Columbia Banking System (NASDAQ:COLB) Q2 2019 Earnings Call

0:00 Ladies and gentlemen, thank you for standing by. Welcome to Columbia Banking System's second quarter 2019 earnings release conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session through both the telephone and web. Instructions will be given at that time. If you are on the telephone and should require assistance during the conference, Please press star zero. As a reminder, this conference is being recorded. I would now like to turn the call over to your host for today, Hadley Robbins, President and Chief Executive Officer of Columbia Banking System. Thank you, Carol. Good morning, everyone, and thank you for joining us on today's call as we review our second quarter 2019 and near-to-date results, which were released before the market opened this morning.

0:58 The earnings release and supplemental slide presentation are available at ColumbiaBank.com. As a result of strong efforts by our lending and credit teams, second quarter earnings were a new record, and quarterly earnings exceeded $50 million for the first time in our history. On a year-to-date basis, net income was $98 million, which was 19% higher than the first half of 2018. Capital levels also remained strong and well above regulatory targets. It was a very busy quarter. Our lending teams generated the second-best production quarter ever, narrowly missing the record set last year by only $8 million. Our Special Act Credits team completed the work out of a few trouble bones, which added nearly $5 million of interest income and reduced non-performing assets 31 basis points, a low not seen for some time.

1:53 Our back office teams are also heads down implementing key technology projects that include new digital banking platforms. Our second quarter deposit mix remains stable and the core deposit ratio was strong at 96%. The total cost of deposits also continues to be well managed at 20 basis points for the quarter and 19 basis points for the year. We did see a reduction in overall deposits during the second quarter. This is typically a seasonal low point of activity for us. One of the other contributing factors impacting overall deposit levels was our efforts to help those clients seeking higher yields by moving cash from traditional accounts to our brokerage and other alternative offerings. On the call with me today are Greg Zegrist, our Chief Financial Officer, who will provide details about our earnings performance and an overview of our share repurchase plan.

2:46 Clint Stein, our Chief Operating Officer, who will review our production activity and highlight the status of some of our digital investments, and Andy McDonald, our Chief Credit Officer, who will review our credit performance. Following our prepared comments, we'll be happy to answer your questions. It's important that I remind you that we'll be making forward-looking statements today, which are subject to economic and other factors. For a full discussion of the risks and uncertainties associated with the forward-looking statements, Please refer to our securities filings and, in particular, our 2018 SEC Form 10-K. At this point, I'd like to turn the call over to Greg to talk about our financial performance. Thank you, Hadley, and good morning, everyone. Second quarter earnings of $51.7 million in EPS of 71 cents per diluted share was an increase of 8 cents from the first quarter and an increase of 14 cents compared to the second quarter of 2018.

3:43 As Hadley mentioned, The operating net interest margin of 4.38%, which was up five basis points on a length quarter basis, benefited from $4.9 million of loan interest recoveries on non-accrual loans. Partially offsetting this was a $650,000 true-up of an interest accrual as we took advantage of short-term FHLV borrowing rates earlier in the year. The net impact of these two items was nearly 15 basis points. Offsetting drivers included a seven basis point impact from the seasonal funding mix shift we experienced given typical second quarter deposit flows and a two basis point impact from deposit rate increases in the first quarter.

4:28 As you've heard us say for the past six quarters, we are actively managing our exposure to a declining rate environment through the ALCO strategies put into place beginning in late 2017. As a reminder, those strategies include taking additional duration in the loan portfolio, growing the balance sheet approximately $500 million by purchasing securities that would respond well in a down-rate environment than the $500 million derivative zero-cost collar strategy put into place early in the first quarter. However, we are not completely immune to a declining rate environment. A 25 basis point rate cut would be expected to reduce quarterly net interest income by $4 million in the first year. On a linked quarter basis, Non-interest income increased by $4 million to $25.6 million, mostly due to bullied benefits of $3 million.

5:21 Loan revenue was up $1.2 million on the strength of CNI production. Our expense run rate remains well controlled, with non-interest expense of $86.7 million increasing quarter on quarter, largely due to increased digital investments. This is in line with what we shared at the last earnings call, that quarterly operating interest Operating Expenses, excluding the impact of our digital investments, would continue in the mid-80s. Excluding acquisition costs of $7.1 million in the first half of 2018, non-interest expense is up $8 million or 5% on a year-over-year basis. Half of the increase is from digital initiatives with remainder from compensation and incentive expenses. In the second quarter, we incurred $2.9 million of expenses that was directly related to our digital initiatives.

