Good morning, and welcome to the Financial Institutions Third Quarter 2018 Earnings Conference Call. [Operator Instructions] Please note that today's event is being recorded..

I would now like to turn the conference over to Shelly Doran, Director of Investor Relations. Please go ahead, ma'am. .

Good morning, and thank you for joining us for today's discussion. Providing prepared comments will be President and Chief Executive Officer, Marty Birmingham; and Chief Financial Officer, Kevin Klotzbach.

They will be joined by Chief Corporate Development Officer, Bill Kreienberg; and Chief Accounting Officer, Mike Grover, for the question-and-answer portion of the call..

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 our historical SEC filings, all available on our website, for our safe harbor description and a detailed discussion of the risk factors relating to forward-looking statements.

We will also discuss certain non-GAAP financial measures intended to supplement and not substitute for comparable GAAP measures. Reconciliations of these non-GAAP financial measures to GAAP financial measures were provided in yesterday's earnings release, which was filed with the SEC as an exhibit to our Form 8-K.

Please note that this call includes information that is accurate only as of today's date, October 26, 2018..

I now turn the call to Marty. .

Thank you, Shelly. Good morning, and welcome to Financial Institutions third quarter earnings conference call. Once again, a good quarter with key drivers of results driven by loan growth, asset quality and a lower tax rate.

As we have communicated in prior calls, we have taken advantage of available talent in our markets over the course of the past 2 years and have hired proven, experienced commercial and residential producers and leaders. This investment in personnel is fueling loan growth stronger than most of our peers..

Total loans at quarter-end were up 3% over the previous quarter and up 14% as compared to the prior year. Total C&I, CRE and small business loans increased 5% from June 30 and 23% from September 30, 2017. C&I and CRE pipelines combined remain strong and relatively unchanged from the last quarter..

Residential loans were up 4% from June 30 and up 14% from September 30, 2017. An additional demonstration of increased productivity in residential loan production was a net gain on the sale of loans that was $172,000 higher than last quarter and $153,000 higher than the third quarter of 2017..

Our Consumer Indirect auto loan portfolio yield increased by 11 basis points during the quarter. We continue to see upward rate movement in this business and expect the trend to continue..

Consumer Indirect lending remains a core competency for us. It is a profitable business. However, we are currently focused on growing commercial and residential lending as these types of loans are relationship based and more conducive to the cross-sale of other customer relationships such as deposits, insurance and wealth management..

Consumer Indirect loans now represent 30% of our total loan portfolio, down from a peak of 35% several years ago. We expect this evolution of loan mix to continue, with the overall percentage of indirect loans to total loans continuing to decline..

Total deposits were $224 million higher than June 30 because of business development efforts in retail, commercial and municipal banking in addition to public deposit seasonality. Total deposits were $204 million higher than September 30, 2017..

Nonpublic deposits were 6% higher than 1 year ago and 4% higher than June 30. We continue to explore initiatives to leverage our attractive deposit franchise and maximize core deposit growth, while we also monitor actions and pricing by peers in our markets..

In September, we hired Alison Miller as our Commercial Market Executive for Central New York. She is responsible for building commercial relationships, growing the bank's commercial loan portfolio and increasing awareness of our bank in the Central New York region. She will focus our efforts on C&I lending.

Alison most recently served as a regional sales manager of business banking at Key Bank and previously held the same role at First Niagara Bank. She is well known and respected in Central New York.

We had already been doing business loan -- we had already been loans in Syracuse and Ithaca and following existing customers into these markets as they expanded geographically. We determined that it made sense to have boots on the ground in this geography rather than service all the relationships out of Rochester.

Several Five Star associates already knew and had worked with Allison. So when it came time to selectively choose someone to assume a lead role in this area, she was the logical choice..

Alison is working out of our Auburn branch and is doing work in our existing footprint as well as in the region we have defined as Central New York..

