Good morning, and welcome to Financial Institutions, Inc. Fourth Quarter and Full Year 2020 Earnings Call. Please note this event is being recorded. I would now like to turn the conference over to Shelly Doran, Director of Investor & External Relations. Please go ahead..

Thank you for joining us for today's call. Providing prepared comments will be President and CEO, Martin Birmingham; and CFO, Justin Bigham. Director of Financial Planning and Analysis, Mike Grover, will join us for Q&A. 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 historical SEC filings available on our Investor Relations website for a Safe Harbor description and a detailed discussion of the risk factors relating to forward-looking statements..

Thank you, Shelly. Good morning everyone and welcome to our fourth quarter 2020 earnings call. Despite the many ongoing challenges presented by the COVID-19 pandemic, thanks to the commitment and significant effort of the collective five-star team, 2020 proved to be a year of strong performance across an array of key outcomes.

We generated record high net income of $13.8 million in the quarter or $0.84 per diluted share as compared to $12.3 million or $0.74 per share in the third quarter of 2020 and $13.1 million or $0.79 per share in the fourth quarter of 2019.

Pre-tax, pre-provision income in the fourth quarter was also the highest in company history at $21 million, a $1.7 million increase from the third quarter of 2020 and a $4.9 million increase from the fourth quarter of 2019.

Revenue growth and expense discipline, reflecting the impact of our enterprise standardization program resulted in a fourth quarter efficiency ratio of 55.8%. We took two actions during the fourth quarter to provide important flexibility in managing our balance sheet in the months ahead.

The first was in October when we sold $35 million of 10-year, fixed-to-floating rate subordinate notes with an annual interest rate of 4.375%. After 5 years, it becomes floating rate debt redeemable at our discretion.

We were comfortable with our capital levels before the offering, but deemed it prudent to take advantage of low interest rates to add capital for use in organic and strategic growth opportunities, and to further strengthen the bank's capital ratios.

The second action was the establishment of a stock repurchase program for approximately 5% of our outstanding common shares. Shares may be purchased in open market transactions and pursuant to any technical requirements of a 10b5-1 trading plan. We did not buy back shares during the fourth quarter due to blackout restrictions.

However, our plan went into effect on January 11, and we have repurchased a total of about 127,000 shares since then. In December, we announced the planned acquisition of a Rochester-based insurance brokerage firm, Landmark Group.

Landmark will be acquired in our SDN Insurance Agency subsidiary and their principles will remain with SDN to lead our Rochester Insurance operations. The Landmark acquisition will expand our insurance business in Rochester in the Finger Lakes region, an important growth market for us. Kelly and Chris Shea.

Landmark’s Chairman and President are highly respected. Their philosophies are consistent with ours and they have a very strong commitment to their clients. We see upside in leveraging our banking and wealth management offerings to their clients and their insurance offerings to local five star customers..

Thanks, Marty. Good morning everyone. Marty said it very well. 2020 really was a year of strong performance across an array of key outcomes, most importantly, the fundamentals which is well measured by pre-tax pre-provision, which increased over 8% year-over-year.

Additionally, we also generated over 2% of operating leverage from 2019 to 2020, excluding branch restructuring charges. With that said, let me start by providing comments on several key areas with comparisons to the third quarter of 2020. Net interest income for the quarter was $36.2 million, an increase of 682,000 from the linked quarter.

The increase was driven by a number of items that increased our interest earning assets which I'll cover now. In December, we started to see PPP loan payoffs through the forgiveness process.

Approximately $17 million of these loans were forgiven, and we accelerated approximately 240,000 in net interest income from origination fees in connection with the payoffs.

Net interest margin was nine basis points lower than the linked quarter, which is lower than we projected, primarily due to a higher than expected increase in our liquidity position.

Specifically, new deposit growth was higher and seasonal decline in municipal deposits were slower than we forecasted, which on a combined basis significantly increased our overall liquidity position.

Some of this excess was deployed into collateral, eligible, mortgage-backed securities in an effort to reduce the NIM pressure associated with interest on excess reserves at the FRB.

While we couldn't fully deploy the excess cash due to the delayed, but expected seasonal public outflows in December, the incremental yield improvement of our investment purchases was about 100 basis points better than the interest earned on cash held at the FRB.

About 5 basis points of the NIM decline is attributable to the investment portfolio and 4 basis points is attributable to the Federal Reserve cash position..

