First Commonwealth Financial Corporation (NYSE:FCF) Q3 2022 Earnings Conference Call October 26, 2022 2:00 PM ET
Company Participants
Ryan Thomas – Vice President, Finance & Investor Relations
Mike Price – President & Chief Executive Officer
Jim Reske – Chief Financial Officer
Conference Call Participants
Frank Schiraldi – Piper Sandler
Daniel Tamayo – Raymond James
Michael Perito – KBW
Matthew Breese – Stephens
Operator
Good afternoon. My name is Chris, and I’ll be your conference operator today. At this time, I’d like to welcome everyone to the First Commonwealth Financial Corporation Q3 2022 Earnings Conference Call and Webcast. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator instructions]
Thank you. Ryan Thomas, Vice President of Finance and Investor Relations you may begin.
Ryan Thomas
Thank you, Chris and good afternoon, everyone. Thank you for joining us today to discuss First Commonwealth Financial Corporation’s third quarter financial results.
Participating on today’s call will be Mike Price, President and CEO; Jim Reske, Chief Financial Officer; Jane Grebenc, Bank President and Chief Revenue Officer; and Brian Karrip, our Chief Credit Officer.
As a reminder, a copy of yesterday’s earnings release can be accessed by logging on to fcbanking.com and selecting the Investor Relations link at the top of the page. We’ve also included a slide presentation on our Investor Relations website with supplemental final information that will be referenced during today’s call.
Before we begin, I need to caution listeners that this call will contain forward-looking statements. Please refer to our forward-looking statements disclaimer on page 3 of the slide presentation for a description of risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements.
Today’s call will also include non-GAAP financial measures. Non-GAAP financial measures should be viewed in addition to and not as an alternative for our reported results prepared in accordance with GAAP. Reconciliation of these measures can be found in the appendix of today’s slide presentation.
And with that, I will turn the call over to Mike.
Mike Price
Hey. Thanks, Ryan and good afternoon, everyone. Net income of $34 million increased $3.2 million over the second quarter on the heels of significant improvement in net interest income and better fee income, partially, offset by pressure on non-interest expense and an uptick in provision expense.
Our pre-provision net revenue of $48.9 million was strong and produced a core pre-tax pre-provision ROA of 2.03% and our core ROA in the first quarter was 1.43%. Key elements of the quarter follow: strong loan growth of 3.3% annualized coupled with the burgeoning net interest margin of 3.76% propelled an $8.7 million increase in net interest income to a record third quarter figure of $82.6 million.
Growth was again broad-based with commercial lending leading the way followed closely by indirect lending and mortgage. All of our regions are reporting healthy pipelines in both our consumer and commercial lending businesses.
Our strong core depository was especially valuable in maintaining a low cost of funds further supporting margin expansion as our cost of deposits only increased by one basis point. Between now and year-end higher rates will result in more muted fourth quarter loan growth and bring the figure to we project mid single-digit guidance.
Non-interest income rose $1.4 million to $25.9 million in the third quarter. A swap income and commercial lending hit record levels. SBA gain on sale picked up steam as well. Third quarter non-interest expense rose $3.6 million and was a function of investments in talent and technology, broad inflationary pressure on salaries and a handful of onetime items. However, the core efficiency ratio still fell to 54.06% due to the aforementioned growth of top-line revenue.
Third quarter provision expense of $5.9 million was up over the second quarter even as overall credit quality remained sound. For example, commercial plus 30-day plus delinquency was only two basis points down from an already low four basis points last quarter. Non-performing loans of $35 million or 48 basis points of total loans were down from last quarter as well.
Looking forward a broad base of both margin and fee businesses coupled with the philosophy of continual improvement should translate into continued growth. We’ve built a well-diversified bank that we feel will do well in multiple interest rate and economic scenarios. This is why we’ve strived for balanced and in the composition of our lending book with 47% of outstandings and consumer loans at quarter end and 53% in commercial categories.
Intentionally and organically, we’ve moved towards balance in our loan portfolio starting at least five years ago to the point where we now have roughly 50% in variable rate loans and 50% of our loans and fixed rates. We’ve also methodically built sources of fee income that peaked at nearly 30% of revenue several quarters ago through meticulous execution in mortgage SBA wealth management and other fee businesses.