I'll now turn the call over to our Chief Financial Officer, Kevin Klotzbach, who will provide an overview of financial results and our outlook on key areas for the remainder of the year.

Kevin?.

Thank you, Marty. Good morning, everyone. I'll begin with a review of our financial results..

net interest income was $2.4 million higher in the quarter due to organic loan growth, our provision was $700,000 lower, the effective tax rate was 19.5% as compared to 29.5% in the third quarter of 2017..

As compared to the second quarter of 2018, net income was $1.6 million lower, primarily as a result of the low loan loss provision recognized in the previous quarter. The second quarter provision was only $40,000 as compared to $2.1 million in this third quarter.

Our disciplined credit culture, responsible lending practices and positive economy have all contributed to higher asset quality..

Third quarter annualized charge-offs were 28 basis points. That's 11 basis points lower than our 10-year average ending in December of 2017 of 39 basis points. The ratio of nonperforming loans to total loans was 26 basis points as of September 30, which is the lowest quarterly level we have experienced over the past 10 years.

The ratio was 34 basis points as of June 30, 2018, and 48 basis points as of September 30, 2017..

Net interest margin for the quarter was 3.18%, up 1 basis point from the second quarter of 2018..

Our average loan yield increased 12 basis points, contributing to an average yield on interest-earning assets of 4.01%, which is up 13 basis points. Our cost of funds was 83 basis points, up 12 basis points from the second quarter of 2018.

The increase in yield on the interest-earning assets was virtually equal to the increase in the cost of funds for the quarter. With a margin of 3.18%, 3.17% and 3.19% for the last 3 respective quarters, we believe the margin has stabilized..

We continued our efforts to convert a portion of our marketable securities in the securities portfolio into loans. Our securities portfolio decreased by $49 million in the quarter, primarily due to maturities, strategic sales and payments received on municipal bonds and mortgage-backed securities.

Proceeds were used to partially fund our strong loan growth..

Over the course of the first 9 months of the year, our marketable securities portfolio decreased $123 million, with $14 million of the decline attributable to negative valuation adjustments. The remaining $109 million represents maturities, sales and payments received and then used to fund our loan growth..

Noninterest income was $1.3 million higher than the second quarter of 2018. Insurance income was up $483,000 because of the second quarter impact of nonrenewals on one of our agency specialty lines of business combined with seasonality.

The first and third quarters of our insurance business continue to be higher than the income in the second and fourth quarters because of annual contingent commission revenue and the seasonality of commissions on commercial accounts.

We anticipate that the seasonality will become less impactful as SDN continues to transition its book of business to a higher composition of personal life. Investment advisory income was up $334,000, driven primarily by the June 1 acquisition of HNP Capital.

The net gain on derivative instruments was $276,000 higher in the quarter, as a result of interest rate swap products offerings to commercial loan customers, which was launched in the third quarter of 2017..

The increase in the gain was the result of an increase in the number and the value of transactions executed in the quarter. Income from investments in limited partnerships was up $205,000. As we have talked about in the past, this income is difficult to predict as it fluctuates based on the maturity and the performance of underlying investments.

And the last significant driver of the increase of noninterest income this quarter was the net gain on the sale of loans, up $172,000 as a result of investments in our residential mortgage lending business, which has facilitated in increasing mortgage sales through the secondary market..

I'll now move on to the discussion of noninterest expenses. Expenses were above the range we have provided in last quarter's guidance, primarily driven by investments in people..

Salaries and employee benefits expense was up $1.1 million from the second quarter. As noted in the earnings press release, average full-time equivalents increased from 661 in Q2 to 681 in Q3. A few of the drivers and factors are HNP Capital, with 8 new employees, was included for the fourth quarter.

We took advantage of available talent and made a few new hires earlier than anticipated, and our retail vacancies were filled..

Professional services were -- professional service expense was $457,000 higher, primarily due to legal and accounting expenses related to shelf registration filing and professional services related to the additional talent..