Thank you, Justin. Pace of activity in 2021 is certainly not slowing. We successfully launched the current round of the Paycheck Protection Program on Tuesday, January 19. Our online application and submission process is working well and there's been strong interest from new and existing customers in applying for their loans with Five Star Bank.

To-date, we have processed more than 800 applications for approximately 100 million in PPP loans. And the SBA is already approved 39 million. We're using an experienced and well respected FinTech partner for the online application process, or loan portal.

We learned a great deal from last year's program and the rollout from the SBA in 2021 has been much smoother. Accordingly, the experience for our associates and customers is greatly improved in the current round. Our organization continues to adapt and evolve to meet the needs of our customers necessary in our fast changing world.

Our new portal should enable us to process a significant amount of loans in 2021. But it all depends on demand in the availability of funds. We've also been working with our community partners to provide information and assistance to low income and minority communities regarding the Paycheck Protection Program.

Conversations with these community partners highlighted the need for necessary communication and support to minority and under banked businesses by a locally based financial institution. At the onset of the first round of the loans in 2020, many minority businesses either missed out or felt as though they missed out on needed funding.

A very high percentage of minority businesses are sole proprietorships have no employees and typically don't benefit from stable banking relationships. In mid-January, we worked with Rochester based community partners to provide a webinar titled, “Ensuring Access for All”.

Discussion focused on the program and recent changes and we let minority businesses know that Five Star Bank is here to help no matter how large or small alone. We also communicated our plan to provide hands on support at two of our urban Rochester branches. We will be good shepherds of the PPP program and help as many in our communities as we can.

We have a wonderful opportunity to help many new and existing customers that will in turn, strengthen relationships and lead to new business and an even brighter future for Five Star. We also continue to work with our customers on the forgiveness of 2020 PPP loans.

As of December 31, 2020 110 loans totaling $17.4 million had been forgiven out of a total of approximately 1700 loans. As of last week, we had received forgiveness applications from only about 45% of borrowers. We believe this is due to customer expectations of potential changes in the forgiveness process, which did occur with the New CARES Act 2.0.

Changes made in the application process for loans of 150,000 or less much simpler and additional expenses are now allowable for forgiveness. We are still awaiting the new simplified form to be released by the SBA and the more than 950 customers that have not sent in their forgiveness application 770 were loans of 150,000 or less.

The SBA has now paid off $44 million of our PPP loans, with another $49 million submitted and approved by the bank for forgiveness. The SBA has 90 days to pay off the loan submitted although to date they have been paying them much quicker. I am proud of our many of accomplishments in 2020.

Despite the pandemic and its many challenges, we delivered uninterrupted banking services while keeping our customers and associates safe. We provided customer relief and helped approximately 1700 customers obtain PPP loans.

Our new online and mobile banking platform launched in late spring to provide improved accessibility to customers during a time when they needed the ability to be able to bank from anywhere, anytime.

Major improvements and processes and operations were implemented and we streamlined our branch network, all as a result of the enterprise standardization program. In the fourth quarter, we completed an unsecured debt offering and a stock repurchase program, important actions to support our balance sheet and provide opportunities.

Progress was made for an opening of our two new branches in Buffalo, and we announced a nice bolt-on insurance acquisition. And our strong community support continued through grants, donations in investments.

Because of the dedication, adaptability and commitment of my associates, we were able to accomplish all these things and deliver impressive financial outcomes.

While year-over-year, net income and earnings per share were negatively impacted by the COVID driven increase in provision, we generated 7% growth in total revenue, comprised of net interest income and non-interest income.

Non-interest expense, excluding the impact of non-recurring charges incurred in connection with the branch transformation increased only 4.6% in 2020, and includes significant investments in technology, such as our digital banking platform, income tax expense benefited from our on-going investment in historic and low income tax housing projects.

We recognize that many uncertainties remain, and I look forward to 2021 with hope for progress by our leaders and providing essential support of the vaccination rollout and pandemic relief in a reopening of our economy. Operator, this concludes our prepared comments and we are ready to open the call for questions..

Thank you. The first question today comes from Alex Twerdahl of Piper Sandler. Please go ahead..

Hi, good morning..

Morning, Alex..

At first, I was hoping you could give us a little bit more color on the loans that were downgraded this quarter, was it was just loans that were on modification or did you go through more of an extensive process, looking at the whole loan book to arrive at that, that bucket of loans that were put into the criticized classified categories?.

