Financial Institutions, Inc. (NASDAQ:FISI) Q4 2023 Earnings Call Transcript

Financial Institutions, Inc. (NASDAQ:FISI) Q4 2023 Earnings Call Transcript January 26, 2024

Financial Institutions, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Thank you all for joining. I would like to welcome you all to the Financial Institutions Inc. Fourth Quarter and Full Year 2023 Earnings Call. My name is Brika, and I will be your event specialist running today’s call with you. All lines are on mute for the presentation portion of the call with an opportunity for questions-and-answers at the end. [Operator Instructions] And I would now like to pass the conference over to your host, Vice President and CEO, Mr. Martin Birminghamto begin. Hi, Martin, 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 Plant. 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, that this call includes information that may only be accurate as of today’s date, January 26, 2024. I’ll now turn the call over to President and CEO, Martin Birmingham.

Martin Birmingham: Thanks, Kate. Good morning, everyone, and thank you for joining us today. Throughout 2023 and the unprecedented pressures it brought to the banking industry, our company is proactive in defending deposits, growing relationships with new and existing customers, and strengthening liquidity and capital. The fourth quarter was no different, as we made strategic decisions in the best interest of the company that reflect our proactive effort to control expenses and put us in a stronger position going into 2024. In December, we announced changes to our leadership team and an associated realignment that strengthens our ability to execute our long-term strategy by enabling us to operate in a more nimble manner by reducing layers of management and realigning key areas of our organization to better leverage the experience within our executive and senior leadership team, drive greater operational efficiency and process improvements, particularly within our retail franchise, accelerate growth of our digital engagement, while ensuring our customer-facing teams remain in a strong position to provide value-added services, align marketing, brand strategy, and enterprise sales more closely with our long-term growth targets, and continue to carefully manage expenses, particularly within salaries and benefits and third-party vendor relationships.

This realignment reflects a very thoughtful process that was certainly not easy, but the current operating environment required us to reflect on past investments to ensure they’re still appropriate and adjust our approach to drive near-term success in support of our long-term objectives. The prolonged higher interest rate environment and inverted yield curve grow funding costs higher throughout 2023, which pressured revenue. As a result, our annual net income available to common shareholders of $48.8 million or $3.15 per diluted share and quarterly net income of $9.4 million or $0.61 per share were down from both the linked and prior year periods. These results were also impacted by a number of items that, again, reflect our proactive work to enhance our forward earnings potential.

Including active balance sheet management through realignment of our company owned life insurance investments and the repositioning of a segment of our investment securities portfolio. Jack will walk through these actions in more detail in his remarks. Our 13% non-public deposit growth and 6% total deposit growth were highlights of 2023 results. While deposits were down from the end of the third quarter due primarily to the seasonality of public deposits, we remain very pleased with our ability to attract and retain deposits amid intense competition over the course of the year. Our success was driven in part by a money market account campaign that ran from late July through November. In total, we welcomed more than 1,000 new retail customers, who were primarily based in the metros of Buffalo and Rochester.

These new customers brought in more than $100 million to Five Star Bank, in addition to deposits brought in by our long-standing customer base. BaaS deposits grew to $127 million during 2023. While this was short of our initial target of $150 million, year-end balances reflect a combination of our thoughtful governance process and deliberate pace of transitioning clients onto our best platform, as well as the natural fluctuation in partner balances. Maintaining our credit discipline lending, we grew loans to $4.5 billion, up 10% in 2023 and about 1% during the fourth quarter. On a linked quarter basis, growth in residential and commercial lending was partly offset by a decline in our consumer indirect as we continue to moderate production, while enhancing the profitability of this portfolio.

We also made the decision to exit the Pennsylvania auto market effective January 1st in order to align our focus more fully around our core upstate New York market. Commercial real estate growth remained muted in the fourth quarter, as anticipated, due to a combination of softer demand amid a challenging economic environment, higher pricing hurdles, and our efforts to moderate production. Commercial and industrial lending was up more than 3% during the quarter. And as a reminder, our newest commercial LPO opened in January 2023 in Syracuse, New York and houses a team of experienced C&I lenders. Given the tech-driven economic development taking place in central New York, we are well positioned to capitalize on both C&I and CRE opportunities that we believe are on the horizon as this region becomes a hub of the microchip industry.

Turning to asset quality, non-performing loans as a percentage of total loans were 60 basis points at year end, up from 21 basis points at September 30th, 2023. This increase was largely due to higher commercial nonperforming loans as we moved a single relationship totaling $13.6 million in exposure to nonaccrual. This CRE sponsor, who has a long and positive track record and strong portfolio of performing properties is working through what we believe are short-term cash flow issues related to newer properties that have not yet stabilized. We are actively managing this situation with our workout group, the borrower and the banks participating in this club deal to ensure a satisfactory resolution. Setting aside this borrower, the remaining $2.6 million of commercial nonperforming loans are primarily smaller relationships that are not concentrated in any specific industry.

