Good day, and welcome to the Mercantile Bank Corporation Fourth Quarter 2019 Earnings Results Conference Call. [Operator Instructions] I would now like to turn the conference over to Mike Houston, Investor Relations. Please go ahead..

Thank you, Jason. Good morning everyone, and thank you for joining Mercantile Bank Corporation's conference call and webcast to discuss the Company's financial results for the fourth quarter and full year 2019. I'm Mike Houston with Lambert IR, Mercantile's Investor Relations firm.

And joining me today are members of their management team, including Bob Kaminski, President and Chief Executive Officer, and Chuck Christmas, Executive Vice President and Chief Financial Officer. We'll begin the call with management's prepared remarks, and then open the call up to questions.

However, before we begin today's call, it is my responsibility to inform you that this call may involve certain forward-looking statements such as projections of revenue, earnings and capital structure as well as statements on the plans and objectives of the Company's business.

The Company's actual results could differ materially from any forward-looking statements made today due to the factors described in the Company's latest Securities and Exchange Commission filings. The Company assumes no obligation to update any forward-looking statements made during the call.

If anyone does not already have a copy of the press release issued by Mercantile today, you can access it at the Company's website, www.mercbank.com. At this time, I'd like to turn the call over to Mercantile's President and Chief Executive Officer, Bob Kaminski.

Bob?.

Thanks, Mike, and good morning everyone. Thank you all for joining us today. On the call, we will provide an update on our overall performance and financial results, along with our key areas of strategic focus. At the conclusion of our comments, we will open the call for a question-and-answer session.

I'd also want to mention that Ray Reitsma is unable to join us for the call today and I will include his commentary within my overview. We are very pleased to report another year of very strong operating performance.

Our robust financial results during 2019 reflect continued growth in the loan portfolio, increases in certain non-interest income revenue streams, controlled overhead costs and sound asset quality.

Based on our strong capital position and healthy commercial loan and residential mortgage loan pipelines and prospects, we believe that the solid financial performance achieved during 2019 has positioned us for further success in the quarters and years ahead.

The quarter and year's operating performance includes growth in net interest income, solid normalized net interest margin levels, continued loan growth -- continuing loan growth with pricing discipline and sound underwriting, and gains in non-interest income.

The noteworthy increase in mortgage banking activity income in the quarter and throughout the year illustrates the success of our dedicated team and the continuing strategic initiatives that were created to enhance market share along with an increase in the percentage of originated residential mortgage loans being sold and a higher level of refinance activity resulting from decreased residential mortgage loan interest rates.

Based on the continued strength of our current residential mortgage loan pipeline and projections, we believe mortgage banking activity income will be solid during 2020. Turning briefly to the Michigan economy, trends remain steady as employment in our primary markets continues to be strong and real estate conditions remain healthy.

We will continue to watch these indicators closely for any longer-term slowing or inflection point. Continuing on, we were pleased with the net loan growth and level of new commercial-to-term loan originations during 2019. Our loan portfolio increased $104 million during the year despite contracting $77 million during the fourth quarter.

The contraction during the fourth quarter primarily reflected an unusually high level of commercial loan payoffs.

The payoffs mainly reflected instances in which we remain committed credit quality and margin preservation along with a few situations involving larger borrowing relationships that refinance the underlying real estate with secondary market credit participants that offered long-term fixed rate non-recourse financing options.

Net loan growth during the year depicts increases in both commercial loans and residential mortgage loans. All commercial loan segments with the exception of multi-family and residential rental segments grew during the year.

The solid growth in commercial loans reflects our lending staff's ongoing focus on identifying new lending opportunities in our markets and meeting the needs of existing customers, while growth in residential mortgage loans depicts the success of various strategic initiatives that were implemented to increase our market presence.

Based on our current loan pipelines and additional lending opportunities conveyed by our commercial lenders, we are confident that we can grow the commercial loan and residential loan portfolios in future periods.