Coupled with sound credit we’ve built the bank to thrive in good and tougher times. We will remain focused on what we can control. We strive to get better in each of our businesses and regions with better talent and processes every quarter regardless of the external environment. We are also excited about our 2023 growth prospects with Centric, SBA, Equipment Finance and continuing growth through our regional business model to name just a few.
As we look forward to 2023 the emerging strategic themes will likely be largely unchanged from 2022 which are as follows: first improve and grow our lending depository and fee businesses in each region of our company. Second, increase digital relevance. Third, maintain operating leverage. Fourth, strengthening our culture leadership and talent and fifth improve brand awareness.
For now, I’ll just focus on one of those themes increasing digital relevance. We continue to be pleased with the adoption of our digital banking platforms. In total for the quarter, we experienced an 11.5% annualized increase in active mobile users. Importantly our customers continue to show high engagement with our digital tools with average logins per user per day at 1.07x, that’s year-to-date which is up 12% year-over-year.
With this strong use of the platform, we continue to make investments to bring more features to our customers. The Centric acquisition is proceeding well in large part due to good dialogue between the leadership teams of both organizations. We still intend to close the transaction on January one as planned subject to pending regulatory approvals. Finally, we are pleased to see that First Commonwealth earned the designation as the number one SBA lender in Western PA and number two in Pennsylvania.
With that I’ll turn it over to Jim Reske our CFO.
Jim Reske
Thanks Mike. As Mike mentioned, the combination of 13.3% annualized loan growth and 38 basis points of margin expansion produced strong financial results for the quarter. As usual, I’ll try to provide some helpful color on our earnings trajectory. The margin is benefiting from improved loan yields, combined with deposit costs that have remained essentially flat.
We had the advantage of coming into this cycle with a cost of deposits low enough to place us in the 90th percentile of our industry and our cumulative deposit beta in this cycle to date has been effectively zero. Our cost of interest-bearing demand and savings deposits was seven basis points in the third quarter which is exactly the same as it was in the third quarter a year ago.
Our total cost of deposits which includes the noninterest-bearing deposits that form roughly 1/3 of our deposit base was 5 basis points for the third quarter. That’s up from four basis points last quarter, but it’s actually down from six basis points a year ago. We do expect deposit betas to change however as we witness deposit competition heat up in our markets steadily over the course of the third quarter.
We have been using a 25% deposit beta assumption based on our historical experience, but a refresh of that analysis leads us to expect deposit betas of 20% going forward both for rate increases from here on out and cumulatively through the cycle. So assuming a beta in the fourth quarter of 20% and a Fed funds rate of roughly 4.5% by year-end we would expect the NIM to expand by at least 20 basis points in the fourth quarter.
The NIM is quite sensitive to the beta assumption. If for example the beta were to come in at just 10% of fourth quarter rate hike that will result in about 10 basis points of upside to the NIM projection I just gave you. We’ll update 2023 NIM guidance going forward to reflect the Centric acquisition once we receive regulatory approvals.
Expenses were elevated in the third quarter compared to last quarter for several reasons. Some things represented normal quarterly volatility. For example, hospitalization expense was up by about $0.5 million after being well contained all year. Other items represent the impact of inflationary pressures and are likely here to stay. For example, salaries were up by about $0.5 million as we filled open positions and work to improve employee retention rates.
So, other items reflect increased activity and long-term investments in the company. This would include roughly another $0.5 million for incentive accruals that were adjusted upwards in recognition of higher loan production in the third quarter and improved performance, and the continued build-out of our equipment finance business.
And finally, there were about $800,000 in one-time expenses that we feel are not part of our normal run rate. We had one-time technology expenses in the third quarter of about $0.5 million, related to a conversion of our credit card system along with costs associated with the cancellation of certain IT contracts and a reconfiguration of our telephone service. There was also about $325,000 in expenses that we don’t expect to be ongoing for facilities projects, the largest of which was related to some flood damage at one of our branches.
In light of third quarter results, however, we are updating our previous non-interest expense guidance of $56 million to $57 million per quarter to $58 million to $59 million per quarter, but we’ll obviously update guidance for 2023 to reflect the Centric acquisition when appropriate.