6:12 We expect the digital investment impact to non-interest expense to be in the $6 to $8 million range for the balance of the year. Our effective tax rate was 19% for the quarter and the year, and it should continue to be in the 19% to 20% range for the remainder of the year. With regard to our share buyback program, we intend to continue to repurchase shares as part of our capital strategy, provided we feel it is advantageous to our shareholders to do so We have a strong capital position and will balance buybacks with special dividends and strategic opportunities in the future. At this point, I'd like to turn the call over to Clint. Thank you, Greg. Good morning, everyone. We continued the momentum created during the first quarter and had an outstanding second quarter on all fronts.

6:57 Our first half 2019 loan production of $767 million is well above levels achieved in the past. In a very competitive market, Our bankers continue to earn new business and even existing relationships while sticking to our credit disciplines. What's impressive is they could produce more, but at this point in the business cycle, we're unwilling to increase our risk appetite. Some of the successful outcomes of the second quarter are not as readily visible in this quarter's financial performance as the loan growth and interest income recovery. However, they are vital to sustaining and growing revenue. We have a very talented group of bankers who are working diligently on the execution of our digital roadmap while never losing focus on the importance of the customer experience.

7:48 The projects they are working on now will enhance our performance for many years to come. Deposits declined $157 million during the second quarter, which is normal due to seasonal business activity. We have seen some deposits migrate off balance sheet to our financial services group as clients invest in equities, treasuries, and other financial instruments. During the second quarter, we had roughly $61 million in deposits that moved to our financial services group, which is fairly consistent with the $65 million of activity in the first quarter. While this activity results in lower deposit balances, we maintain the client relationship and generate non-interest income.

8:36 The mix of our deposit base remained consistent, split evenly between interest and non-interest bearing. The composition also remained steady with 59% commercial and 41% retail. As seasonal patterns hold, deposit balances should pick up in the third quarter. Loan production was the second best quarter ever at $401 million. narrowly missing the record by $8 million set in the third quarter of 2018. Even with record first half production, the loan pipeline remains our satisfaction. Term loans represented $236 million of total new production, while production from new lines accounted for $165 million.

9:23 The portfolio mix remained stable with 46% fixed rate and 54% variable. New loan production throughout the quarter came on at an average tax-adjusted coupon rate of 5.15%, which compares favorably to the overall portfolio rate of 4.97%, which was down two basis points during the quarter. The modest decline is a result of higher yielding repayments in the construction and CRE space, coupled with repricing of variable rate loans. Prepayments of $176 million in the current quarter were lower when compared to an elevated $189 million in the second quarter of 2018.

10:11 However, $23 million in the current period was the result of special credit workouts, and when excluded, our trends continue to improve even further. For context, prepayments in the first half of 2018 were up 60% over 2017. 2019 prepayments have moderated to roughly 18% above our 2016 and 2017 levels. The primary prepayment drivers remain the sale of businesses or commercial real estate as well as unattractive rates and terms offered by bank and credit union competitors. During the current quarter, C&I production was 56% or $222 million of the total production.

10:58 which is consistent with prior quarters. Commercial and multifamily real estate loan totals were flat during the quarter, while commercial and multifamily construction loans were up slightly during the quarter, but are down 132 million since the second quarter of 2018. Year-over-year declines are primarily in the multifamily, warehouse, and healthcare sectors. Implementation activities for our digital program are on schedule. Our commercial online banking system rollout is going smoothly and will be complete by the end of September. We anticipate being live on a new human resources and talent management platform by the end of the year. Among a variety of other projects, we're also on target to introduce Zelle and the ability to open deposit accounts online by year end.

11:52 Our bankers are doing a great job with expanding our customer base generating high-quality loans and long-term deposit relationships. Recent announcements on the trade war and anticipated Fed rate cuts are resulting in more conversations with clients as they assess the impact to their businesses. Now, I'll turn the call over to Andy. Okay. Thanks, Clint. Our second quarter provisions for loan and lease losses of $218,000 compared favorably to the $1.4 million in the first quarter. This included provision of $500,000 for the originated portfolio and $150,000 for the Pacific Continental portfolio. Offsetting these provisions was a release from the West Coast portfolio of $400,000 and net releases of $33,000 for the TTI portfolio.

