)

Criticized loan.

Kevin Riley (President and CEO)

Oh, criticized?

Marcy Mutch (CFO)

Yeah.

Kevin Riley (President and CEO)

Oh, I thought we were talking about-

Marcy Mutch (CFO)

Yeah

Kevin Riley (President and CEO)

performing. Okay, go ahead.

Marcy Mutch (CFO)

It's the criticized loans, those were acquired and largely in the senior housing sector. Again, we expect those to improve over the long term just because we're, you know, as the states kind of resolve the reimbursement rate issues, you know, we could see some improvement in those credits.

Jeff Rulis (Managing Director and Senior Research Analyst)

Yeah.

Kevin Riley (President and CEO)

We're forecasting. Just so you know, we're forecasting that our criticized loans should go down from here throughout the remainder of the year.

Jeff Rulis (Managing Director and Senior Research Analyst)

That, Kevin, is that resolution of some of these credits, or is that broad-based other improvement that you, that you see?

Kevin Riley (President and CEO)

It's a resolution of these credits as well as other credits that are in that portfolio.

Jeff Rulis (Managing Director and Senior Research Analyst)

Okay, I appreciate it. And you mentioned the elevated charge-offs this quarter were related to the office credit. Is that right?

Kevin Riley (President and CEO)

Yeah, 85% of the charge-off, which was the office, credit in Seattle.

Jeff Rulis (Managing Director and Senior Research Analyst)

Great. Thank you. Then Kevin, and Marcy, you touched on it as well, but Kevin mentioned the margin in June and July was near 3%, I believe. Just wanted to clarify, Marcy, you kind of in the guide as well, is that the expectation that you've moderated and so for the balance of the full quarter average could be down, but kind of hugging the 3% at this point?

Kevin Riley (President and CEO)

That is correct.

Jeff Rulis (Managing Director and Senior Research Analyst)

Okay, great. Last one for me would just be interested in the competitive, on the deposit side, not just your own customers sort of asking rate, but just seeing the peer landscape. How aggressive do you see pricing amongst peers in your in your footprint?

Kevin Riley (President and CEO)

Well, it varies geographically, but I would tell you that, everybody's pretty much at the same place, and that's kind of, really where the short-term rates are. It's, I would say pretty much everybody's moved to the same position. It's pretty competitive.

Marcy Mutch (CFO)

Yeah, it is very competitive, and really to credit unions as much as anything that, you know, kind of tend to price up some deposits.

Jeff Rulis (Managing Director and Senior Research Analyst)

Okay. I appreciate it. Thanks.

Operator (participant)

Presenters, there are no further questions at this time. Please proceed with your closing remarks.

Kevin Riley (President and CEO)

Again, thank you for your questions. As always, we welcome calls from our investors and analysts. Please reach out to us if you have any follow-up questions, and thank you for tuning in today. Goodbye.

Operator (participant)

Ladies and gentlemen, this concludes your conference call for today. We thank you for joining. You may now disconnect your lines.