At year-end 2019, we had $105 million of commitments in commercial construction and development loans, which we expect to fund over the next 12 to 18 months. Our asset quality is sterling as non-performing assets declined to $2.7 million or less than 0.1% of total assets at December 31.

The improved level of non-interest income in the fourth quarter of 2019 compared to the prior year fourth quarter was largely driven by increased mortgage banking income reflecting the success of ongoing strategic initiatives designed to increase market share, a higher level of refinance activity stemming from a decrease in rates and an increased percentage of loans sold.

Continuing to enhance mortgage banking income through increased market share, including an increased share in the purchase market, remains a priority. And we will continue to hire proven mortgage loan originators as we are able.

We also recorded growth during the quarter in other fee income categories, including credit and debit card income, service charges on accounts and payroll processing fees. The exercise of discipline related to overhead costs as we focused on efficient delivery systems in all of our lines of business remains our priority.

Our focus on meeting organic growth objectives in a cost conscious manner has not wavered. As depicted by our ongoing cash dividend program, including the announcement of an increased first quarter 2020 regular cash dividend earlier today, we remain focused on providing shareholders with a competitive dividend.

We are committed to enhancing shareholder value. Our strong operating performance in 2019 has set the stage nicely to help us meet our growth objectives and further build shareholder value. Our steady core profitability, strong capital levels and healthy loan pipelines position us well for the balance of the year and beyond.

Our banking philosophy, which entails developing mutually beneficial relationships and offering market-leading products and services through efficient delivery channels, has continued to successfully attract new customers and allowed us to retain existing customers.

We are excited about Mercantile's future and look forward to sound financial performance in the current year. That concludes my comments. I'll now turn it over to Chuck..

Thanks, Bob, and good morning everyone. This morning, we announced net income of $13.3 million, or $0.81 per diluted share for the first -- fourth quarter of 2019, up from $11.6 million, or $0.70 per diluted share for the fourth quarter of 2018.

Net income for the full year 2019 grew to $49.5 million, or $3.01 per diluted share, increasing from net income of $42 million, or $2.53 per diluted share for the full year 2018.

Net gains and losses on sales and write-downs of former branch facilities decreased reported net income during the fourth quarter of 2019 by $0.3 million or $0.02 per diluted share.

Interest income related to purchased loan accounting entries increased net income during the fourth quarter of 2019 by $0.2 million, or $0.01 per diluted share, and net income during the fourth quarter of 2018 by $0.5 million, or $0.03 per diluted share.

Excluding the impact of these transactions, diluted earnings per share increased over 22% during the fourth quarter of 2019, compared to the fourth quarter of 2018.

Full year 2019 earnings benefited from bank-owned life insurance claims and the net impact of gains and losses on sales and write-downs of former branch facilities increasing reported net income by $2.7 million, or $0.16 per diluted share.

In addition, the full-year benefit of interest income related to purchased loan accounting entries increased net income during 2019 by $1.1 million, or $0.07 per diluted share and net income during 2018 by $3.2 million, or $0.19 per diluted share.

Excluding the impacts of these transactions, diluted earnings per share increased almost 19% during 2019 compared to 2018.

We remain pleased with our financial condition and earnings performance and believe we are very well positioned to continue to take advantage of lending and market opportunities, while delivering consistent results for our shareholders. Our net interest margin was 3.63% during the fourth quarter compared to 3.71% during the third quarter of 2019.

As part of our interest rate risk management program, we routinely include prepayment fees on fixed rate commercial term loans and periodically purchased discounted agency bonds through periods of increasing interest rates. These specific practices, among others, had helped to offset the negative impact of the declining interest rate environment.

During the fourth quarter of 2019, we recorded loan prepayment fees of $1.3 million and accelerated discount accretion on called agency bonds of $0.2 million.

Excluding the impact of these entries along with the elimination of the impact from excess balance sheet liquidity, our core net interest margin was 3.53% during the fourth quarter, well within the guidance provided on our third quarter conference call.