Advertising and promotion expense was up $228,000. You may recall last quarter, we indicated that this expense line item will fluctuate because of the timing of certain aspects of our branding campaign that was launched in February..

The effective tax rate was 19.5% in the third quarter and 19.7% in the second quarter, reflecting the lower corporate federal tax rate due to the Tax Cuts and Jobs Act. .

I'd now like to provide our estimate outlook for some key areas.

We anticipate low double-digit growth in our loan portfolio for the full year of 2018, with loan growth in commercial and residential lending at the higher end -- higher rate than the Consumer Indirect, mid- to high single-digit growth in nonpublic deposits for the year, a net interest margin of approximately 3.18% for the year, full year noninterest income of approximately $36.5 million, full year noninterest expense of approximately $98.5 million, an efficiency ratio for the full year of approximately 61.25%, conversion of approximately another $25 million of our securities -- marketable securities portfolio in the fourth quarter of 2018, an effective tax rate for the full year of approximately 19.5%..

And with that, I'll now turn it back to Martin. .

Kevin, thank you very much. We are currently in the process of developing our 2019 budget and business plan and will not be providing guidance at this time. We plan to provide full year 2019 guidance during the fourth quarter conference call..

I'll now provide an update on the impact of our branding campaign. As I've mentioned before, this is a multiyear campaign focused on increasing consumer awareness of our brand and moving prospects through the path -- through the purchase of banking, investment and insurance services and advocacy.

Our lead metrics for measuring awareness are based on website access, and indications remain very positive. From March through September of 2018 versus the same period in 2017, total users are up 43%, new users are up 44%, number of sessions is up 22% and mobile users have increased 174%..

Purchase metrics include new customer and account opening data as well as deposit growth. For March through September of 2018 versus the same period in 2017, total new checking accounts, representing consumer and commercial combined, increased 14%..

Total new premier accounts increased 66%, and new-to-bank customers with a checking account increased 5%. In addition, total nonpublic deposits and core deposits, defined as consumer and commercial DDAs and NOW accounts, year-over-year, have increased and are ahead of plan.

We break our premier accounts in this analysis because these are our relationship-based checking customer accounts at the consumer level. These customers receive benefits because of the extent of their relationship with us..

Additionally, our advertising campaign featured this product specifically. The campaign has been well received and has also received several awards. Most recently, Five Star Bank won 4 awards from Graphics, Incorporated in the television and poster campaign categories.

This is a prestigious international publication that awards campaigns in several categories, and this year, recognized national and international companies such as Nike and Harley-Davidson..

Earlier this year, the television campaign won bronze and silver Telly Awards. Last April, we announced that Kevin will step down as Chief Financial Officer in March of 2019, and that a search for his successor would be a priority.

We were very pleased to report earlier this week that the search has been completed, and Justin Bigham was named Executive Vice President and Deputy Chief Financial Officer. Justin will assume responsibility for Finance and Treasury operations next week, reporting to Kevin.

Justin brings to us a strong financial accounting and treasury background as well as broad-based banking line of business experience.

During his tenure at M&T Bank, he was a key contributor on a team that centralized the bank's segment finance function, leading a team that served as financial business partners for every business line throughout the organization.

After the Great Recession, he moved into mortgage and consumer lending where he served as divisional CFO in mortgage, consumer lending, banking services and support services..

After 7 years at M&T, Justin was recruited by First Niagara to build out their financial planning and analysis function. He later served as head of consumer product management, directing product and P&L for business lines of consumer and small business, including deposits, payments and lending..

Committed to Western New York, Justin chose not to relocate to Key's headquarters after its acquisition of First Niagara. He subsequently joined HealthNow, the parent company of BlueCross BlueShield of Western New York.

There, he has led the financial planning and analysis function, while supporting the management and the firm's $700 million security portfolio. Justin has a reputation as a motivating team leader and colleague with a strong track record of developing talent.

