Q4 2023 Financial Institutions Inc Earnings Call

Participants

Kate Croft; Investor Relations; Financial Institutions Inc

Reid Whiting; Chief Banking Officer; Financial Institutions Inc

Presentation

Operator

Thank you for joining. I would like to welcome you all to the Financial Institution fourth-quarter and Full Year 2023 earnings call. My name is Erica, and I will be your event specialist running today's conference all. (Operator Instructions) And I would now like to pass the conference over to your host, President and CEO, Mr. Martin Birmingham. 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 Plants. There will be joined by additional members of the company's financial leadership teams. During the question and answer session of 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 for an installation of these measures to GAAP financial measures were provided in the earnings release filed as an exhibit to Form eight K. Please note that this call includes information that may only be accurate as of today's date, January 25th, 2024. I'll now turn the call over to President and CEO, Marty Birmingham.

Thanks to good morning, everyone, and thank you for joining us today for our 2023 and the unprecedented pressures it brought to the banking industry. Our company was 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 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, aligned 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 requires 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 drove funding costs higher throughout 2023, which pressured revenue. As a result, our annual net income available to common shareholders of $48.8 million were $3.15 per diluted share and quarterly net income of $90.4 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% nonpublic 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 money market account campaign that ran from late July through November. In total, we welcomed more than 1,000 new retail customers who are primarily based in the metros of Buffalo and Rochester.
These new customers brought in more than $100 million to 5 Star Bank. In addition to deposits provided by our long-standing customer base, fast deposits grew to $127 million during 2023. While this was short of our initial target of $150 million at 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 disciplined 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 first 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. Nonperforming loans as a percentage of total loans were 60 basis points at year end, up from 21 basis points at September 30, 2023. This increase was largely due to higher commercial nonperforming loans as we moved the single relationship totaling $13.6 million in exposure to nonaccrual. The CRV 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 billion recovery recorded in the third quarter. Our full year 2023 commercial net charge-off ratio was zero basis points, while consumer indirect charge-offs are up compared to September 30 and year end 2022. They're 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 2018, apart from the exceptionally low 14 basis points we reported in 2021. What we've experienced since then has returned 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 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 the summer 28. Our non-performing loans have ranged from 17 to 90 basis points of total loans every quarter. Considering that the median publicly traded $5 million to $10 million asset bank in the U.S. today reported between 36 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 28. 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.

Thank you, Marty, and 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 inverted yield curve and strong competition in our markets. We continued to experience margin compression in the fourth quarter supporting 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 and was impacted by the reversal of interest income associated with the single commercial relationship placed on nonaccrual during the quarter, which reduced quarterly NIM by three basis points.
And then 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 beta 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 into investment divisions of a separate account product and the economic value of the stable value component, incremental income associated with the cash surrender value of these policies in 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 reinvestment proceeds more than offset the $5.4 million in incremental taxes associated with the capital gains in modified endowment contract penalties on the general account, Coley's surrender courier capital, our RIA.'s subsidiaries serving mass affluent and high net worth individuals and families. Institutional clients for one K plan sponsors saw positive net inflows in the quarter and increased revenue that supported a CAD125,000 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 awards and reversal 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 a $13.6 million relationship moved to nonaccrual in the fourth quarter, our ACL to total loans ratio increased to 114 basis points, up two basis points from the linked quarter. 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 Coley's 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% in tangible 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 the 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 into higher-yielding Ginnie Mae and Freddie Mac bonds. Considering the two 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 and key areas. We expect net interest margin of 285 to 295 basis points using a spot rate forecast as of year end, Neumune 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 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, VAS 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 a 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 preserving 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% growth. We focused on the nonpublic deposit category, which includes banking as a service. Although we do expect continued disintermediation from lower-cost, higher priced deposit product types of 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.

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 in 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, and operator, please open the call for questions.

Question and Answer Session

Operator

(Operator Instructions) Nick Cucharale, Hovde.

Hi, everyone.

Good morning. Nick.

I just wanted to start on the loan growth. Can you provide some additional context for the 1% to 3% target for 2024 and after double digit growth in 23, you alluded to some pipeline rebuild. Are you moderating the growth given the funding and economic landscape.

So generally, in general that 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 the 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 commercial industrial space. But the specifics for how we built our plan for 2020. For Jack, I'd ask you to comment shares.