Assuming a steady interest rate environment, we expect our net interest margin to be in a range of 3.50% to 3.55% during the first and second quarters of 2020 and 3.55% to 3.60% during the third and fourth quarters of this year.

The expected improvement reflects a steady yield on assets and a gradual decline in our cost of funds as time deposits that were originated in a higher interest rate environment mature and are renewed and/or replaced at lower interest rates.

We recorded $0.3 million in purchase loan accretion and payments received on CRE-pooled loans during the fourth quarter of $2019 and $1.4 million for all of 2019, compared to $0.6 million and $4.0 million during the respective time periods in 2018.

With our adoption of CECL as of January 1, income recorded from purchase accounting activity in future quarters would generally be nominal in amount. The overall quality of our loan portfolio remains very strong with continued low levels of non-performing loans and loan charge-offs.

Non-performing assets as a percent of total assets equaled only 8 basis points at the end of the fourth quarter. Gross loan charge-offs totaled only $0.1 million during the fourth quarter and $0.9 million for all of 2019.

We recorded a net loan recovery of $0.2 million during the fourth quarter and net loan charge-offs of only $0.2 million during all of 2019. We recorded a negative provision expense of $0.7 million during the fourth quarter, primarily reflecting several larger commercial loan pay-downs and net loan recoveries being recorded during the period.

We recorded a provision expense of $1.8 million for all of 2019 in large part reflecting net loan growth. We currently expect to record quarterly provision expense in the range of $0.5 million to $1.0 million throughout 2020 assuming a steady economic environment.

Our loan loss reserve totaled $23.9 million at the end of 2019 or 0.89% of total originated loans.

Given the implementation of CECL on January 1 of this year and subject to the finalization of our analysis and documentation, we currently expect to recognize a reduction in our loan loss reserve of approximately $1.0 million, which will be recorded directly on our balance sheet.

The net reduction largely reflects a decrease of required reserves for commercial loans given the relatively short duration and an increase of required reserves for residential mortgage loans given the relatively longer maturities.

With the CECL requirement to reserve for potential losses during the contractual life of a loan -- loan duration, taken into account maturity dates and estimated prepayments has a significant impact on the model calculations.

We recorded non-interest income of $7.3 million during the fourth quarter of 2019, which included a $0.3 million gain on the sale of a former branch facility. Non-interest income during the fourth quarter of 2018 was $5.4 million, which included a one-time $0.9 million accounting adjustment.

Excluding these transactions, non-interest income increased $2.6 million or over 57% during the fourth quarter of 2019 over that of the fourth quarter of 2018. Non-interest income during all of 2019 totaled $27 million, compared to $19 million for all of 2018.

Non-interest income during 2019 include a bank-owned life insurance claims totaling $2.6 million. And gains on the sale of former branch facilities totaled $0.8 million, while non-interest income during 2018 included the previously mentioned one-time $0.9 million accounting adjustment.

Excluding these transactions, non-interest income increased $5.4 million or almost 30% during all of 2019, compared to 2018. During 2019, we recorded increases in virtually all fee income producing categories. The increase was most notable in mortgage banking activity where income increased over 106% for 2018.

However, we also recorded increases of 10% in credit and debit card income, the 11% in payroll processing and 5% in service charge income; the latter of which in large part is due to expanded treasury management income.

The significant increase in mortgage banking activity income primarily reflects a 72% increase in mortgage loan origination volume and an increase in the percentage of mortgage loan originations that were sold compared to being recorded on our balance sheet.

With the understanding that accurately predicting mortgage banking activity income is difficult due to such factors as interest rate environment, home inventory and seasonality, we expect non-interest income to be in a range of $5.0 million to $5.5 million during the first and fourth quarters of 2020 and in a range of $5.5 million to $6.0 million during the second and third quarters of this year.

We recorded non-interest expense of $23.3 million during the fourth quarter of 2019, up $1.4 million or 6% from the prior year fourth quarter. Non-interest expense for all of 2019 was $89.3 million, an increase of $3.1 million or 4% for all of 2018.