12:45 Provisioning was primarily driven by charge-off. However, the impact of charge-off activity and loan growth to a lesser extent were offset by favorable migration and declining loss rates. Net charge-offs were $3 million during the quarter, up from $1.5 million, and equate to about 14 basis points on an annualized basis, up from seven basis points last quarter. So while higher than the prior quarter, 14 basis points is still very good. And as such, I'm extremely pleased with the performance of our bankers this past quarter. As Hadley mentioned, NTAs to total assets were down to 31 basis points, which is the lowest since 2016 and prior to that, 2006.

13:34 During the quarter, we were able to resolve our largest non-performing loans and sell our largest OREO parcel, thus driving down non-performing loans and OREO to these very low levels. In so doing, we were also able to recapture $4.9 million in interest income recorded gain on the disposal of loans of $667,000 and recorded gain on the sale of Oreo of a little over $700,000. So it goes without saying, our special credit team had a great quarter. As of June 30, 2019, our allowance to total loans decreased by 5 basis points to 93 basis points of total loans. As always, we like to remind folks that this ratio is impacted by our acquisition and the associated loans that were recorded at fair value.

14:26 Embedded in those valuations is approximately $21 million of net discounts for which approximately $16 million is associated with the Pacific Continental portfolio, $3 million with the West Coast portfolio, and $2 million with the Intermountain. After a relatively low first quarter net charge-offs were back to normal levels in the second quarter, However, we actively monitor the sector and collateral concentrations, and we believe we are adequately reserved going forward. In summary, credit improved modestly during the quarter. The portfolio continues to perform well, and we remain focused on positioning the bank for the next downturn. So that's all I have. Hadley? Thanks, Andy. Regarding the economy, fundamentals continue to look healthy through the end of 2019.

15:18 Conditions continue to evolve that have the potential of creating earnings pressure, most notably a flat to inverted yield curve, potential Fed rate reductions, and trade-related uncertainties. For us, we see this as a time to remain diligent and stay the course with our risk disciplines, hold our focus on creating efficiencies, and take actions that position us to offensively be prepared should a downturn materialize. We're pleased to announce our regular quarterly dividend of $0.28, which represents a dividend yield of 3.04% based on the closing price of our stock on July 24. This quarter's dividend will be paid on August 21 to shareholders of record as it closes the business on August 7, 2019.

16:07 This concludes our prepared comments this afternoon. As a reminder, Greg, Clint, and Andy are here with me to answer your questions. And I'm Carol. We'll open the call for questions. Thank you. Thank you. To ask a question via the web, click the Q&A button in the lower left-hand corner of your screen. Type your question in the open area and click Submit. If you would like to ask a question over the phone, simply press star, then the number 1 on your telephone keypad. If you would like to withdraw your question, press the pound key. Our first question over the phone today comes from Jeff Rulis. Please go ahead. Thanks. Good morning.

16:52 Morning, Jeff. So on the margin, I guess if we net the interest recoveries and true up against the core of 438, if you get down to 423, in Q1 were there comparable returns? Are there any other recoveries or true-ups if you had a comparable number to the 423? No, I don't think we would add any of those types of true-ups in the first quarter, Jeff, so I'd take that 423 and compare it back to that number. And as I said in my prepared remarks, when you do that, you're really seeing the two basis point increase from the deposit rate adjustment in the first quarter and then the seven basis points coming from the seasonal mix shift on funding.

17:43 for the 433 last quarter operating as comparable to the 423 if you take out the recoveries in true up? Yes. Okay. And then just interested in, Greg, thanks for the dollar hit on the cut. I guess just outlook on margin as that translates and, you know, on a go forward with, I guess, within your 25 basis point, and many more. Thank you very much. at or below the floor rate subject to repricing.

18:44 But we've got over $900 million of loans that are above floor rates that reprice over the next four quarters. So again, absent a rate cut, that's a positive impact. I would also expect us to get back some of the impact of the funding mix here in the third quarter, again, to Clint's point, assuming deposit rates return back to historic levels. When I add all that together, absent a rate cut, it feels to me like we're up a little bit on the margin. And as I said in my prepared remarks, we do have the ALCO strategies in place, which help to mitigate some of the impact of a 25 basis point rate cut. But if it is 25 basis points, we would expect a $4 million annual impact in that first year after a rate cut.

19:29 Okay. That's good color. Thank you. Then on the expense, I wanted to make sure that – so if you had – I guess call it, would you assign $2 million in the quarter to the digital spend and then does that compare to an additional $6 to $8 for the balance of the year? Well, no, the spend in the quarter was $2.9 million roughly, which was roughly $1 million ahead of last quarter, maybe $1 million ahead of last quarter. So, so far we're at the $4 million mark and I'm expecting another $6 to $8 million on the balance of the year, which Fuller puts us 10 to 12. And I think in last quarter remarks that indicated 9 to 12. So we're still kind of where we thought we would be.