Provision expense was a bit higher than in previous quarters. But the ACL coverage ratio stayed unchanged at 1.31% of total loans. Provision was driven by our strong loan growth and the normal charge-offs. We did increase reserves due to changes in our economic forecast, but these increases were largely offset by the release of some COVID-related reserves that we still had on the balance sheet.
We would emphasize that we still see very few signs of stress in our credit quality metrics. And as Mike mentioned, we actually saw improvement in a number of credit metrics year-to-date, including reductions in non-performing, criticized and classified loans. Finally, our effective tax rate was 19.82% in the third quarter.
And with that, I will turn it back over to Mike.
Mike Price
Thanks, Jim. And operator, we’ll turn it over to you for questions.
Questions–and–Answers Session
Operator
Thank you. [Operator Instructions] Our first question is from Frank Schiraldi with Piper Sandler. Your line is open.
Frank Schiraldi
Good afternoon.
Mike Price
Hey, Frank.
Frank Schiraldi
Mike, I think you mentioned in speaking on loan growth an expectation of mid-single digits, if I heard right. So, is that for the fourth quarter the guidance?
Mike Price
It is. We’ve had some ebb and flow to our loan growth. Like this year, we were at 9, 11 and 13. I think the year before we had a down quarter and then three up quarters and there’s just an ebb and flow to some payoffs in the third quarter. And hopefully, we’ll be back off to the races and the first — we expect to be in the first quarter of 2023.
Frank Schiraldi
Okay. And then, previously kind of thought about maybe a little bit of a handoff from consumer to commercial. And then I guess, commercial is a bit stronger. But as you look out in 4Q, do you see — it sounds like you talked about strong pipelines in both. Do you think it’s still maybe sort of 50-50 growth in consumer and commercial in 4Q?
Mike Price
Yes. It’s been surprisingly so throughout this year. Corporate Banking has some nice pipelines in quality investment real estate projects in good markets. We also built up a nice construction book where advances should average about $25 million a month next year. And they’re in growing markets. Like Columbus, you have projects coming in there with Honda and Intel. So, there’s a lot of tailwinds in those markets.
But even on the C&I side, we see some nice pipelines in the regional books in Cincinnati, Columbus, Cleveland, Pittsburgh and Community Pennsylvania. Really excited about Centric and what they’re going to add to the equation. We expect some good swap fees in the fourth quarter, probably a little bit muted over the third quarter.
Then as we move to the consumer businesses, they’re off a little bit but not much. Indirect is having a strong quarter. SBA pipelines are getting deeper. Mortgage has settled down at probably 30% less than peak, but we really still like the business and the operator there has scaled it for that size. And interestingly on the branch based side we’ve seen the HELOC volume moved or HELOAN volume moved to HELOC, which you have to wait for the draw. But we like the activity. We like the way it sets up for 2023 all things being equal. And that’s trudging along with — despite inflation tight employment and really constructive business outlook at least in our markets.
Frank Schiraldi
Okay, great. And then just a question for Jim on the margin. I just wanted to make sure I understood, or I heard correctly on the expected beta. So was that a 20% beta through cycle? And then just curious if you could talk a little bit about why the change in expectations? Is it just as simple as what you’ve seen to date on that side of things?
Jim Reske
Yeah, Frank a good question. I’m glad you asked, because we’ve been saying 25% beta all through the cycle. And we say that every quarter and then the beta comes in at zero. And looking back to be honest, we thought we were pretty clever at the beginning of the rate cycle by instituting a delay in our expectations. So we said at the beginning that rather than just 25% from the get-go, we thought we would be able to go the first two rate hikes with no beta zero and then 25% thereafter. That was three or four quarters ago on our earnings call. So you recall us saying that.
And then, of course, we’ve gone 300 basis points of hikes at a zero beta through this time. So the beta study we have is based on our historical data. Just look back. The look back was done in October of last year. That was very consistent with our store experience at that time. It was 25%. That led us to the 25% conclusion. We just refreshed that analysis when taking into account the low beta this year. The new number is 20% in the aggregate. Obviously there’s a different beta in every deposit category, but the aggregate number is 20%.