The higher level of expense in the 2019 periods primarily resulted from increased salary costs, including merit pay increases, higher mortgage loan origination -- originator commissions and stock-based compensation expense. During the fourth quarter of 2019, we recorded a net loss and write-down on former branch facilities totaling $0.7 million.

We currently expect quarterly non-interest expense to be in a range of $22.5 million to $23.5 million in 2020 with our effective tax rate at about 19%. Total deposits at year-end 2019 were $227 million higher than a year in 2018. Local deposits increased $207 million, while broker deposits were up $20 million.

Non-interest-bearing checking accounts continued to grow, increasing $35 million during 2019, in large part reflecting new commercial loan relationships.

Local time deposits increased to $151 million [ph] during 2019, reflecting the combination of a special campaign run during the first quarter and increased deposit balances from certain existing individuals, businesses and public unit customers. At year-end 2019, wholesale funds comprised 15% of total funds compared to 16% as of year-end 2018.

We remain a well-capitalized banking organization. At year-end 2019, our bank's total risk-based capital ratio was 13.0% and in dollars, was approximately $97 million higher than the 10% minimum required to be categorized as well capitalized. Stock buybacks during the fourth quarter were limited.

However, during all of 2019, we repurchased about 233,000 shares for $7.2 million at a weighted average price per share of $30.79. Since January of 2015, we have repurchased approximately 1.4 million shares for $32.6 million at a weighted average price per share of $23.47. We currently have about $16 million available in our current buyback plan.

Those are my prepared remarks. I'll now turn the call back over to Bob..

Thank you, Chuck. That concludes management's prepared comments. We will now open the call for the Q&A..

We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Brendan Nosal from Piper Sandler. Brendan, you may begin..

Hey, good morning, Bob. Good morning, Chuck.

How are you guys?.

Fine.

How are you?.

Good, thanks. Just wanted to start off here on loan growth for the quarter. I mean, it sounds like a heightened competitive environment resulted in more payoffs than you've typically seen in the fourth quarter.

Was there a shift in the competitive environment or just lineup where you just had more volume of payoffs through these factors in this quarter?.

I want to say it was a shift in competitive environment as these are projects that were conducive to the kind of financing that our borrowers obtained, secondary market type of financing. And so, there is always the risk with both kinds of projects going that direction at some point in time.

And so, I would say it was just more a matter of timing than anything else and these happen to be all bunched together in the fourth quarter as opposed to any change in the environment that is not really -- is very competitive, but any more competitive than it had been.

And as mentioned in our comments, the other part of that was the preservation of asset quality. So one of our watch list clients [love] [ph] the Bank and went in another direction there as well. And so, the combination of those things are accumulated in the fourth quarter and produced the results for the net contraction of the portfolio as it did.

But -- so going back to your question, I wouldn't say it's any shift in the competitive environment, Brendan..

All right, fantastic. That's good color.

And then, to follow up on growth, just as you look at 2020, call it, 6% to 8% loan growth for the full year is still a pretty reasonable expectation assuming the timing doesn't line up again like you had like this quarter on the payoff side?.

Yes, I think it's a fair range. You bet..

Perfect. Thanks for taking the questions..

All right. Thank you..

[Operator Instructions] The next caller is Damon DelMonte from KBW. Please go ahead..

Hey guys, good morning.

How is it going today?.

Good morning, Damon.

How are you?.

Good, thanks. So, quick question. Just wondering if you can give a little bit more color on the mortgage banking outlook.

Chuck, I know you gave your expected quarterly ranges for non-interest income, but just kind of what you guys are seeing, I think this quarter's results were -- well, at least to my model is a pretty big beat and a kind of unexpected to be this strong.

So could you just kind of talk about what the pipeline looks like and kind of how you're viewing 2020?.

Yes, and I will admit that the pipeline or -- the income that we recorded in the first quarter was better than what we had expected as well, but I think that demonstrates the fantastic momentum that we've got going in an operation.