Thanks, Marty, and thanks for the question, Nick. So one of the areas that we've been focusing on, I guess, have a mantra for the Company is liquidity, capital and earnings. And to Marty's point, we're focusing more directly on full 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 transactional exposures in the event that one does come across it would require us sufficient pricing to clear our internal risk-adjusted return on capital hurdles. So what that translates to and in tandem with what we're seeing in the market from a demand standpoint is 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.

Appreciate the color. And then in terms of the margin, you mentioned the Fed, what are your assumptions with respect to rate cuts from a book point in the guidance we provided assumes high interest rate environment.

And when I look at what the market's expecting versus what the Fed's 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 recent guidance.

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

Yes. We are 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.

Appreciate that, and then just lastly from me, I heard the best 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 year for partnership growth?

So we have Reid 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 really pleased.

Reid Whiting

Yes. Good morning, Nick. Thanks for the question. I think with our existing pipeline, we do expect some flat 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. Really double down on our commitment to select those partners that are most financially advantageous and really aligned well with our operational readiness to execute as well as our risk appetite and strategy.

Thank you for taking my questions.

Operator

Damon DelMonte, KBW.

And good morning, everyone. Probably is doing well today and thanks for taking my question. I just had a question on the deposit trends that we're seeing on. Do you guys feel that the rotation out of noninterest-bearing into higher costing accounts has slowed or will be slowing here in the early part of 2014. Would you expect that to continue throughout the year?

Hi, David, 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 into 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 May, probably the third and fourth quarters next year.

Got it. Okay, thank you. And then with regards to the guidance side, with credit in the US, how to look at like net charge-offs for 2024 as you tried to back into an appropriate provision level? Is it fair to kind of model that 30 to 40 basis points of net charge-offs. And then just kind of layer on top of that, something for loan growth and kind of have something in that maybe 3.5 times, $4 million a quarter range.

I think that appropriate measure for provisioning expectations is maintain the coverage ratio of around 114 basis points with the loan growth estimate at 1% to 3% and then as you suggested, the MCOs in that 30 to 40 basis point range.

Got it. Okay, great. And then just to clarify, you said on the fee income, you're expecting that to be flat on a year-over-year basis. Is that on the reported now that's on your operation?

That's again, like, call it $44 million-ish flat -- flat level.

Yes. Great. Okay. That's all that I had.

Thank you.

Operator

Alex Twerdahl, Piper Sandler.

Hey, good morning.

Yes, and Jack, appreciate all the guidance on the NIM., I guess, on your outlook as it is now, but can you just help clarify your expectations for how the balance sheet she would react to a Fed cut?

Yes, we did some modeling that was aligned with our expectations that if the Fed did cut as they intend to, which is the three constant they've outlined in the dot plot and were fairly neutral. I think we were showing about $500,000 of interest income benefit under that scenario. And the reasoning behind that is that it comes down to repricing in our time deposit portfolio and then repricing in the money market campaign that we launched in the summer of last year, which did have a guaranteed rate for a 12 month period. So those deposits would be expected to start to come up on their 12 month guaranteed maturity and July of 2024, which would align with that of Fed reduction. So modest improvement in the current period or the current projection. And then I would see expansion in 2025.

That's great color, thanks. And then on the auto book is on, is that just fully in rundown complete mode at this point, or do you think that stabilizes that at a certain percentage of the loan portfolio or a certain level.

That's a we've been thoughtfully considering the percentage of the overall loan portfolio in terms of our indirect book and this is just a reflection of some adjustments we've made the last year and the exit of Pennsylvania consistent with trying to simplify the business and focus on our core upstate markets and continuing to drive it forward in a way that's consistent with our plans relative to our budget and the market opportunities. And so I think that will continue to moderate but be around the $900 million mark plus.

Yes, that's fair margins. And the only thing I would have to add, Alex, is we have the ability to really test price elasticity in that platform over the course of the last 18 months. And we've gone to a level where the spreads that we're originating for new to production that aligns with our ideal credit mix are really up great opportunities for us to expand the profitability in that line of business. But as we think about the big picture for the Company and opportunities to improve tangible and regulatory capital. We're comfortable with our approach for 2024, although that is a spec that we can adjust so to speak from a pricing standpoint as we see the landscape unfold in future periods.