We believe he will be a terrific addition to our leadership team, and we look forward to introducing him to the investment community over the coming months..

Kevin will continue to serve as Chief Financial Officer until the end of March, at which time Justin will assume the CFO role. To ensure a successful transition, Kevin will continue to support the company through December 31, 2019..

That said, we're now ready to open the call for questions and answers.

So Rocco, can you please facilitate that process?.

[Operator Instructions] And today's first question comes from Alex Twerdahl of Sandler O'Neill. .

I first just wanted to -- and I appreciate you're not quite ready to give guidance for 2019. But just over the last couple of years, you guys have obviously done a lot to transition to the balance sheet and a lot of that's included a number of hires.

Can you just talk a little bit sort of about the pace to hires from here? Do you think that now we're at a point where -- obviously, 1 or 2 positions are here and there, but are you kind of full staffed in all the areas you want to be at this point?.

I do believe, Alex, that the pace of hires that you're talking about will continue to moderate as we go forward. It's a question now of managing these -- managing the opportunities in front of us with the team that we have built and assuring that the contributions by teammates and individual producers are consistent with our expectations. .

Okay, great. And then just talking about this -- the transition of the balance sheet from the remixing of assets from securities into loans. I know you've got a little bit more to do in the fourth quarter, but that brings securities down to a little bit under $900 million, and now you've got a municipal book that's over $1 billion.

Can you just talk about how big that securities portfolio has to be? And how much more remixing could potentially be done into 2019? Or is it kind of now at the point where the asset side of the balance sheet in terms of the percentages of everything? Or kind of how they're going to look going forward?.

A couple of thoughts on that, Alex. First, I would share that our peers pretty much have -- our peers have about a 20% ratio of securities to overall assets. So at $4.2 billion, we get a little bit below $900 million. That feels right relative to that group.

Notwithstanding that, your question was how much do you think we need? That is -- which you might be aware of, there is a product out there called a MULOC, a municipal line of credit, which we can access through the federal home loan bank.

And we've been successful in encouraging several of our municipal clients to accept a MULOC in lieu of a security budget. They're generally the larger clients because it takes a little more sophistication. But the MULOC can be backed by loans.

So we do believe there still is some additional room below $900 million that we can continue to reduce the portfolio. I hesitate to give you a target because it's dependent on several factors, but we think there will be an opportunity next year to continue to reduce that portfolio to some extent. .

Alex, I'd also add that we continue to work as the senior leadership team on thinking about constructively and critically of the optimal mix of our balance sheet. And as your first question implied, we've been working over the last several years to drive our lending activities in traditional community banking lending.

And as we continue to pick up momentum in our residential and commercial, we have an opportunity to think about the growth rate of Indirect.

And as I've talk about in my prepared remarks, that percentage of our overall loan book and percentage of our overall balance sheet, we think, will continue to moderate as compared to where we've been historically. .

Okay. And then just final question from me. Just talking about the provision. You got your NPLs now down to 26 bps, charge-offs have been low, the reserve has been coming down gradually.

Can you -- is there a target -- based on the historical trends and all the different things that work into the reserve, should we expect that reserve to continue to trend down towards 1%? Or maybe you can just give us a little bit of thoughts around the reserve and the provision going forward?.

So we build our reserves each quarter based on the risk inherent in the portfolio as well as loan composition. So we do not have a targeted goal for that. Obviously, over the last several quarters, the credit quality has improved. And I think you've seen a linear adjustment in the same direction relative to our coverage ratio.

So if there's continued improvements, it might go lower, but it's really built from the bottom up not viewed from the top down. .

So from that -- based on that if you continue to remix into residential and commercial and away from indirect auto, the reserve theoretically could have a little bit more to come down?.

Yes, I think that's a good way to think about our allowance. .

And our next question today comes from Joe Fenech of the Hovge Group. .