We're looking at the folks -- that the program that we developed, the folks that we've been bringing on and continue to bring on and have just done an excellent job.

For a good part of the year, maybe not so much the fourth quarter, but definitely the good part of the year, we definitely had the benefit of a lower rate environment, which certainly helped on the refinance side. We definitely saw a pickup in the percentage of originations that were refinances. So just a lot of really good momentum we're looking at.

We're looking at our pipelines on a regular basis. And while that's a relatively lower now than what it was for most of 2019, in large part, I think that's more seasonality than anything else.

There's just not a lot of homes bought and sold in Michigan in January, but we continue to be very upbeat about the outlook for mortgage banking as we continue -- as Bob mentioned, continuing to talk with others of joining the team, which will give us additional wind in our sails.

I think probably the biggest thing that we look at in trying to project the future is really that refinanced bucket and what that's going to look like in 2020 and in the quarters going forward. So in our expectations, we have scaled back our expectation on refinances certainly as a percent of our total book.

But we're still looking for a solid year in 2020. It might be difficult to overcome the loss in some of the refinanced activity to have results in 2020 beat that of 2019. But I think if you look at the core results backing off some of that refinanced activity, I think our core results are going to be larger than what they were in 2019.

And I think in large part, that reflects ongoing improvements in our market shares..

Yes, I think just to add to that, Damon, if you look at our pipeline is now in mid-January, it's really higher than I can ever remember in January, which is obviously the slowest season for us here in Michigan in terms of real estate mortgage activity. So that's really encouraging.

If you look, as Chuck said, that the people that we added to the team and they get a full year of their contribution. And we continue to look and add new commissioned lenders as we find folks that really fit our culture and the way our team operates and I look forward to having a full year of those folks on board with us as well..

Got it, okay. Thank you. That's really good color.

And then if you could just touch on the CECL update that you gave, so Chuck, did you say that you're kind of -- your shakeout here from CECL is that you actually expect loan loss reserves to decline by $1 million, is that right?.

That's correct..

Okay.

So, I mean in simple terms, all of CECL like your loan loss reserve, this past quarter is 84 basis points that you're expecting that to drop down a little bit?.

Yes..

Okay..

That's correct..

All right, great. And then, I guess, lastly, kind of a housekeeping item, I think the effective tax rate was a little bit lower this quarter, but you did give guidance in the 19% range going forward.

Was it just some like kind of cleanup year-end things that fell into it this year?.

Yes, the cleanup primarily reflects the BOLI claims that we had earlier in the year. We kind of stuck with the 19%, which is kind of our core tax rate run and then we -- it's hard to do the calculation when you have some of those one-time type items that are non-taxable. So I think you're right, it was more of a cleanup, primarily reflects the BOLI.

We're certainly not budgeting for any of that this year. And so, we'll be back to the core of 19%..

Got it. Okay, that's great. Good stuff, guys. Very helpful. Thanks..

The next question comes from Kevin Swanson from the Hovde Group. Kevin, you may begin..

Hi, guys. Obviously having high levels of capital is a good problem to have, but maybe just can you talk about your appetite for the buyback going forward. I know you guys did some this quarter, the dividend announced and then maybe just maybe an outlook on M&A, if that's changed at all? Thanks..

No problem, Kevin.

On the capital, yes, we definitely see the numbers going up, which like you say, kind of, is not necessarily a bad thing, but we look to -- we would like to bring our leverage ratio down and help those metrics like ROE, but obviously, we don't want to do that in an inappropriate fashion certainly by increasing our risk on the loan side -- our risk appetite on the loan side.

On the regular capital -- on a regular cash dividend, we continue to look around 40%, maybe 45% of our net income to be returned to shareholders in the form of cash dividends. We have from time-to-time done special dividends.

And that is -- our overall level of capital is something that we talk to our corporate Board about every quarter and we'll continue to do that as we go forward. So I wouldn't take a special dividend off the plate, but that’s certainly nothing that we look to imminently.