So Alex, I'm sure you can appreciate that's been a fundamental focus of our risk and our commercial team for the most part of the last 10 months to 11 months, and the overarching approach that we've taken has been to make sure that whatever actions we're taking are logical, they're reasonable, they're defensible, and ultimately documented because so much of what we're trying to manage through here is not explicitly guided for from a regulatory accounting, et cetera, perspective.

So we in terms of the CARES Act, and the specific provisions that it provides for in our case, TDR relief from an accounting and regulatory perspective, but as well the spirit and intention of the CARES Act to provide support to help good customers that didn't have anything to do with obviously, a pandemic impacting them as negatively as it has.

So we've worked as an organization to develop an addendum to our credit policies that we've called our COVID addendum to basically manage through and guide us through this process.

And as part of that, Alex, one of the things by definition, if we are dealing with and helping customers effectively bridge to the end of the pandemic through relief and modifications, we’ve elected to call those loans special mention by definition, so we are watching carefully.

We also want to make sure it's as transparent as possible for all of our constituencies; our investors, our regulators, our auditors, and as well the teams inside the bank that are working there, these loans.

So, to your question, Alex, we have individually analyzed each of these credits, and ultimately through the policy that we develop, but the core conclusion was focused on their sustainability to get beyond the pandemic and to return to normal operations and in a post COVID world.

So, that's the fundamental approach that we've taken that we are dealing with our COVID addendum, Incorporated, as I said, our best logical, reasonable approach, defensible, whatever regulatory guidance was out there. But ultimately, it's a policy that we developed to support this question in this issue.

And, as Justin talked about, our CECL loss drivers, were in terms of our model, we're signaling stronger employment numbers, and we, as a result, worked in terms of our qualitative factors and the underlying risk that's out there in continues to be out in the economy and making sure that those were appropriately adjusted.

And then in the fourth quarter, we identified those lists as part of this COVID bucket of loans that we believe had the highest loss flow risk and segregated them and took appropriate action relative to provision expense. So, Justin, I'll stop there, and you can help Alex with more specifics..

Yes, so Alex, just to help you kind of reconcile, I think you're quite -- one of your questions was, is it only deferrals? And the answer is no. It was a broader look at the portfolio. So there are some loans, in that, that that pool of 127 million, about 44 million that represent loans that were not on deferral.

And the attributes associated with those loans, it could be -- there's a variety of different circumstances. But one good example, is sort of a construction or stabilization loan project, and it's been paused, right. That loan project’s been paused.

They are paying accordingly, but because of the paused project, and the paused project is primarily driven by a circumstance where they have just one example is they have an event space, and there's no events right now.

So some projects, we have a handful of loans, it's very few in that, that pool, that we're just going to keep a close eye on and have set aside, those and class of move those to criticized assets to make sure that we can keep an eye on the way that Martin has described. And then about 83 million of the total deferral population has also been moved.

So that's the combination, I think that adds up sort of 127 million. And then from a deferral perspective, as you probably saw on our deck or we have about 99 million on deferral at year end, it’s actually lower.

Now, we've actually -- because we had a couple of -- we had a handful of loans at year end that were scheduled to come back to return to -- normal payment activity in January, February, March, etcetera, near term, a few of them actually already have returned to their normal payment activity and actually made their payments in January, so that population was not moved because we – to this criticized pool, even though they're on deferral, because the expectation was that they would return to normal payment activity.

And the reason we knew kind of how to think about all this is we are really close to our customers, Alex. I mean, we're -- we've been monitoring this pool for a really, really long time, not 127, but our total COVID exposure pool for a long time, and trying to really keep our arms around it. And we believe we fenced it in at this point.

And we're pretty comfortable and confident that what we set aside is adequate based on what we know today. It feels adequate for COVID exposure..

Thank you for all the additional color.

Do you have, by any chance things like LTVs weighted LTVs on that bucket of criticized classifieds?.

Yes. So, we did do a very robust analysis that included looking at the latest appraised value. I will tell you the LTVs what's interesting about COVID Alex, as I'm sure you can imagine, is the latest appraisal, the variation that occurs during COVID relative to values is pretty dramatic.

So when we looked at it, we actually applied a pretty significant discount to our current appraisal, and we had a handful of loans after applying that discount that we were concerned about, and that handful of loans is sort of the loans that we've set aside some dollars for if that provides any color..

Okay, understood. And then, just in your fee income guidance that you went through, I just missed that.

Would you mind repeating that, please?.

Yes, sure. Just to make sure I get it right. I'm going to actually look at it here. So low single digit growth in non-interest income, and that's excluding gain on investment securities..