Got it is presumably there'll be some mix shift, then commercial growth will be faster. Indirect continues to wind down a bit towards that $900 million level.
And does that I guess what's the ACL like in the auto book versus the commercial? And does that provide a little bit of relief on the on the provision?

So the ACL on the indirect book is a little bit higher. And generally what you see in that portfolio is the as the portfolio seasons, the credit performance becomes a little bit more pronounced as far as delinquencies are concerned, are you wouldn't expect to see even even with a low tier credit or a level of delinquency in a short period of time. So with the seasoning in the portfolio, that's what's key pushed up a little bit in the fourth quarter. And we expect that trend to continue at our current levels for at least the first nine months in 2024. But overall, it's layered into our overall NCO and provision guidance.

That's like $3 million per quarter issue charge-offs level?

Yes, I think that's a good estimate.

Okay. And then I mean, just as you kind of look at that, I mean, it's just I know just sort of seasoning in the portfolio, but it does seem like that level is higher than you know, than historical standards based on the ranges you gave and whatnot. Is there any specifically like subset segment of the indirect auto of the borrower that's kind of driving those higher losses that you can point to?

And is there a way to sort of ring-fence those specific types of customers I think what we're experiencing in the current time is working through some vintage buckets, production buckets that relate back to pandemics, high stimulus period, et cetera. And now we're overlaying economic headwinds, and that has definitely impacted the performance of the portfolio, but we continue to grow. And the focus in origination of 70, 70% or above right now is in 700 above credit framework, our Tier one bucket and 88% is Tier one into six, 80 and above. So no changes. It's just kind of the idiosyncrasies of the last several years are working their way through the portfolio. And the fact that we are shrinking at those good credits are paying off faster than the same time slower credits.

Got it. And then just final question for me, Marty, last quarter, I think you expressed some openness to exploring the idea of seeing what your insurance business was worth. Is that something that's still on the table and being considered?

It's consistent with my comments earlier in terms of liquidity, capital and earnings. And I remain we, as a Company remain open to that opportunity and we're aware of the transactions that have happened and to the extent that it's something we can take advantage of, we will thoughtfully consider it.

Appreciate you taking my questions.

Thanks, Alex.

Operator

Matthew Breese, Stephens Inc.

I was hoping we could start the math on the new outlook Good morning guys. And where and when do you expect deposit costs to peak in 24? It sounds like it's a back half of the year type events and then can you remind us of what percentage of loans reprice immediately?

Sure. This is Jack. I'll take that one. From a cost of funds perspective, our modeling indicates that the cost of funds is expected to increase around 20 basis points from the fourth quarter 2023 to the fourth quarter of 2024. However, when you look at the earning asset side, of the portfolio. That's off approximately 40 basis points over that same period, which is contributing to the the modest margin expansion that we're guiding to. And then on the variable component of the portfolio, I think it's around 33%.

Got it. And could you just give us some additional color on what the blended new origination yields are on loans versus what's rolling off or does that roll on versus roll anyway?

I think we put a slide presentation that shows roll offs we have and then expectations for '24, they say range anywhere from 60 to 300 basis points on our roll-on basis over what's coming off depending on the portfolio. We ultimately didn't want to guide to our full coupons that we're putting on just to limit some competitive pressures we might see in the commercial space.

Okay And what was the other anticipated securities cash flow for the year?

$150 million.

And last one I had was just on the commercial relationship, the $13.6 million. What type of loan was that was that office multifamily industrial and then where was it? Was it in upstate New York or DC or one of your other geographies?

It's upstate New York called the Finger Lakes, a really unique small city that's crowded by the headquarters of a large Ivy League institution and another elite college that calls at home. And we're very confident as a result of the unique characteristics of that but the collateral values are solid. It's just the issues that we talked about with working through some short-term issues here, but it was a light industrial loan that's tied to kind of a major economic drivers of the community down there. Okay. And it is a club deal. So that's all I had, not leading it. We're a participant, as I said.

Interesting, what's the denoting overall banks mattered sizes?

I don't know off the top of my head.

Okay. I'll leave it there. Thank you very much.

Operator

With that, I would like to hand it back to Mr. Birmingham for any closing remarks.

Thanks very much for your assistance this morning, operator. And to those who attended the call, we look forward to building on this conversation with our second-quarter results.

Operator

Thank you for joining. I can confirm this does conclude today's conference call. You may now disconnect your lines, and please enjoy the rest of your day.