20:16 Okay. So the 2.9 was total digital spend this quarter. And then if we were to look at 6 to 8 for the balance of the year, that's either flat to up to 4. Is that fair? Yeah. Quarter on quarter, that's fair. Okay. Got you. I'll step back. Thanks. Yep. Our next question comes from Aaron Deer. Please go ahead. Hi. Good morning. Just to clarify on the expense run right there, maybe just give some guidance around the actual dollar non-interest expense that you'd be looking for here in the back half of the year, just because it's a little confusing talking about the quarter-to-quarter variances.

21:08 Yeah, I mean, I would just reiterate what we said the past couple of quarters, which, you know, factor out seasonal impacts we have, you know, usually in the first quarter, but we're still expecting our non-interest expense run rate, excluding digital, to be in that mid-80s range. I think the other thing, though, as we get into next year, and I'm not going to give guidance on it, but we still remain very focused on our operational efficiencies and figuring out how to drive that down and help to pay for the digital initiatives as we get into 2020. Okay. And then, Clint, you expressed satisfaction with the loan pipeline. I'm just curious if... It seems like you've been doing a good job on the hiring front. You guys just announced an impressive banker here earlier in the week. Just curious to know how those hires are playing out vis-a-vis what sounds like kind of a more conservative outlook in terms of what you're willing to underwrite and what that should mean for loan growth heading into the back half of the year.

22:19 Yeah, I think that what we've talked about on prior calls is capacity and how we've had a focus on increasing that capacity by selectively hiring new talent across our entire footprint. And we continue to be fortunate to be an employer of choice. Our talent management team continues to source really great candidates, and what that's done over the past couple of years is it's enabled us to increase our capacity, get new relationships, as well as just our long-time bankers are very good at, and I think the term that I used in my prepared remarks was deepening existing relationships, and so it's It's a combination of what's been tried and true in terms of our production folks that have been with us for many, many years, as well as the supplemental production and growth that's coming from recent hires.

23:37 That's enabled us to have those production numbers without really changing or deviating from our credit disciplines. It's very competitive. We will compete for really solid deals if we have to on price, but we won't absolutely give on structure. And so I think that you're seeing that come through in the quarterly production numbers. You're seeing that come through in terms of usually, historically, if we've had a big quarter from the production standpoint, the pipeline gets a little depleted and takes some time to rebuild. You know, it's still very much to our satisfaction.

24:23 It's an extremely competitive market, and so we won't give guidance in terms of what that translates into for loan growth. And then there's the prepayment activity, and I did provide some color on that, that it continues to moderate, but it's still elevated relative to What we had in 2016 and 2017, but it's about a third of what it was in terms of the increase compared to what we experienced in the first half of 2018. Okay. Is it safe to say that based on your commentary there that the prepayments haven't accelerated recently as a result of the drop in rates that we've had in kind of the midpoint of the curve?

25:15 Yeah, I think it's safe to say that what we're seeing in prepayment activity is really still the thing that's been a dynamic for us since we came out of the downturn, and that's the sale of businesses, the sale of real estate properties given where valuations are. and then some deals that we'll let go because competitors are willing to do things structurally that we're unwilling to do. Sure. Okay. Thank you for taking my questions. I'll step back. Thank you. As a reminder, it's Star 1 in order to ask a question over the phone.

26:01 Our next question comes from John Armstrong. Please go ahead. Thanks. Good morning, guys. Good morning. Good morning. A couple of follow-ups here. Maybe, Greg, for you, the 25 basis point impact driving $4 million a year headwind in net interest income, is it similar for a second rate decline? Is it any more or less or is it similar? Yeah, it's not linear. It's a good question, John. The protection on the derivative side really doesn't kick in until the drop approaches 25 basis points. So, you know, for context, – the $4 million in the first 25 is about a million of protection between the investment strategy we have and the derivative strategy. If it's a full 50 basis points, the impact would be $7 million, and that's net of about $5 million of impact. So you start to see some pickup and acceleration of the derivative benefit.