A similar question to the balance sheet -- on the balance sheet mix. You all have executed really as you said you would, and you kept the margins stable throughout.

But a similar question on the overall business model, maybe Marty or Bill, in terms of the contribution from fee revenues that you're looking for longer term, efficiency and just the overall geographic positioning of the franchise.

And then also any longer-term sort of profitability targets you're shooting for?.

A very comprehensive question. Thank you, Joe. Let's -- strategically, we continue to be very well positioned in our footprint in terms of the Rochester, Buffalo MSAs.

We talked about Alison this morning as the next logical extension because we have been finding opportunities that our customers have been taking us to beyond our proper footprint, and it's a very next logical extension in terms of a very similar market in terms of Central New York.

But we have plenty to do from a retail and commercial perspective in terms of converting deposit loan opportunities in greater Rochester and Buffalo as far as a primary focus for the company. As far as our fee income percentage of revenue, we have, historically, over the last several years, put some -- a target out there.

And Kevin, as our revenues have move around, given the expansion of our lending categories that -- where do we end up there?.

So the better-performing community banks, as you know, have a higher percentage of revenue derived from fee income. So when Marty -- back in 2013, when Marty started his position as CEO of the company, our revenues were exclusively driven by branch-related deposit type fee income, represented about 18%.

This most recent quarter, we're approaching 25% of our revenues from fee income. And clearly, opportunity and desire to continue to grow that as a percentage of revenue and looking to build out of our fee-based platforms that we've successfully added to the franchise, both our insurance platform as well as our wealth management platform.

And you may have noticed last quarter that we added another piece of the wealth management platform in the Rochester market. So we feel good about those businesses. We want to continue to drive that as a percentage. We're not done at 23% to 25%, we desire a higher level, and we'll continue to pursue it. .

So Joe, Bill Kreienberg. A couple of things to wrap up what Marty and Kevin said. With the addition of the staff we've added to our commercial group, we have experienced lenders from larger organizations that are very good at cross-selling bank services and also our fee-based subsidiary services and insurance, wealth management.

For us, going into 2019, we are looking to take the efforts we've had in wealth management and develop our platforms sort of from dollar 1 through branch activity through, let's call it, the affluent market, which Courier Capital and HNP have typically navigated.

We also have been working hard over the last couple years to convert our insurance agency to more of a classic bank-owned agency, whereby our commercial group is driving significant revenue and referrals through that agency. So we're starting to see the fruits of that work over the past 18 months to 2 years.

Also, our bank has, through a talent acquisition, acquired a true treasury management specialist. We expect, in '19, to drive more fee-based income through our cash management activities for commercial customers. So we see the benefits of these investments in what I've described bearing more fruit out in '19 for us. .

And then how about, just hopping around here, the loan-to-deposit ratio, you guys are very liquid at just the right time to the change in the rate environment and the growth they've been putting up. How high do we likely see that go? Is there a specific target in mind where you're most comfortable? I think you're at about 86% today. .

Yes, the loan-to-deposit ratio here has been traditionally low because of the composition of the balance sheet, heavy on securities, heavy on municipal deposits. We definitely want to see that higher. We do not have a target externally we've talked about. And -- but I do -- I strongly believe that 86% is a level that we'll exceed in the future. .

Okay. And then just remind us of your comfort level -- the PC ratio has been remarkably steady. I think it was a 10 basis point range for 4 quarters in a row now.

Are you still comfortable with the changing mix and the balance sheet operating in this low 7% range on PC?.

Yes, so there's a couple of things going on there. One is clearly our loan growth spend, excellent. And as a result, obviously, that puts some -- a little bit of pressure that's held that ratio relatively constant. Additionally, the ALCI adjustment rate's up, the bond price is down.

The good news on our bond portfolio is it's essentially a 6-year laddered portfolio. So that will eventually mature in part and recover the adjustment for that. So we're comfortable with our capital levels where they currently are, and we think they'll continue to build through retained earnings as well as maturity of bonds over time. .