Annualized net charge-offs to average loans were 38 basis points for the fourth quarter and 20 basis points for the full year of 2023. During the fourth quarter, we did experience a commercial charge-off of approximately $1 million largely associated with one relationship. Given the $1 million recovery recorded in the third quarter, our full year 2023 commercial net charge-off ratio was 0 basis points while consumer indirect charge-offs are up compared to September 30 and year-end 2022, they are commensurate with the size of this portfolio and remain within our historical norms with annual net charge-offs to average loans of 76 basis points in 2023. This annual ratio has ranged between 45 to 87 basis points since 2008 apart from the exceptionally low 14 basis points we reported in 2021.

What we’ve experienced since then is a return to normalcy, and we do expect delinquencies in this asset class to remain somewhat elevated through at least the first half of 2024, as the impacts of inflation, the exhaustion of stimulus payments by consumers, resumption of student loan payments and economic headwinds work their way through the portfolio. As we continue to reduce overall indirect balances, consistent net charge-off amounts over the next few quarters would be reflected as higher charge-off ratios. I would note that as the total loans have grown, our credit quality metrics have remained solid and generally stable, a reflection of our strong fundamental underwriting processes and experienced credit professionals working in separate credit delivery and relationship-based functions.

Since December of 2008, our nonperforming loans have ranged from 17 basis points to 90 basis points of total loans every quarter. Considering that the media and publicly traded $5 billion to $10 billion asset bank in the U.S. today reported between 36 basis points and 278 basis points over the same time period, we consider this to be exceptional. In fact, our nonperforming loans ratio beat this peer group median more than 80 basis points on average in all but one of the more than 60 quarters since the start of 2008. Overall, we remain very confident in the health of our loan portfolio and associated asset quality metrics. This concludes my introductory comments. It’s now my pleasure to turn the call over to Jack for additional details on results and details of our 2024 guidance.

Jack Plants: Thank you, Marty. Good morning, everyone. Net interest income of $39.9 million for the fourth quarter was down $1.8 million from the third quarter of 2023 as our overall cost of funds increased 24 basis points to 2.54%, reflective of the impact of the continued high interest rate environment, the inward yield curve and strong competition in our markets. We continue to experience margin compression in the fourth quarter. Reporting net interest margin on a fully taxable equivalent basis of 278 basis points for the quarter compared to 291 basis points in the linked quarter. NIM was impacted by the reversal of interest income associated with a single commercial relationship placed on nonaccrual during the quarter, which reduced quarterly NIM by 3 basis points.

NIM for the full year was 294 basis points at the low end of our previously guided range. Given our more than $1 billion in anticipated cash flow in 2024, which you’ll see summarized in our investor presentation along with the associated yields rolling off of securities and loan books, we have ample opportunity to redeploy these funds into higher-yielding earning assets. Accordingly, we expect margin to incrementally improve throughout the year. Relative to the magnitude of FOMC rate increases that occurred in 2022 and 2023, our total deposit portfolio has experienced a cycle-to-date beta of 45%, including the cost of time deposits. Excluding the cost of time deposits, the non-maturity deposit portfolio had a beta of 27%. Given FOMC expectations and internal modeling, we expect the trajectory of deposit betas to slow in 2024.

Noninterest income totaled $15.4 million in the fourth quarter, up $4.9 million on a linked quarter basis. Noninterest income included $9.1 million of company-owned life insurance income, of which approximately $8 million related to the investment of premium into a separate account product in the fourth quarter of 2023. The premium was redeployed from the surrender of underperforming general account policies. The increased income was driven by several factors, including the timing of the premium deployment in two investment divisions of the separate account product and the economic value of the stable value component. Incremental income associated with the cash surrender value of these policies and the stable value component is expected to stabilize in 2024 and is included in our forward guidance related to noninterest income.

I would like to further note that the income from the reinvested proceeds more than offset the $5.4 million in incremental taxes associated with the capital gains that modified endowment contract penalties on the general account COLI surrender. Career Capital, our RIA subsidiary serving mass affluent and high net worth individuals and families, institutional clients, the 401(k) plan sponsors saw positive net inflows in the quarter and increased revenue that supported a $125,000 or 5% increase in overall investment advisory income. Swap income was down as expected, given our lower level of commercial real estate activity during the quarter. Noninterest expenses were up less than 1% on a linked quarter basis as lower salaries and benefits and advertising and promotion, partially offset increases in computer and data processing, professional services and restructuring charges.