26:59 Okay. Okay, got it. That helps. Have you guys seen any cresting in deposit cost pressures? I know your deposit costs are fairly low relative to peers, but just curious on that topic as well. It's still been pretty active. I'm curious to see what happens after the next Fed meeting and if at that point we do see a cresting of pricing pressure, but right now I think it's more I don't want to say frenzy, that's too strong of a word, but there's a lot of client conversations and that's back to my prepared remarks I referenced.

27:48 We've had 126 million in the first half of the year of deposits that, based on conversations with clients, understanding what their needs are and their desire to get a better return We've been able to move them into our financial services group. I think that there's a sense of urgency from a client perspective that they've been through this low rate environment in terms of earnings on their deposit balances and the expectation at the start of the year was that there was still room to run from a rate perspective, and I think those expectations are tempered, and that's creating a little more sense of urgency for folks to figure out what they do. Okay, good.

28:45 That's helpful. And then just one more maybe bigger picture conceptual question on your production numbers. You talked about lower payoffs and a little more competition, but I'm just curious here. Assessment of the overall economic environment. Is it any more or less active than it was a year ago? Or is this increased production really, you know, the same amount of production but just less of the payoffs? Thanks. It's more production. I mean, that's why we throw the production number out there is because the payoff activity based off of economic factors, you know, i.e., the business sales, and as well as the seasonality that we have in our portfolio can impact the quarter over quarter bottom line growth number.

29:46 I don't think that the reduction in prepayment activity is driven by A slowdown in economic factors. I think it's really probably more around some of the things that caused that elevation last year. If you recall, we did some additional credit pruning throughout 2018. While we still continue to do that on an ongoing basis, It's at more of a normalized level, I'd say, compared to what it was last year. So that's one side of it. And then the other side is that, much like Bank M&A, as our clients are looking at strategic alternatives for their businesses, there's lumpiness in the timing of when they can actually do some of those things.

30:45 So with regard to the economic influences out there, we see some of our clients applying Cash to Debt. We also see some of our clients making decisions to sell because they believe that either their business or a particular piece of property is fully valued and that we're keeping a cycle and they would prefer to liquidate at this point in time. But I believe that the economic fundamentals are still there. We're getting our at-bats. We have increased some of our capacity, so that feeds into production. So overall, I don't really see that there are prepayment trends that are approaching what we saw last year.

31:38 They're more normalized and that the economic activity is giving us opportunity within the context of our risk appetite. We're able to produce at levels seen in the past and maybe a bit more. Okay, good. Thanks for that. I appreciate it. Okay. Our next question comes from Gordon McGuire. Please go ahead. Thanks for taking the question. Hi, Gordon. Hi, how are you all? Good. The $4 million on a 25 basis point cut, was that based on a static balance sheet or is that assuming growth as well? Static. Static. Okay. And then just thinking about the mechanics of the TRUUP, I may have missed it. Where did that fall out of in the NIM?

32:31 Was that the borrowings? Yeah, it's really on the FHLV borrowing side. That's right, Gordon. Okay. Any updated expectations on where you'd expect to see the securities balances move over the next few quarters? Looks like that was used to fund some of the loan growth this quarter. I guess, will that continue or do you think you can start to grow those? Well, I mean, obviously moving loans to deposits up to 85% in the quarter. I mean, that's as much a function of the deposit seasonality that we see. And I would say the other side of that is the securities portfolio. So I would actually say it's difficult without knowing exactly how much production Clint's going to give us that drops into loan growth. to say exactly what's going to happen to the securities balances. But if you assume the deposits get to normalized levels and then make your assumptions around loan production, how that translates, it would then translate into the way we look at the securities portfolio, which is really that reservoir of liquidity we need to fund the rest of the balance sheet.

33:37 Got it. And just the borrowings, I guess, do you think those stick around here at these levels or do you think there's potential to manage those down? We had grown the balance sheet by roughly $500 million to support the strategy on the security side, which we talked about. I would expect there to continue to be some form of borrowing at roughly that level to support that strategy, Gordon. And then last thing for me, where in the expense lines did, I guess, the $2.9 million related to the digital initiatives fall? I think the release mentioned professional fees, but were there any other buckets? It's in a couple of different lines. Professional fees, certainly, but it's also going to be in the line that's around occupancy and technology.

34:23 A lot of it comes through those two lines. Got it. I'll step back. Thank you. You got it, Gordon. Thank you. And we have no further questions at this time. I'll turn the call back for closing remarks. I think we're prepared to close the call if there are no further questions. Thank you. Thanks to all of our participants for joining us today. We hope you found this webcast presentation informative. This concludes our webcast and you may now disconnect. Have a great day.