Okay. And then finally….

I'm sorry, I was just going to say the other color that we added in that paragraph was just a reminder that we waived fees this year, right for COVID relief. And that was offset by a really, really strong year of the interest rate swap business, as well as mortgage banking.

And we are assuming that those two really strong performers are going to moderate a bit next year..

Understood. And then final questions for me. The buybacks.

It sounds like you guys are using a e 10b5-1 program, are you able to share with us what the parameters of that program are?.

We're really not Alex. I will tell you that, based on kind of the activity that we've had so far, we're looking at a payback period of less than nine months. And our evaluation of the parameters was based on strong economic return. As you can imagine, you kind of have to evaluate the return of that versus the return of something else.

And a less than nine month return, is obviously a very strong return..

Great, thanks for taking all my questions..

Thank you, Alex..

The next question comes from Capital. Please go ahead..

Morning, everyone. Justin, I thought the margin guidance for the year was encouraging. Apologize if I missed the detail on this, but can you give us a sense for the macro backdrop, you're assuming that supports the margin outlook? Thanks..

Yes, sure. So our margin outlook, is based on pretty extensive analysis that we've done, trying to understand, how we expect our portfolio to behave. We do expect that we're going to continue to see some pressure on yields, loan yields, but we also continue to think that we're still going to get some benefit out of our deposit book.

And, obviously we can see a lot more into that deposit book than perhaps it's visible externally. But we have a really strong opportunity on certain areas of our deposits, continue to see, good CD repricing, our reciprocal portfolio has a lot opportunity to come down.

If you think about the environment that we were in exactly this time last year, rates were high, deposits were extremely valuable. And people were taking CDs if they were doing a one year or two year CD at that time, it was pretty, pretty favorably priced.

So we do see some opportunity in the deposit book that's going to help compensate for some of the loan yields that we're expecting to compress.

We also have an interest rate cap that we've that we talked about a while back a couple, I think it was a couple years ago when we initiated that interest rate cap, and that cap is expiring, and that's going to give us some benefit as well.

The real driver of the macro view that that's creating the compression that we see is really driven by the excess level of liquidity. We anticipate that's going to continue. You probably in the guidance heard what we're talking about for deposits. We do think deposit growth is going to be more significant than loan growth next year.

And that is going to create some pressure on our NIM, as we try to deploy that cash into something that looks and feels as much like a loan as we can get, which unfortunately, is going to be a lower yielding asset that a loan would be. So I hope that's helpful.

That's the best color, I think I can provide just relevant to the macro environment that we see..

That's helpful. I guess, I'm just generally speaking though, it doesn't seem like they're, you're assuming any kind of improvement in the rate backdrop, or the shape of the yield curve or anything, like we just kind of sit where we are. That's sort of the 40,000 foot assumption that you're using to be able to receive that -- nice..

Absolutely assuming a lot what I call a spot rate environment. Yes..

Okay, great. And then last one, for me is on the provision.

Did you offer any provision guidance for the year just trying to get a sense for all things being equal? And we kind of, the outlook stays with what you guys are assuming now that the reserves build, you feel like is sufficient to kind of carry you through from here?.

So it's interesting. The challenge with -- so no, we didn't provide any specific guidance on provision. We just stuck with Charge-offs. And, the reason is, the same story that we've had this year is, tell me what our unemployment forecasts are going to look like. And tell me what's going to happen with the pandemic.

And I can probably do a little bit of a better job, predicting the CECL model outcomes. It's a really tough thing to predict. I, I am very comfortable with where our ratios are right now, from a coverage perspective, from a reserve perspective.

But, that doesn't necessarily mean that what happens next year, relative to modeled outcomes and CECL, that doesn't necessarily mean I'm, we're going to stay at that reserve level. We could be driven for to increase it depending on what happens with economic forecasts.

And we could be driven to bring it down depending on what happens to those forecasts. So it's just a really difficult thing to predict. So we've chosen to sort of give you some guidance relative to charge-offs, but haven't really talked much about what's going to happen to the overall provision or allowance..

Got it. I appreciate you taking the questions. Thanks, guys..

Of course. Thanks, Joe..

This concludes our question and answer session. I would now like to turn the conference back over to Martin Birmingham for any closing remarks..

Thank you very much operator. I want to thank all those that participated in the call this morning and we'll look forward to continuing to build on the conversation in the quarters to come in 2021..

This conference has not concluded. Thank you for attending today's presentation. You may now disconnect..