Good morning, and welcome to the Mercantile Bank Corporation 2024 First Quarter Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. Please note, this event is being recorded.

I would now like to turn the conference over to Nichole Kladder, First Vice President, Chief Marketing Officer of Mercantile Bank. Please go ahead..

Good morning, and thank you. Welcome to the Mercantile Bank Corporation's conference call and webcast to discuss the company's financial results for the first quarter of 2024.

Joining me today is Bob Kaminski, President and Chief Executive Officer; Chuck Christmas, Executive Vice President and Chief Financial Officer; and Ray Reitsma, Chief Operating Officer and the President of the Bank. We will begin with prepared remarks and a presentation reviewing the quarter's results and open the call to questions.

Before we begin, 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 factors described in the company's latest Securities and Exchange Commission's 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 first quarter 2024 press release and presentation deck issued by Mercantile today, you can access it on the company's website at www.mercbank.com. At this time, I would like to turn the call over to Mercantile's President and Chief Executive Officer, Bob Kaminski.

Bob?.

solid core local deposit growth, strong asset quality, continuation of our strong commercial loan pipeline and ongoing focus on near-term and long-term strategic initiatives. Ray and Chuck will have the full details on the first quarter performance shortly.

For 26 years, Mercantile Bank has been setting the standard for what a relationship-focused community bank should be. Our customers are at the center of all that our team does. In Mercantile, we understand that the key to developing and maintaining long-term customer relationships is focusing on our customers and delivering what's best for them.

We work diligently to understand customers' needs and then craft solutions that provide them the tools to help them reach their financial goals. This is how Mercantile was built and continues to operate today. Many financial institutions seem to place a higher priority on advancing their products ahead of what is optimal for the client.

Another tenant for Mercantile is the desire to develop strong partnerships within the communities we serve. This helps to make better places where we live and work.

The manner in which we do business with our clients while operating as a strong corporate citizen will continue to promote and enhance the sustainability of our company and our communities. Those are my prepared remarks. I'll now turn the call over to Ray and then to Chuck for their comments.

Ray?.

Thank you, Bob. My comments will focus on rightsizing our loan to deposit ratio, deposit growth, loan growth, asset quality, noninterest income and cost control. Over the last three years, commercial loan growth and mortgage loan growth has been strong, while deposit growth has been solid, it has not kept pace with total loan growth.

As a result, the bank's loan to deposit ratio has increased to 110% at year-end 2023 compared to 85% at year-end 2021 when deposits were elevated because of the PPP program and the resulting excess liquidity in the system.

We believe that the bank's elevated loan to deposit ratio, which has been a long-term trade at the bank, is a contributing factor to our below peer valuation despite a strong return profile. We are now embarking on a path to alter that element of our business model.

The following comments summarize the management initiatives that will contribute to a reduced loan to deposit ratio over time. We have undertaken a three-pronged approach to building our deposit base with the objective of reducing the loan to deposit ratio into the mid-90% range over time.

First, we will grow the public and municipal realm through strategic personnel additions with existing relationships in this space. Second, an additional focus on small business banking through more efficient underwriting and obtaining the full relationship that characterizes this type of business.

Third, a retail customer focus based on total balances as opposed to activity hurdles such as transactions or card usage.

These efforts led to an increase in deposits in the first quarter of approximately $107 million, an 11% annualized growth rate despite the contrary seasonal pattern typical of the first quarter of reduced deposits as our commercial customers pay bonuses, partnership distributions, and taxes.

Mortgage loans have grown substantially over the past few years as borrowers have opted for ARMs rather than fixed rates in the increasing rate environment.

We have altered and successfully executed our pricing strategy to encourage the borrower to select the fixed rate that we can in turn sell in the secondary market rather than funding it on our balance sheet.

The positive outcomes include a 117% increase in income on sale of mortgage loans on a year-over-year basis and a nominal increase during the quarter in mortgage loans on our balance sheet. Commercial loan growth in the first quarter was $14 million or 1.7% annualized.

The fourth quarter of 2023 featured commercial loan growth of 22% annualized, so it is natural that the funding in the current quarter would be somewhat depressed as the pipeline is rebuilt.

That has been the case as the current pipeline stands near the long-term trend line established over the last three years, including commitments to fund commercial construction loans of $345 million and residential mortgage loans of $36 million. A reduction in line usage of $27 million during the quarter also impacted our commercial totals.

Taken together, these strategies produced a loan to deposit ratio of less than 108% as of March 31, 2024 compared to 110% at year-end 2023. This ratio reduces to 102% when giving effect to our sweep account balances.

These strategies will also contribute to a more stable net interest margin over time as the cost of growing money market deposits correlates strongly with our asset-sensitive balance sheet and the increase in the relative size of our securities portfolio will provide a greater protection to the net interest margin should rates fall at some point in the future.