And again, we'll just talk to our corporate Board each quarter in regards to those types of things. Specifically to the buyback, we've been kind of looking at a range of $32 to $33 a share as kind of our upper limit.

When we do the buybacks, that's something obviously we look at and we look at from time-to-time not only in relation to what our tangible book value is, how our stock is performing but also in relation to our overall level of capital as well. So that is something that we reassess on a regular basis that we will continue to do so.

All things being equal where they are now, if anything we might get a little bit more aggressive and maybe buy somewhere 34-ish, something like that. But again, we'll just see how things go as we move along. It's always nice to have excess capital.

It seems like at least with the economists that we tend to follow -- is that 2020 and maybe even 2021 will look a lot like 2019 especially in relation to measurements like GDP and unemployment, those key metrics. So we don't look at any significant slowdown coming down anytime soon.

Our discussions with our borrowers continue to be relatively positive on an overall basis. So I don't think we need any excess capital from an economic standpoint, but obviously always good to have in case something dramatic does take place on finance standpoint.

In regards to M&A, I'll let Bob speak most of that, but regards to capital, obviously, if we were to entertain some M&A opportunities, you have a little bit of excess capital to absorb, but those types of events would be helpful as well..

Yes, Kevin, to answer your question on M&A, nothing new on that front. As we talked about in the past, we remain opportunistic, yet selective on acquisition opportunities for us.

And things cross our desk a fairly frequently and we certainly take a look and make sure we have -- we do our due diligence, but there's nothing evident or anything on those lines on the M&A front for us..

Great, thanks. That's it from me..

Thank you, Kevin..

[Operator Instructions] The next question comes from Daniel Cardenas from Raymond James. Daniel, you may begin..

Good morning, guys. So maybe just a quick follow-up on the M&A question, while it sounds like things are maybe -- you're looking, but nothing seems imminent.

How about organically any plans to expand de novo through either LPOs or branch openings? And if so, what part of the state would you see yourself kind of expanding towards?.

Yes, it's a good question, Dan.

On the organic front from that aspect, as you know, we opened our branch in Southeast Michigan almost two years, it will be three years in March and the philosophy that we had with that situation is similar to our philosophy today that we are looking for bankers that are good match for our culture and lends the way we lend, and that the market, while important, is always secondary in our opinion to the quality and the philosophy of the team that we're going with, and that continues to be our philosophy.

And so, just as we were selective with the Southeast Michigan opportunity as we do on the mortgage lending side, we're looking for people at a good cultural fit. As we do, we start to engage conversations to possibly bring them on board. And as I said, that's really, in our opinion, more important than the market necessarily.

While we have a pretty broad branch footprint, our location footprint in Michigan right now, there are some areas of the state where we're not located and certainly to fill that out would be nice, but the people are the most important part..

Got you, makes sense. All right. And then maybe just a quick question on credit quality, I mean, the metrics are solid, but maybe if you could provide a little bit of color on watch list trends.

Any concerns in that -- in the substandard or doubtful or any of the watch list portfolio?.

The watch list trends are continuing to be quite favorable, just as they have for the last few years now, very pleased with what we see there.

So our early indicators or any problems -- but we continue to diligently look at and stay in the portfolio all the time to make sure our lending staff remain close to our clients, so I understand what's happening with them, to be able to be an early warning indicator for any potential problems.

And we remain very pleased to see -- we're not seeing anything of a systemic nature or trend that will give us cause for concern, but it's not going to stop us from looking because we want to stay ahead of the curve and maintain that really solid asset quality.

So -- but again right now, we're pleased with the trends and where it appears to be going..

All right, great. All my other questions have been asked and answered. Thanks guys..

Thanks, Dan..

This concludes our question-and-answer session. I would like to turn the conference back over to Bob Kaminski for any closing remarks..

Thanks, Jason, and thank you all very much for your interest in our Company and joining us today. We look forward to speaking with you again in April. That's the end of the call..

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect..