Financial Institutions, Inc. (NASDAQ:FISI) Q3 2023 Earnings Call Transcript

Financial Institutions, Inc. (NASDAQ:FISI) Q3 2023 Earnings Call Transcript October 27, 2023

Operator: Hello, and welcome to today’s Financial Institutions, Inc. Announces Third Quarter 2023 Results. My name is Elliot, and I will be coordinating your call today. [Operator Instructions]. I’d now like to hand over to Kate Croft, Director of Investor Relations. The floor is yours. Please go ahead.

Kate Croft: Thank you for joining us for today’s call. Providing prepared comments will be President and CEO, Marty Birmingham; and CFO, Jack Plants. They will be joined by additional members of the company’s finance and leadership teams during the question-and-answer session. 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 investor presentation as well as historical SEC filings, which are available on our Investor Relations website for a safe harbor description and a detailed discussion of the risk factors relating to forward-looking statements.

We’ll also discuss certain non-GAAP financial measures intended to supplement and not substitute for comparable GAAP measures. Reconciliations of these measures to GAAP financial measures were provided in the earnings release filed as an exhibit to Form 8-K. Please note this call includes information that may only be accurate as of today’s date, October 27, 2023. I’ll now turn the call over to President and CEO, Marty Birmingham.

Martin Birmingham: Thank you, Kate. And good morning, everyone, and thank you for joining us today. Third quarter results were highlighted by healthy deposit growth and a continuation of stable credit quality metrics, both of which position us well for the remainder of 2023 and give us confidence in our ability to effectively navigate the operating environment in 2024, including capitalizing on opportunities. Third quarter net income available to common shareholders was $13.7 million or $0.88 per diluted share, down from $14 million or $0.91 per share in the second quarter of 2023 and in line with the prior year results of $13.5 million or $0.88 per share. Like much of the country, competition for deposits remains fierce in our markets, and I’m incredibly proud of our team’s ability to drive 6% deposit growth during the quarter.

The fact that this growth was led by core nonpublic deposits is all the more noteworthy with retail, Banking-as-a-Service or BaaS, and commercial, all contributing. A significant driver of nonpublic deposit growth was the 5% money market account campaign that you’ll recall we launched in late July. In addition to helping us deepen relationships with existing customers, we have introduced more than 800 new retail customers to Five Star Bank and our relationship-based approach to community banking through this campaign. These new customers brought in approximately $72 million in balances through October 14. In addition to balances deposited by our long-standing customer base, we plan to continue the campaign through mid-November providing a strong start to the fourth quarter.

BaaS also gained momentum during the third quarter with approximately $77 million of related deposits at quarter end. We consider these to be an attractive alternative to higher cost wholesale funding. While these deposits have come out slower than we originally anticipated, our approach to onboarding new partners includes a thoughtful governance process before transitioning them on to our BaaS platform. We look forward to continued growth in 2024 and beyond as we build out our pipeline of Fintech and nonbank partners. Our Commercial Banking franchise also supported deposit growth in the quarter. As we implemented changes earlier in the year to incentivize our commercial lenders to focus on deposit gathering initiatives. Public deposit balances at September 30, 2023 were up compared to the end of the second quarter, largely reflecting seasonal inflows that we typically experienced late in the third quarter.

Reciprocal deposits also grew during the quarter as this continues to be an attractive option affording our larger customers the benefit of FDIC insurance on accounts greater than $250,000. Setting aside our third quarter deposit growth, the latest data from the FDIC summary of deposits underscores the strength of our position in our markets. Based on June 30, 2023 deposit balances, our company ranked Top 3 and 10 of the 14 Upstate New York counties where we reported deposits. In addition, we are among the Top 10 financial institutions serving Area Monroe Counties, Home to Buffalo and Rochester, respectively. Growth in these cities is an important element of our Community Bank franchise growth strategy and accordingly, our recent money market campaign was heavily focused on these markets.

Total loans were relatively stable on a linked quarter basis at $4.4 billion, as modest growth in residential and commercial lending was partially offset by a decline in our indirect portfolio. Other consumer loans were also up slightly, reflecting a relatively small amount of solar panel financing related to a BaaS client focused on climate positive banking. With respect to commercial lending, as anticipated, CRE growth slowed significantly in the third quarter due to a combination of softer demand amid a challenging economic environment, higher pricing hurdles in our effort to moderate production. Competition remains strong for C&I loans in our markets, but we are seeing opportunities from prospects looking for a true local community bank.

Our residential loan portfolio grew during both the three and 12 months ended September 30, 2023, despite the higher interest rate environment and tight housing inventory that has impacted home sales in our market. We continue to see success through our partnerships with select new homebuilders in the Western New York region. Consumer indirect loan balances declined again in the third quarter as expected, primarily as a result of our internal efforts to moderate production. While we did see an uptick in charge-offs associated with this portfolio in the third quarter, I would remind you that our second quarter indirect charge-offs were exceptionally low as a result of strength in recoveries. We remain comfortable with this asset class and the quality of our portfolio, given the deep experience of our management team and long track record of this line of business.

Third quarter consumer and direct charge-offs were partially offset by a commercial recovery as outlined in our earnings press release, resulting in annualized NCOs to average loans of 14 basis points. Our commercial portfolio asset quality remains sound, and we are confident in the strength of the underlying credits. Our relationship managers have been and continue to be in close contact with their customers than what has been a volatile operating environment. And we recently completed additional internal stress testing on loans larger than $1 million within our multifamily and office portfolios set to mature in the next 24 months. As part of this analysis, we ran a variety of scenarios stressing loans larger than $1 million in these segments with NOI downside and higher interest rates, even above where current rates have transitioned in the last 12 to 18 months.

Under these scenarios, the large majority continue to have debt service coverage ratios at or greater than 1:1 coverage. After individually analyzing any debt that would fall below that threshold, we found that guarantor strength, access to capital, project progress or completion and the overall strong quality of sponsors all reinforce our confidence. We anticipate incorporating this focused exercise into our management routines for the foreseeable future. We remain comfortable with our allowance coverage ratio with an allowance for credit losses to total loans of 112 basis points and 521% of nonperforming loans as of September 30. This concludes my introductory comments, and it’s now my pleasure to turn the call over to Jack for additional details on results and updates on our guidance for 2023.

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Jack Plants: Thank you, Marty. Good morning, everyone. As Marty noted, net income was down modestly from the linked quarter due in part to higher funding costs as we work to successfully defend and grow our deposit base in the current interest rate environment. Results were also impacted by lower noninterest income and a modest increase in noninterest expenses that were partially offset by a lower level of provision in the most recent quarter. Net interest income of $41.6 million was down $660,000 from the second quarter of 2023, as our overall cost of funds increased 27 basis points during the quarter to 230 basis points. We continue to experience margin compression in the third quarter, though at a more moderate pace. Net interest margin on a fully taxable equivalent basis was 291 basis points for the quarter compared to 299 basis points in the linked quarter.

Relative to the magnitude of FOMC rate increases that occurred in 2022 and so far in 2023, our total deposit portfolio has experienced a cycle-to-date beta of 38% including the cost of time deposits. Excluding the cost of time deposits, the non-maturity deposit portfolio had a beta of 18%. Noninterest income totaled $10.5 million in the third quarter, down $980,000 on a linked quarter basis. While our earnings release provides additional detail on our diverse fee-based revenue sources, I would like to touch on a few key areas this morning. Our investment advisory and insurance businesses are the largest contributors of noninterest income, making up about 40% in the third quarter. Insurance income increased as a result of the timing of commercial renewals as well as business development.

Declines in our investment advisory income were attributable to the third quarter market downturn and the impact on AUMs coupled with our strategic decision to focus on wealth management services for high net worth individuals as opposed to our retail branch network. While this has negatively impacted transaction-related fees in the near-term, we believe this move will support enhanced profitability in this line of business moving forward. Swap income was down as expected, given our lower level of commercial loan activity during the quarter. Noninterest expenses were up less than 3% on a linked-quarter basis as higher salaries and benefits, occupancy and equipment, computer and data processing and FDIC insurance expenses were partially offset by lower professional services expense.

Income tax expense was $2.4 million in the quarter, representing an effective tax rate of 14.8% and relatively consistent with the linked quarter. Our accumulated other comprehensive loss stood at $161.4 million at September 30, 2023. We reported a TCE ratio at September 30 of 5.25% in tangible common book value per share of $20.69. Excluding the AOCI impact, since December 31, 2021, the TCE ratio and tangible common book value per share would have been 7.69% and $30.31, respectively. We continue to expect these metrics to return to more normalized levels over time given the high credit quality and cash flow nature of our investment portfolio. Earlier this month, we sold approximately $54 million of agency mortgage-backed securities at an after-tax loss of $2.8 million, reinvesting the proceeds into higher-yielding Ginnie Mae and Freddie Mac bonds.

The after-tax income benefit of $1.4 million annually translates to an earn-back of two years. I would now like to provide an update on our outlook for 2023 in key areas. We now expect full-year NIM of 295 to 300 basis points, five basis points lower than previous guidance, given the impact of higher interest rates on our funding base. Our forecast assumes Fed activity remaining muted for the remainder of the year. Given the continued strength of our credit quality metrics, we expect full-year net charge-offs of between 15 and 20 basis points, 10 basis points lower than previous guidance. We now expect the 2023 effective tax rate to fall within a range of 15% to 16%, down 200 basis points from previous guidance. Reflecting the impact of the amortization of tax credit investments placed in service in the current quarter and recent years, coupled with the impact of revised margin guidance on pretax income for the remainder of 2023.

We are lowering our guidance for flat noninterest income to a single-digit decrease given the pressures we have seen on investment advisory fees and slower onboarding of BaaS initiatives than anticipated. This guidance excludes the impact of securities gains or losses, limited partnership income and nonrecurring items such as enhancement on company-owned life insurance and gains on the sale of indirect loans. Our expectations for mid-single-digit full-year expense growth, mid-single-digit growth in nonpublic deposits, low double-digit growth in loans, and an ROA between 85 to 95 basis points remain unchanged. That concludes my prepared remarks and updated guidance. I’ll now turn the call back to Marty.

Martin Birmingham: Thank you, Jack. We were off to a solid start in the fourth quarter and remain focused on balance sheet management as well as opportunities to enhance margin and manage noninterest expenses. We have an incredibly strong team in place and several promotions and appointments we announced recently underscore that. Within key internal functions like information security and accounting, we have identified experienced and well-prepared internal candidates ready to step into leadership roles. In addition, just this week, we announced a leadership succession at our wealth management subsidiary, Jim Iglewski who joined our firm in mid-2022 after more than two decades in private banking with several large U.S. banks has been promoted to President.

He succeeds longtime leader, Tom Hamlin, who transitions to the role of Executive Vice President of Wealth Management and Co-Chief Investment Officer. We believe that this new leadership structure allows Career Capital to continue serving its wealth management, retirement plan and institutional services clients at the highest level, while positioning us for continued growth moving forward, following the merger of our two RIA subsidiaries earlier this year. And finally, in addition to these internal appointments, we recently hired Blake Jones as Chief Marketing Officer. She brings more than 20 years of branding and communications experience and will lead both marketing and analytics. On an enterprise-wide basis, focusing on strategy, branded performance marketing, along with customer and prospect insights.

With diversified and complementary lines of business, including consumer and commercial banking, wealth management, insurance and BaaS, our company has excellent opportunity to deepen relationships with existing clients and attract new customers across our footprint and beyond. Operator, that concludes our prepared remarks. Please open the call for questions.

Operator: Thank you. [Operator Instructions] First question comes from Nick Cucharale with Hovde Group. Your line is open.

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Q&A Session

Nicholas Cucharale: Good morning, everyone. How are you?

Martin Birmingham: Good morning, Nick.

Jack Plants: Good morning, Nick.

Nicholas Cucharale: Just a question on the Banking-as-a-Service strategy. Just referencing Slide 5, there was a large step-up in total clients from June to September. Do you anticipate a period where you slow new client relationships and focus more on monitoring and cultivating the existing relationships? Or do you have capacity to continue adding partnerships at a strong pace?

Martin Birmingham: So thanks for pointing that out because we’ve got some assumptions built into our balance sheet and related deposits for the year, and that’s being impacted by the timing of onboarding clients. And we have spent a lot of time upfront ensuring that our management and our governance routines as well as our controls are right for this line of business as its new activity. So that has impacted our timing overall of onboarding clients to our platform. We’re very comfortable with the clients that we’ve added to this point. But Sean Willett is here, who leads that line of business for us. I’d ask you to comment, please.

Sean Willett: Yes, good morning and thank you for the question. I would just say that we have capacity to continue to bring on clients. But that being said, as Marty has indicated, we will continue to be hyper selective and ensure that those opportunities fit with our risk appetite and the thesis-driven approach that we’ve taken to client selection.

Nicholas Cucharale: And just a follow-up there. When do you anticipate a material impact on the noninterest income side from these partnerships? Or is that already occurring?

Jack Plants: I can take that one. So this is Jack. I can cover that first, Sean. Our first strategy was to have an impact on the balance sheet outstandings, which we’ve seen through deposits which were up about $78 million in the quarter in this line of business. And that is something that I think is critical to franchise success, particularly in this environment, given that they have lower cost relative to funding that we’re raising in our current market footprint. And on the noninterest income side, that’s been slower to translate as the fee sharing is coming in a little bit later from the deposits. I would expect to see some marginal contribution in the fourth quarter and beyond. But I’ll ask Sean to discuss the partnerships that we’re onboarding and how they can contribute to future periods.

Sean Willett: Yes. So I think you’re spot on, Jack, in terms of the opportunities that we’re going after, our focus is Deposit acquisition. And then with that, as we start to see activity from those partners, then we start to see contribution not only on the platform side, but also on interchange income.

Nicholas Cucharale: That’s very helpful. Maybe just a follow-up on the NIM after the revised guidance. I understand it’s too early for 2024 commentary. But can you help us think about the direction of the margin as we turn the page into New Year?

Jack Plants: Yes, Nick, this is Jack again. So we’ve had some success with repositioning the liability side of the balance sheet during the quarter. We were successful with the retail money market campaign coming on board, success in the BaaS deposits. Growth in commercial deposits, which allowed us to pay off a little over $300 million of higher cost wholesale borrowings. We’ll see the full quarter benefit of that in the fourth quarter as well as the benefit of the securities repositioning, which should help to limit the margin compression that we’ve observed throughout this year and quarter-to-date. Now it appears to be slowing, and it certainly feels like we’re approaching a bottom. Our guidance that we provided for full-year, which was revised to 295 to 300 basis points, would assume that if we reach a low point of 280 basis points in the fourth quarter, that would put us at the lower end of our full-year guidance of 295 basis points.