Mercantile Bank Corporation (NASDAQ:MBWM) Q4 2022 Earnings Call Transcript

Mercantile Bank Corporation (NASDAQ:MBWM) Q4 2022 Earnings Call Transcript January 17, 2023

Operator: Good morning, and welcome to the Mercantile Bank Corporation Fourth Quarter 2022 Earnings Results Conference Call. All participants will be in a listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note that this event is being recorded. I would now like to turn the conference over to Julia Ward, Lambert Investor Relations. Please go ahead.

Julia Ward: Good morning, everyone, and thank you for joining Mercantile Bank Corporation’s conference call and webcast to discuss the company’s financial results for the fourth quarter and full year of 2022. Joining me today are members of Mercantile’s management team, including Bob Kaminski, President and Chief Executive Officer; Chuck Christmas, Executive Vice President and Chief Financial Officer; and Ray Reitsma, Chief Operating Officer and President of the Bank. We will begin the call with management’s prepared remarks and presentation to review the quarter’s results, then open the call to questions. Before turning the call over to management, it is my responsibility to inform you that this call may involve certain forward-looking statements such as projections of revenue, earnings, and capital structure, as well as statements on the plans and objectives of the company’s business.

The company’s actual results could differ materially from any forward-looking statements made today due to factors described in the company’s latest Securities and Exchange Commission’s filings. The company assumes no obligation to update any forward-looking statements made during the call. If anyone does not already have a copy of the fourth quarter 2022 press release and presentation deck issued by Mercantile today, you can access it at the company’s website at www.mercbank.com. At this time, I would like to turn the call over to Mercantile’s President and Chief Executive Officer, Bob Kaminski.

Bob Kaminski: Thank you, Julia, and thanks to all of you for joining us on the conference call today. Mercantile released its December 31st financial results this morning, which reported another strong quarter, finishing 2022 with continued success in numerous performance metrics. Highlights for the fourth quarter include: continued increases in net interest margin rising to more normal ranges for Mercantile, which drove strong profitability in the quarter; solid growth in many fee income categories; continuation of our strong asset quality; disciplined control of overhead expenses; and while loan growth was dampened by some loan payoffs, customer relationship building by the sales staff continued to generate successes and pipelines remained strong.

For the fourth quarter, Mercantile produced earnings of $1.37 per share on revenues of $58.4 million. Full year 2022 earnings were $3.85 per share on revenues of $190.3 million. This morning, we also announced a cash dividend of $0.33 per share, payable on March 15, 2023. This represents a 3% increase over the fourth quarter dividend. Ray will have more information on the loan portfolio, fee income and other operational topics, and Chuck will provide more detail on overall financial performance for the quarter and full year, as well as some guidance on our performance in 2023. The Michigan economy continues to perform at a level we would describe as steady. Unemployment is only slightly higher at 4.3% in November compared to 4.1% at the end of the third quarter, but lower than what it was at January 01, 2022, when it was 5.1%.

Mercantile bankers and our clients continue to prepare and position for a potential economic downturn of some sort. Customers have been able to absorb higher interest costs thus far. This seems to reflect the strong balance sheets and robust performance coming out of the pandemic. The real estate sector, most notably multifamily housing, has demonstrated some signs of reduced activity toward the end of 2022 as a result of higher borrowing costs and the level of new projects has slowed. Our overall pipeline, however, remains very healthy. Our team continues to diligently monitor our client base and engage our borrowers, so that we understand their financial condition and any challenges they may be encountering. We remain very pleased with the performance of our customers and their ability to navigate in economic slowdown.

Should difficulties arise, however, the deep customer knowledge of our bankers allows them to provide meaningful feedback and counsel to assist the borrowers and ultimately help manage risk for the bank. The loan portfolio, however, continues to be very strong. While our senior management team is keenly focused on maneuvering through near-term economic conditions, we eagerly look forward to the future with much anticipation to craft strategies for long-term sustainability and success of our company. Our team ensures comprehensive plans are in place to create, develop and leverage opportunities for growth and excellence in performance in our existing markets as well as potential new markets. An important key to future success is maintaining the steady pipeline of new talent entering our organization and the ongoing development and training of all employees so they can help us achieve our strategic initiatives.