And ladies and gentlemen, our next question comes from Damon DelMonte of KBW. .

Just a couple of quick questions for you, probably for Kevin here on the modeling aspect of it. I think you had said the expected noninterest income for the year is $35.6 million.

And is that on a GAAP basis? Or is that on a -- I know in the first quarter, you had like almost $600,000 of nonrecurring income, so does that include that or exclude that?.

Yes, that does include that. It's on a GAAP basis. .

That does include -- it's on a GAAP basis. Okay. And then similarly on the expense side, would that include -- I think you had a $1 million compensation-related expense in the first quarter.

Would that 30 -- I'm sorry, would that $98.5 million include that as well?.

Yes, it does. .

Okay, great. And then kind of to circle back on the provision. So the provision this quarter matched the net charge-offs. So effectively there was no reserving for the 12% or so loan growth that you had this quarter.

Could you just take us a little bit through your thought process there and why you're comfortable with not providing anything for the growth? Or maybe there's some moving parts behind the scenes that don't come out in the numbers. .

Yes, I think it's really driven by our favorable asset quality trends that we're seeing. We're very comfortable with that -- allow us the total loans ratio of 1.14% for the quarter, which it is down 3 basis points from last quarter, but we're very comfortable with that. .

Okay. So how -- I mean, how should we think about the provision going forward? Because the first quarter and this past quarter were similar. The second quarter, there was nothing.

I mean, is there a range that you'd feel comfortable in providing for us to try to model that out?.

Well, historically, the provision is a little bit volatile and it's difficult to predict. So at this point, we have not provided guidance on the provision. .

Damon, just want to confirm that the guidance that we gave for the fourth quarter on -- full year noninterest income was approximately $36.5 million. So I wanted to make sure that, that was your number. I thought I heard a different one. .

Yes, $36.5 million on noninterest income. Got it. .

And our next question today comes from Matthew Breese with Piper Jaffray. .

So I just wanted to reconfirm on the capital front. You do have a recent shelf authorization, but the message is, no need for capital and that what you're growing internally is sufficient.

Is that accurate?.

That is accurate. We had a shelf, it was utilized to issue our subordinated debt in the spring of 2015, and it's also providing capacity for the secondary offering in the summer of 2017, it expired. And there's a matter of standard operating procedure for a company like ours to have an active shelf. .

Okay. And then my second question is really regarding the NIM. It sounded like the message was stability.

And so I wanted to get a sense for -- during the quarter, what was the blended loan yield and what was the blended cost of deposits? What -- on the deposit front, where are you seeing the most pressure, in what products?.

So I'll start with the pressure on the cost of the funding side. We have 4 basic components of our funding side. The first is the overnight borrowings, which is approximately $300 million, I believe, it is. And those have a beta of 1 basis point. Then we have our SEDAR's program, which is about $320 million. Those have a beta of about 60 basis points.

And then our retail deposits as well as our municipal deposits have obviously come under pressure, competition in the market space, et cetera. But we've seen so far a beta of about 20 basis points almost. .

Blended loan yield for the quarter was 4.55%..

Was there another question in there also?.

So your blended loan yield -- so what was brought onto the book was basically flat with what was already there.

Is that accurate?.

No. It actually was a little bit higher than what was on the portfolio. .

Right. So what was the blended origination yield? I'm sorry if I was... .

How was the blended origination yield?.

Yes, I think we might have to get back to you on that. I don't have that number in my head. .

We'll get that to you off-line. .

And ladies and gentlemen, I would like to turn the conference back over to the management team for any final remarks. .

Just want to thank everyone for your participation this morning, and we'll look forward to continuing our conversation with you at the end of January. .

Thank you, sir. Today's conference has now concluded, and we thank you all for attending today's presentation. You may now disconnect your lines, and have a wonderful day..