So we think going forward if the Fed does hike in the fourth quarter, we’re going to pass some of that along to our depositors and that’s the term period beta assumption. And then over time the beta will catch up. So I mean if there are no hikes in the first, second, third quarter next year if the Fed holds path, our deposit rates will continue to rise just like everybody else such that we still think at the end of the cycle cumulatively, it will end up totaling around 20%. Hopefully that gives a little clarity. I appreciate your question.
Frank Schiraldi
Yeah. Thanks. And then just on the 4Q NIM expansion. So that was based on betas moving higher over time, not necessarily a 20% cumulative beta by 4Q. Is that right?
Jim Reske
Yes, it’s not a cumulative — not — thank you again for asking. It’s not saying that we’ll have reached a cumulative beta of 20% by the end of 4Q. It’s only saying in our assumption is that it will be a 20% current period beta. So if the Fed fund raise rates by 100 basis points, we expect passing on 20% of that the profits in the fourth quarter, only the current period. And the rate forecast I gave you actually is based on our — that’s based on our latest rate forecast that we received that it currently expects 275 basis point hikes, so 150 basis points of rate increases in the Fed funds rate by year-end.
Frank Schiraldi
Great. Okay. Thanks for all the color.
Jim Reske
You bet.
Operator
The next question is from Daniel Tamayo with Raymond James. Your line is open.
Daniel Tamayo
Thanks. Good afternoon guys. Now to continue on this margin discussion, but that’s great color on the fourth quarter. Obviously the margin is going to be above historical levels by that point. Just curious how you’re thinking about the margin going forward past the fourth quarter assuming we get some stability in rates if those start to come down to I guess historical levels, or do you think there’s something structural about the margin now where you can maintain higher net interest margin? Thanks.
Jim Reske
Well, I do think we’ll be able to maintain a higher interest margin for some time. It will continue a little bit and we keep repricing the loans upward. We reprice to fixed loans up even though if they come due, we reprice this upward. We saw a nice steady progression of that throughout the third quarter. So there’s the instant repricing of Fed raises rates here in the fourth quarter. But even if the Fed stops raising all through next year, we’ll still see some upticks in loan yields just as we reprice the book upward.
But I think the question, you’re getting kind of gets at this mission of a peak NIM, and when do you think that NIM will peak, it’s hard to predict because we’re in the middle of an acquisition and it’s hard to — we can’t really talk about some of those numbers, right now. But it does look like the NIM will peak sometime over the course of next year. And then if the Fed holds rates pass for a while a lot of the loan book repricing, will kind of settle into a nice higher NIM and stay there for some time.
Mike Price
I would just add, the five acquisitions that we’ve done notwithstanding Centric, have all been accretive to our margin and profitability. And we expect the same.
Daniel Tamayo
Okay. All right. That’s very helpful. Thank you. And then maybe we talk a little bit about the fee income. I think we’ve talked about guidance in the $26 million to $27 million range per quarter. Just wondering what your current thoughts are on that?
Mike Price
Probably, roughly the same. We have SBA ticking up a little bit. Maybe the swap income ticks down, even with the strength of Christmas. I think our — interchange will probably be roughly the same maybe up a little. So that’s kind of the tale of the tape, at least from this vantage point. You’re always surprised, a little bit.
And mortgage has been chugging along and doing well, but it’s certainly not at the height it was two or three years ago. We’re long on that business. We get a young creditworthy household with the mortgage and that’s also important to the bank.
Daniel Tamayo
Understood. Terrific. And then lastly, just from a credit perspective, wondering if you’re kind of purposely pulling back anywhere as we prepare for perhaps an economic slowdown next year. Any categories or just a little bit less aggressive in terms of lending? Thanks.
Mike Price
We’re not, yet. We’re reading the tea leaves with the economy from quarter-to-quarter, but we’re not yet. We feel like we can with good standards and we can at least lend through the cycle notwithstanding severe shocks or unanticipated consequences in the economy.
Daniel Tamayo
Right. Well, thanks for all the color, guys. That’s all for me. Appreciate it.
Operator
The next question is from Michael Perito with KBW. Your line is open.
Michael Perito
Hi, good afternoon. Thanks for taking my questions.
Mike Price
You bet.