Relationship-focused banking allows us to understand the clients’ immediate and long-term needs and design and implement products to fulfill those needs. Attainment of these objectives allows our company to provide best-in-class service to our customers, demonstrate peer-leading performance and provide attractive returns for our shareholders. In closing my initial comments, I want to thank the Mercantile team for their excellent work in the fourth quarter and throughout 2022. Each day our staff members engage our clients and demonstrate the Mercantile way of relationship banking. Consumers and businesses have seemingly endless choices for their financial needs. For 25 years, customers and our markets have discovered the benefits of banking with Mercantile.

As a result, Mercantile has grown consistently and profitably for its shareholders and proven to be a strong partner for the communities we serve. Those are my prepared remarks, and I’ll now turn the call over to Ray.

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Ray Reitsma: Thanks, Bob. My comments will center around dynamics in the commercial and residential mortgage loan portfolios and noninterest income. Core commercial loan growth for the year is 7% despite a contraction of 2% annualized in the fourth quarter. This contraction is attributable to payoffs of $39 million resulting from asset sales, $24 million from refinancing to the secondary market, and $39 million paid down from excess cash flow or cash reserves. Our commercial backlog has grown sequentially over the last four year-ends and over each of the last four quarters, and currently resides at a four-year high. The pipeline for commercial construction commitments that we expect to fund over the next 12 to 18 months totals $197 million compared to $170 million last quarter.

Presently, line of credit utilization is 42% compared to 37% a year ago. However, bank commitments in aggregate have increased $385 million or 21% over the past year. The portfolio is well positioned for a rising rate environment, as 65% of the portfolio is comprised of floating rate loans, up from 50% at March 31, 2021, accomplished largely through our swap program. Asset quality remained strong with nominal amounts of past due loans and non-performing assets of 16 basis points of total assets compared to 3 basis points last quarter. A single addition to non-accrual loans accounted for 90% of the increase to non-performing assets during the quarter. The deterioration of the C&I credit is attributable to an isolated management failure rather than stress in the industry or the general economy.

While we are proud of our outstanding asset quality metrics, we remain vigilant in our underwriting standards and monitoring efforts to identify any sign of deterioration in our loan portfolio. Our lenders are the first line of defense to recognize areas of emerging risk. Our risk rating process is robust with an emphasis on current borrower cash flow and our rating model, providing sensitivity to any challenges evolving within a borrower’s finances. All that said, our customers continue to report strong results to-date and have now begun to experience impacts of a potential recessionary environment. We continue to closely monitor concentration limits within our loan portfolio. The mortgage business has slowed due to the rising rate environment, seasonality and lack of available housing inventory in the markets we serve.

Higher rates have led to more demand for adjustable-rate mortgages, and the lack of inventory has led to more construction lending activity. We hold each of these types of loans on our balance sheet and, as a result, residential mortgages have increased 60% over the prior year. Compared to a gain on sale event and immediate recognition of income, a portfolio loan takes about 24 months to generate an equal amount of income. We continue to pursue share in the purchase market with originations in the fourth quarter decreasing 36% compared to the fourth quarter last year due to the increase in mortgage rates since that time. Availability under residential construction loans is $72 million this quarter compared to $59 million one year ago. Refinance activity is just 13% of last year’s comparable quarter.

Noninterest income for the fourth quarter is down 38% compared to the fourth quarter of 2021. The primary contributor to the overall reduction was the previously described decrease in mortgage banking income of 75%, which more than offset a 5% increase in service charges on accounts, a 23% increase in payroll services, a 7% increase in credit and debit card income and a 47% increase in swap income. The optimization of our branch network is an ongoing endeavor that has yielded seven-figure annualized savings. Utilizing tools such as appointment banking, limited-service branches, live ATM machines and branch consolidations complemented by investments in our remaining facilities resulted in a nominal deposit attrition in the impacted markets. We have added commercial and mortgage lending talent in Saginaw and Traverse City markets, and plan to establish loan production offices in those markets in the near future.

That concludes my comments. I will now turn the call over to Chuck.

Chuck Christmas: Thanks, Ray. As noted on Slide 10 of our presentation, this morning we announced net income of $21.8 million or $1.37 per diluted share for the fourth quarter of 2022 compared with net income of $11.6 million or $0.74 per diluted share for the respective prior year period. Net income for the full year 2022 totaled $61.1 million or $3.85 per diluted share compared to $59 million or $3.69 per diluted share during the full year 2021. Higher net interest income, stemming from an improving net interest margin and ongoing strong loan growth, combined with continued strength in asset quality metrics and increases in treasury management fee income revenue streams, more than offset a significant decline in mortgage banking revenue, as industry-wide originations come off the record levels of 2020 and 2021, which were driven by low mortgage loan rates and resulting refinance activity.

Our earnings performance in the 2021 periods also benefited from lower loan loss provisions, reflecting improved economic expectations. Turning to Slide 11. Interest income on loans increased significantly during the 2022 periods compared to the prior year periods, reflecting an increase in interest rate environment and strong loan growth in core commercial and residential mortgage loans. Our fourth quarter loan yield was 93 basis points higher than the third quarter and 142 basis points higher than the fourth quarter of 2021. The yield on loans during the full year 2022 was 44 basis points higher than the full year 2021, as the increase in interest rate environment impact didn’t start in earnest until the second quarter of 2022, and the 2021 period was significantly impacted by PPP net loan fee accretion.

Interest income on securities also increased during the 2022 periods compared to the prior year periods, reflecting growth in the securities portfolio to deploy a portion of the excess liquid funds position and the higher interest rate environment. Interest income on other earning assets, a vast majority of which is comprised of funds on deposit with the Federal Reserve Bank of Chicago, also increased during the 2022 periods compared to the prior year periods, generally reflecting the higher interest rate environment. In total, interest income was $21.2 million and $38.3 million higher during the fourth quarter and full year 2022 when compared to the respective time periods in 2021. We recorded increased interest expense on deposits during the fourth quarter of 2022 compared to the fourth quarter of 2021 in large part reflecting the increase in interest rate environment and enhanced competition for deposits.

In comparing the full year 2022 to the full year 2021, we recorded an increase in interest expense on deposits, as deposit rates increased primarily during the latter part of 2022 and average interest-bearing deposit balances grew about 4%. Interest expense on other borrowed money increased during the fourth quarter of 2022 compared to the fourth quarter of 2021 and grew during the full year 2022 compared to the full year 2021. The increases largely reflect interest costs associated with $90 million in subordinated notes issued between December of 2021 and January of 2022, and higher rates on our floating rate trust preferred securities. In total, interest expense was $3.1 million and $4.2 million higher during the fourth quarter and full year 2022 when compared to the respective time periods in 2021.

Net interest income increased $18.1 million and $34.2 million during the fourth quarter and full year 2022, respectively, compared to the same time periods in 2021. We recorded a credit loss provision expense of $3.1 million and $6.6 million during the fourth quarter and full year 2022, respectively, compared to a negative provision expense of $3.4 million and $4.3 million during the respective time periods in 2021. The provision expense recorded during the 2022 periods was necessitated by the net increase in required reserve levels stemming from changes to several environmental factors that largely reflected enhanced inherent risk within the commercial loan and residential mortgage loan portfolios, as well as loan growth and increased specific reserve for certain distressed loan relationships.

A higher reserve for residential mortgage loans reflecting slower principal prepayment rates and the resulting extended average life of the portfolio also impacted provision expense during 2022. The negative provision expense recorded during the 2021 periods mainly reflected reduced allocations attributable to improvement in both current and forecasted economic conditions and net loan recoveries, which more than offset required reserve allocations necessitated by loan growth. Overhead costs decreased $4.8 million during the fourth quarter of (ph) compared to the fourth quarter of 2021 and were down $2.9 million for the full year 2022 when compared to the full year 2021. Adjusting for charitable contributions to the Mercantile Bank Foundation, overhead costs decreased $1.8 million during the first quarter — fourth quarter of 2022 compared to the fourth quarter of 2021 and were down slightly for the full year 2022 compared to the full year 2021.

Salary and benefit expenses declined during the 2022 periods, mainly from lower compensation related costs, in large part reflecting lower residential mortgage lender commissions, reduced stock-based compensation costs, and higher residential mortgage loan deferred costs. Regular salary costs, primarily reflecting annual merit pay increases and market adjustments, and bonus accruals were higher in the 2022 periods. Continuing on Slide 14, our net interest margin was 4.30% during the fourth quarter of 2022, up 74 basis points from the third quarter of 2022 and up 156 basis points from the fourth quarter of 2021. The improved net interest margin is primarily a reflection of an increased yield on earning assets, in large part reflecting an increase in interest rate environment in 2022 as well as strong loan growth.

As I noted earlier, we recorded increased interest income on loans during the 2022 periods compared to the 2021 periods, which was achieved despite a significant reduction in PPP net loan fee accretion. During the full year 2022, PPP net loan fee accretion totaled $1.0 million compared to $10.8 million during the full year 2021. Our average commercial loan rate increased 252 basis points during the full year 2022, a significant increase at a loan portfolio that averaged $3.1 billion during that time period. Given the asset sensitive nature of our balance sheet, which includes 65% of our commercial loan portfolio comprised of floating rate loans, any further increases in short-term interest rates will have a positive impact on our interest income.

After increasing only about 3 basis points per quarter over the past three quarters, our cost of funds increased 17 basis points during the fourth quarter of 2022. Despite the increase in interest rate environment, our deposit rates and those of our competitors were not meaningfully raised during the first nine months of 2022, which we believe reflected a relatively low level of competition for deposits given the excess liquidity positions of most financial institutions. However, as interest rates continue to rise and excess liquidity positions decline and end, deposit rates are now increasing and we believe deposit rate betas will ultimately return to historical levels. We remain in a strong well-capitalized regulatory capital position. Our total risk-based capital ratio and all of our bank’s regulatory capital ratios were augmented about a year ago with an aggregate $90 million in issuance of subordinated notes, of which a vast majority of the funds were downstreamed to the bank as a capital injection.

As of year-end 2022, our bank’s total risk-based capital ratio was 13.7% and was $166 million above the regulatory minimum threshold to be categorized as well-capitalized. We did not repurchase shares during 2022. We have $6.8 million available in our current repurchase plan. In regards to our thoughts on — for 2023, on Slide Number 18, we share our latest assumptions on the interest rate environment and key performance metrics for 2023 with the caveat that market conditions remain volatile, making forecasting difficult. This forecast is predicated on 25 basis point increases in the federal funds rate at the next two FOMC meetings and then unchanged for the remainder of 2023. This forecast also assumes no significant recessionary pressures.

We are projecting total loan growth in the range of 7% to 9%, with commercial loan growth itself of around 5%. While our commercial loan pipeline remains strong, we experienced a high level of payoffs and paydowns in 2022, especially in the latter part of the year. We are forecasting our first quarter net interest margin to decline from the just-completed fourth quarter, as expected increases in our cost of funds more than offsets further increases in asset yields from the FOMC interest rate decisions. For the remainder of 2023, we project our net interest margin to further gradually decline as our asset yield remains stable, but our cost of funds continues to increase from competitive pressures and growth in interest-bearing liabilities to fund expected loan growth.

In closing, we are very pleased with our 2022 operating results and believe we remain well positioned to continue to successfully navigate through the myriad of challenges faced by all of us. Those are my prepared remarks. I’ll now turn the call back over to Bob.

Bob Kaminski: Thank you, Chuck. That concludes management’s prepared remarks this morning, and we’ll now open the call up for the question-and-answer period.

Q&A Session

Operator: We will now begin the question-and-answer session. And our first question here will come from Brendan Nosal with Piper Sandler. Please go ahead, sir.