With respect to the realignment and associated workforce reduction announced in December, nonrecurring severance expense of $759,000 was more than offset by a reduction in stock-based compensation expense due to the forfeiture of rewards and reversals of incentive compensation for those impacted. Provision for credit losses was $5.3 million in the fourth quarter of 2023 compared to $966,000 in the linked quarter. The higher provision for the current quarter reflected the increase in net charge-offs that Marty previously discussed, coupled with an increase in specific reserves on commercial loans, primarily associated with the $13.6 million relationship moved to nonaccrual in the fourth quarter. Our ACL to total loans ratio increased 114 basis points, up 2 basis points from the linked quarter.

A coverage ratio we are very comfortable with, given the quality of our loan portfolio. Income tax expense was $5.2 million in the quarter, representing an effective tax rate of 34.5%. This reflects taxes on capital gains and modified endowment contract penalties associated with the COLI surrender executed in the quarter. Our accumulated other comprehensive loss stood at $119.9 million at December 31, 2023, compared to $161.4 million at the end of the third quarter. We reported a TCE ratio at December 31 of 6%, intangible common book value per share of $23.69. Excluding the AOCI impact since December 31, 2021, the TCE ratio and tangible common book value per share would have been 7.75% and $30.61 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.

That said, as we shared with you on our third quarter call, we did reposition a segment of our securities portfolio in October. Selling approximately $54 million of agency mortgage-backed securities and an after-tax loss of $2.8 million and reinvesting the proceeds in the higher-yielding Ginnie Mae and Freddie Mac bonds. Considering the 2-year earn back, given the associated $1.4 million of annual income, we believe this to be an appropriate use of capital. I would now like to provide an update on our outlook for 2024 in key areas. We expect net interest margin of 285 to 295 basis points using a spot rate forecast as of year-end. NIM is expected to show modest improvement throughout 2024 as we reposition our balance sheet by utilizing cash flow from the loan and investment portfolios, coupled with core deposit growth, to fund the anticipated loan originations.

We are projecting relatively flat noninterest income for 2024 versus 2023. Excluding items such as the impact of the stable value component in the 2023 company-owned life insurance transaction, impairment of investment tax credits and other noninterest income categories that are difficult to predict, such as limited partnership income and losses on investment securities. We are also projecting relatively flat noninterest expense for 2024 versus 2023. Our spend in 2024 reflects the cost reductions from our fourth quarter realignment activities, offset by inflationary impacts experienced in recent years and ongoing investments in strategic initiatives, namely digital banking, technology, BaaS and risk oversight. These investments are expected to contribute to the positive operating leverage that we are modeling for 2024.

We expect the 2024 effective tax rate to fall within the range of 14% to 16%, including the impact of the amortization of tax credit investments placed in service in recent years. We will continue to evaluate tax credit opportunities and the positive impact these investments would have on our effective tax rate. We expect full year loan growth will be relatively modest between 1% and 3%. This guidance is based on recent quarterly production and pipelines as we remain focused on reserving balance sheet capacity for our most profitable business partners and realizing the corresponding benefit to our capital ratios. We also expect full year total deposit growth of between 1% and 3%. The growth will be focused on the non-public deposit category, which includes Banking as a Service, although we do expect continued disintermediation from lower cost to higher priced deposit product types in 2024.

We expect full year net charge-offs to be within our historic annual range of 30 to 40 basis points. Our overall focus remains on executing strategic initiatives that will improve profitability and operating leverage over time. We believe that achieving results in line with the guidance provided will drive these outcomes. That concludes my prepared remarks and updated guidance. I’ll now turn the call back to Marty.

Martin Birmingham: Thanks, Jack. We are off to a strong start in the first quarter and ready to maximize the benefits of the improvements we’ve made to our organizational structure and our balance sheet. With good momentum from 2023 carrying us into this year, our team remains focused on liquidity, capital and earnings. Just as we have done, we will continue to evaluate our business for opportunities to protect and enhance these three key areas to drive long-term value for our shareholders. Before I conclude, I want to thank our Five Star associates for all they did to contribute to our success in 2023 and all they will do in 2024 to take great care of our customers, communities and shareholders. That concludes our prepared remarks. Operator, please open the call for questions.

Operator: Thank you. [Operator Instructions] We have the first question on the phone line from Nick Cucharale from Hovde Group.

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Q&A Session

Nicholas Cucharale: Hi, everyone. Good morning.

Jack Plants: Hi, Nick.

Martin Birmingham: Good morning, Nick.