Michael Perito
I wanted to start. Jim, you mentioned the new kind of expense run rate for the fourth quarter. And I know you guys will provide more commentary for next year specifically in January. But just curious, if you guys have any initial thoughts kind of excluding Centric, when you think about that NIM stepping up towards 4%, the investments you guys are making some of the digital progress? Do you guys think you will be able to generate positive operating leverage on the kind of the core business next year, if rates kind of do what the consensus forecast say they’re going to do at this point?
Mike Price
That’s our history. And as we think about deposit betas understand too, if the growth doesn’t materialize the beta will be lower. And if the growth is higher — the loan growth is higher, the beta will be higher. So we’re — Jim and Jane our deposit committee meets every other week, and they monitor that very, very closely.
Michael Perito
And what are some of the pressure points, I guess for lack of a better way of putting it where the loan-to-deposit ratio sits at about 90% today. Like let’s say, you guys do high single-digit loan growth in the next couple of quarters, right? I mean, what’s the flexibility to maybe shrink investments or cash, or would you guys look to maintain the liquidity level, and just try to be more aggressive adding funding and push the data a little bit? Can you just maybe spend a little bit more time just on that, element of the dynamic in terms of deposit betas?
Mike Price
Yes. We’ve only begun to hang rate in the last 30 to 60 days. So, we have not hung any rates.
Jim Reske
Deposit rates.
Mike Price
Deposit rates. So we just haven’t been in deposit acquisition mode. We haven’t had to be. We could sop up a lot of liquidity out there.
Jim Reske
Yes. And I’ll give some additional color just components to your question. We basically have been letting the securities portfolio run-off, and it’s been a nice source of funding for the bank. The run-off slowed down a little bit because we put on some of the securities at lower rates. And if you look at AOCI obviously, a lot of that is underwater. So the prepayment speeds have slowed but it’s still producing cash flow. So our plan is to let that continue to produce cash flow and reinvest that into loan growth.
And then the excess cash we had earlier in the year I mean I think early in the year at some point this year a crested and peaked at about $0.5 billion during calendar year 2022 I think it was early in the second quarter of excess cash. We deployed a lot of that into – we’ve put all that in loan growth. So the plan is as Mike said, now that are pursuing – we want to be – we want to pursue the deposit. We want to fund our loan growth with deposit growth. That obviously is a higher rate environment to keep up with competition but that is the long-term plan.
Michael Perito
Helpful. And then just lastly for me. I know you can’t be too specific but just kind of love to check in on this. The this whole AOCI book value, tangible capital dynamic has kind of had a – I don’t want to say an odd but an interesting impact on the way the stocks are trading and the way I think people are thinking about M&A. And obviously with Centric, you guys are kind of nudging about $1 billion or so over the $10 billion threshold. And just curious Mike, if you have any kind of just general thoughts about how you’re viewing the markets and the opportunities that will be out there. And obviously, there’s not a huge rush and we discussed that when you announced the deal but just curious if there anything that’s gone on in the last 90 days has been noteworthy or changed the way you kind of view the M&A environment?
Mike Price
Nothing in terms of the M&A environment. I’ll let Jim speak to AOCI. But I mean we’re really constructive on the deal we have right now. And they’re a branch-light franchise with high net interest margin commercially-oriented bank. It just fits like a glove for us. It’s well run with good producers. So we just think like the other opportunities that that will be very positive for the forward momentum of our company. And as Jim mentioned, we can’t speak about that for another quarter. But Jim, why don’t you talk a little bit about the other aspect of this question?
Jim Reske
So I just – I think I can bifurcate your question in two different streams of thought. One is that there is definitely an impact of AOCI as things go on. So for example from the time you negotiate a deal to the time you actually close the deal there can be such a movement in rates now. That your calculation of marks will change and you have to take that kind of thing into account. But I don’t think any of that affects and it really impacts our long-term thinking on M&A. We want to do deals that are both strategic that fit our franchise but our community bank philosophy and that are financially accretive to the bank. So I don’t think that even though the kinds of M&A that we have considered in the past, the geographic regions we’ve considered in the past, the general M&A long-term strategy for us really hasn’t changed as a result of this phenomenon. You have to take it into account. You take the rate environment into account, but it doesn’t change anything for us long term.