Brendan Nosal: Hey, good morning, folks. How are you?

Bob Kaminski: Good morning.

Chuck Christmas: Good morning.

Brendan Nosal: Maybe just to start off on kind of the balance sheet side of things as you look ahead. Maybe just talk about your expectations for deposit flows as we move through 2023? And then, maybe tie that together with your ability to grow loans of that 7% to 9% clip in the context of your loan to deposit ratio at 106% today?

Chuck Christmas: Yes, Brendan, this is Chuck. I’ll take a swing at that one. So, clearly funding is back in vogue. Certainly, it was something that this company was very familiar with throughout its history up until the last couple of years, which obviously, virtually every financial institution saw itself with a strong level of excess liquidity. We worked through that primarily through funding loan growth that we’ve had over the last couple of years. We did enhance our securities portfolio a little bit. And then, more recently, we are starting to see depositors use their funds. Although I will say in December of each year and this follows into January, we do typically see some meaningful reductions as our commercial customers pay taxes and tax payments as well as bonus payments.

But clearly, that’s going to be — one of our primary jobs as we get into 2023 here and likely beyond is getting back into the — our ability to efficiently and effectively build our liabilities of the balance sheet instead of being able to rely on the asset side, primarily our funds at the Federal Reserve Bank of Chicago to fund any increases in our total assets. So, we have — even though we had all that excess liquidity over the last couple of years, we have never taken our foot off the — we need to grow deposits (ph). We knew that the excess liquidity was going to dry up at some point in time, it was just a matter of when. So, we have been enhancing our deposit relationships, bringing in new deposit relationships throughout this period, and that’s something that, obviously, we’ll continue to strive to do.

We also get meaningful deposit growth with our growth in our commercial loan portfolio, especially on the C&I credits when they bring over their operating accounts and, obviously, we try for ancillary business owner and management accounts as well. I wish I had a silver bullet. I wish I think every CFO or management seem to wish to have a magic bullet when it comes to deposit growth. But a lot of it is just kind of, as I mentioned, keeping the foot on the gas pedal. It’s a job for everybody, not just our branch and treasury management staff, but we expect every sales employee here at the bank to help us grow our deposit base. We think there are some opportunities in some of the markets that we’re in and some of the deposit products offerings that we have.

So, we’re in the process of enhancing some of our products, looking at some markets and types of depositors that maybe we didn’t spend as much time on historically in an effort to fund any asset growth that we do have.

Brendan Nosal: All right. Awesome. Thank you, Chuck, for all the color. Maybe just one more for me. Just on the margin, perhaps more conceptually, I definitely appreciate the detailed guide here, I guess what would be better for the margin once the Fed has done raising rates? Would it be stability in short-term rates for a period of time? Or would it be better if they cut rates sooner?

Chuck Christmas: I think from a pure margin standpoint, it would be better if they hung on to rates for a while. Clearly, our margin has improved dramatically with the big increase in interest rates. Although I think it’s important for us to remember that those rates came off incredibly low levels, which in fact had a pretty negative impact on bank net interest margins. Ours is — I can vouch for over the last three to five years, pre-COVID days, and into the COVID period. So, I think that it would seem that unless there’s a significant recession coming, if the Fed does decide to start reducing rates, we don’t think that they’re going to get down to where they started from before. So, there would be some reduction in interest rates.

It would have some negative impact on our company. But to the degree that the Fed holds rates steady or it has a slight decline in the future, that would be better on our net interest margin and certainly if they got very, very aggressive in cutting rates. I think that being said, clearly one of the things that we keep an eye on, and Ray already kind of touched on a little bit, is what is the impact that the Fed is doing on the economy and more specifically to Mercantile, what does that doing to our commercial customers and our retail customers as well, and clearly their ability to pay existing debt and what type of impact that has on future decision making as that could impact loan growth opportunities as well. So, clearly changes in interest rates have an impact on our net interest margin, but we certainly aren’t going to take our eye off the fact that, that can also have a pretty big impact on our asset quality as well.

Brendan Nosal: Yes, got it. Okay. Thank you for taking the questions.