Nicholas Cucharale: I just wanted to start on the loan growth. Can you provide some additional context for the 1% to 3% target for 2024 after double-digit growth in 2023. You alluded to some pipeline rebuild? Or are you moderating the growth given the funding and economic landscape?

Martin Birmingham: So in generally — in general, Nick, we’ve been moderating growth in light of the economic landscape. And we’ve been doing that through a variety of tactics. We’ve been working with our lending teams to ensure that we’ve got adequate spreads in light of changes to our cost of funds at our company as well as the general interest rate environment. As well as working with our customers and receiving feedback that they themselves are being more conservative in terms of taking on projects, whether it’s in the CRE or our commercial and industrial space. But on the specifics for how we’ve built our plan for 2024, Jack, I’d ask you to comment.

Jack Plants: Sure. Thanks, Marty. And thanks for the question, Nick. So one of the areas that we’ve been focusing on, I guess, is a mantra for the company is liquidity, capital and earnings. And to Marty’s point, we’re focusing more directly on four relationships. So those that have come with deposits or expansion into our insurance and wealth management platforms in addition to loan originations. So in that regard, we’re backing away from transaction-only exposures. And in the event that one does come across, it would require sufficient pricing to clear our internal risk-adjusted return on capital hurdles. So what that translates to in tandem with what we’re seeing in the market from a demand standpoint as continued runoff of the indirect portfolio, largely flat to low single-digit growth in commercial and then continued low digit — so I would say, mid-single-digit growth in the commercial real estate space.

Nicholas Cucharale: I appreciate the color. And then in terms of the margin, you mentioned the Fed. What are your assumptions with respect to rate cuts?

Jack Plants: In the guidance that we provided assumes [Technical Difficulty] interest rate environment. And when I look at what the market is expecting versus what the Fed is expecting, there’s quite a wide range of estimates there. So I personally don’t like to bet against the Fed. So if there are rate cuts, I would assume that they follow the Fed dot plot with the three cuts that they’ve indicated in their most recent guidance.

Nicholas Cucharale: Okay. And then did I hear you correctly that as it stands now, you assume an increase in margin across the year?

Jack Plants: Yes. We — what we saw in the fourth quarter was what we consider to be the bottom from a margin standpoint, and we’re projecting modest expansion through 2024.

Nicholas Cucharale: I appreciate that. And then just lastly for me. I heard that BaaS deposits at $127 million at the end of the year, but could you discuss your expectations for new partnerships over the course of the year? Are you expecting to hold relatively steady and harvest your existing relationships? Or should we expect another big year for partnership growth?

Martin Birmingham: So, Reid Whiting is here, our Chief Banking Officer, and I’ll ask him to comment. But in general, we are comfortable with the five customers that we have on-boarded to our platform. In light of what’s happening in the industry, regulatory feedback, we’re very conscious to ensure that we’ve got the right governance around this business activity, the right management routines and making, as Jack commented, the right investments to support risk management and other technological initiatives that support this business. So we want to take a measured pace to ensure that we are doing it correctly and drive operational integrity into the company. But Reid, please.

Reid Whiting: Hi, good morning, Nick. Thanks for the question. I think with our existing pipeline, we do expect some vast deposit growth throughout the year. So as Marty noted, we would expect some growth in the pipeline through 2024. However, not at the pace or scale that we’ve seen over the past couple of quarters. We’ll really double down on our commitment to select those partners that are most financially advantageous and really align well with our operational readiness to execute as well as our risk appetite and strategy.

Nicholas Cucharale: Thank you for taking my questions.

Martin Birmingham: Thanks, Nick.

Operator: Thank you. We now have Damon DelMonte from KBW.

Damon DelMonte: Hi. Good morning, everyone. I hope everybody is doing well today. And thank for taking my questions. I just had a question on the deposit trends that we’re seeing. Do you guys feel that the rotation out of noninterest-bearing and into higher costing accounts has slowed or will be slowing here in the early part of 2024? Would you expect that to continue throughout the year?

Jack Plants: Hi, Damon, this is Jack. I’ll take that question. So that’s something that we obviously saw throughout the course of 2023. And while we do expect that, that is slowing and we do expect to see that it will continue in 2024. And we’ve also, from a cost standpoint, expected that the trajectory of our betas are slowing as we enter 2024 as well. So it appears as though that trend is expected to come to an end towards the end of probably the third and fourth quarters of next year.

Damon DelMonte: Got it. Okay. Thank you. And then with regards to the guidance with credit in the — how to look at like net charge-offs for 2024. As you try to back into an appropriate provision level, is it fair to kind of model the 30 basis points to 40 basis points of net charge-offs and then just kind of layer on top of that, something for the loan growth and kind of have something in that maybe $3.5 million to $4 million a quarter range?