Mike Price
And what also doesn’t change is us appearing in 2024 and 2025 on the other side of Durbin impact and striving to be as profitable and I’ve said if not more profitable than we were the last several years in terms of ROA, pre-tax, pre-provision, all of the above. That’s the goal. And obviously, M&A gives you nice operating leverage but we also have businesses that are growing, like SBA, like equipment finance, our core businesses in our regions, our consumer lending businesses. I mean these were hard gang. I mean we were in a de novo three or four years ago and now they create a broad base of revenue for our company and opportunities for growth and to serve our customers. And they also help us through thick and thin when things get tough. We’re not reliant on a category or two of loans.
Jim Reske
I hope that helps.
Michael Perito
Yes, no, it does. Good color and thanks again for taking my questions.
Jim Reske
You bet.
Operator
[Operator Instructions] Our next question is from Matthew Breese with Stephens. Your line is open
Matthew Breese
Good afternoon. Just thinking about kind of the Fed outlook and what happens post-Fed tightening. So if we get a cessation in Fed hikes in early 2023, what is the expectations for the NIM and the aftermath of that? I mean a lot of asset sensitive banks are talking about somewhat of a peak and some decline in the margin after that. Curious, if that’s your expectations?
Jim Reske
Yes, it would be. It would be because there will be a continuing linger effect of repricing loan book upper, but also repricing deposits stuff were to get to that cumulative data we talked about before. So just to kind of be more clear about that we would think that we probably would reach peaking in sometime in the first half next year. It’s hard to pinpoint the exact time. It’s first quarter, second quarter or late this quarter or early second quarter, but it’s probably sometime in the first half next year.
Matthew Breese
Okay. And then as we approach that point and given to the earlier question about you’ll be running at above historical average, kind of, NIM do you do anything to preserve it? Any sort of balance sheet swaps or migration of the balance sheet towards a more interest rate neutral position? Should we expect that?
Mike Price
Well we’ve done that organically with how we’ve constructed the balance sheet 50-50 variable fix. So we’ve done that. And then also in the past we have layered in macro swaps to protect upward and downward movement. We’ve done it a number of times.
Jim Reske
Yes, so we’re going to be open to that.
Matthew Breese
Okay. And then secondly just on some of the fixed rate loan resets I’m curious what the incoming new loan yields are on some of the commercial real estate and multifamily and things like that? And then on a reset are you seeing any stress on the borrowers kind of bottom-line as you go from rates from three, four, five years ago and call it the 4% range. So today I’m guessing it’s north of 6%. Is there any, sort of, stress on their bottom lines? And have they been able to kind of mitigate that higher interest rate with higher rents and the like?
Mike Price
Well, they have to when they bring a project because we’re all stressing the projects with different interest rate assumptions. And if you have better developers they understand that. And so that would be the way I would answer that question. Invariably there will be stress for projects but it depends on the quality of sponsors and developers that you’ve underwritten and are wherewithal to work through it should things get even tougher.
Jim Reske
And on the rate reset question I don’t have it by category in particular to get to you but I’d just tell you this is just such a nice progression over the course of the quarter. So for the entire quarter the new loans were coming on at four call it 4.59%. The old loans are going off at 4.39%. So it’s nice replacement yields. But it’s a really solid progression month-over-month through the third quarter.
So for example, the new loan yields in the three months of the quarter we’re coming out of 4.30% then 4.60%, and then the last month in according to September 4.97% so pushing 5% and the subcategories some commercial categories over 5%. That’s just a really nice progression month-over-month. That’s the bank as a whole. That’s in aggregate. But it’s a nice progression month-to-month in the third quarter. And so we’d expect that to continue even after the Fed –for some time anyway even after the Fed stops raising rate.
Matthew Breese
Got it. Okay. I appreciate taking questions. That’s all I had. Thank you.
Mike Price
Thanks, Matt.
End of Q&A
Operator
We have no further questions at this time. I’ll turn it over to Mike Price, President and Chief Executive Officer for any closing remarks.
Mike Price
Sincere thanks for your interest in our company and questions, and it’s good to be with you this afternoon.
Operator
Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may now disconnect.
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