Asset quality remains very strong as non-performing assets totaled $6.2 million at quarter-end or 11 basis points of total assets. Past due loans number 24 in dollars represent 2 basis points of total loans. Non-owner occupied office exposure is $271 million or 6% of total loans.

The borrowers in this asset class have performed well and continue to be monitored closely. We remain vigilant in all of our underwriting standards and monitoring to identify deterioration within our portfolio. Our lenders are the first line of observation in defense to recognize areas of emerging risk.

Our risk rating model is robust with a continued emphasis on current borrower cash flow, providing prompt sensitivity to any emergency -- excuse me, any emerging challenges within our borrowers' finances.

That said, our customers continue to report strong results to date and have not begun to experience the impacts of a potential recessionary environment in any systemic fashion. Total noninterest income grew 56% during the first quarter of 2024 compared to the first quarter of 2023 with growth reported in every category.

Mortgage banking income grew 93% based upon the strategies outlined earlier and the resulting ability to sell a greater portion of originations on the secondary market. Income from swaps -- interest rate swaps grew 29% as we met our customers' needs for fixed rate financing.

Service charges on accounts grew 56%, reflecting higher activity levels and customer growth and less earnings credit offset to charges based on reduced balances and transaction accounts. Payroll services grew 20% as our offerings continue to build traction in the marketplace. Credit and debit income -- excuse me, credit and debit card income grew 3%.

Cost control is an ongoing focus and S&P reports that efficiency ratios have been under pressure in the banking sectors. We are pleased to report that our efficiency ratio is 51% for the first quarter, consistent with the preceding four quarters. That concludes my comments. I will now turn the call over to Chuck..

Thanks, Ray, and good morning to everybody. As noted on Slide 5, this morning we announced net income of $21.6 million or $1.34 per diluted share for the first quarter of 2024 compared with net income of $21 million or $1.31 per diluted share for the respective prior-year period.

The improvement primarily reflects a higher level of noninterest income, which more than offset a lower level of net interest income, larger provision expense and increased noninterest expenses.

Turning to Slide 7, interest income on loans increased during the first quarter of 2024 compared to the respective prior-year period, reflecting an increased interest rate environment and solid growth in commercial and residential mortgage loans.

Our first quarter of 2024 loan yield was 75 basis points higher than the first quarter of 2023, with average loans up over 9% over the respective period.

The improved loan yield largely reflects the combined impact of an aggregate 100 basis point increase in the federal funds rate since the beginning of 2023 and approximately two-thirds of our commercial loans having a floating rate.

Interest income on securities also increased during the first quarter of 2024 compared to the first quarter of 2023, reflecting growth in the securities portfolio and the higher interest rate environment.

Interest income on other earning assets, a vast majority of which is comprised of funds on deposit with the Federal Reserve Bank of Chicago, increased during the first quarter of 2024 compared to the first quarter of 2023, in large part reflecting a higher average balance and an increased yield.

In total, interest income was up $16.2 million during the first quarter of 2024 compared to the respective prior-year period.

We recorded interest -- increased interest expense on deposits in our sweep account product during the first quarter of 2024 compared to the first quarter of 2023, reflecting the increased interest rate environment, money market and time deposit growth, transfers of deposits from no or low-cost deposit products to higher-costing deposit products, and enhanced competition for deposits.

Our first quarter of 2024 cost of deposits was 138 basis points higher than the first quarter of 2023. Interest expense on Federal Home Loan Bank of Indianapolis advances also increased during the first quarter of 2024 compared to the respective prior-year period, reflecting growth in the advanced portfolio and the higher interest rate environment.

Interest expense on other borrowed funds increased during the first quarter of 2024 compared to the first quarter of 2023, reflecting the higher interest costs of our trust preferred securities. In total, interest expense was $17.3 million during the first quarter of 2024 compared to the respective prior-year period.

Net interest income decreased $1 million during the first quarter of 2024 compared to the first quarter of 2023. Our net interest margin declined 54 basis points during the first quarter of 2024 compared to the same quarter in 2023.

Although our yield on earning assets increased 71 basis points during that time period, our cost of funds was up 125 basis points.

While we experienced rapid growth in our earning asset yield during the period of March of 2022 through July of 2023, when the FOMC raised the federal funds rate by 525 basis points, meaningful increases in our cost of funds did not begin to materialize until the latter part of 2022 when competition for deposit balances increased deposit rates and depositors began to move funds from no and lower costing deposit types to higher costing deposit products.

Our net interest margin peaked during the latter part of 2022 and the early stages of 2023. We recorded a provision expense of $1.3 million during the first quarter of 2024 compared to $0.6 million during the first quarter of 2023.

The first quarter of 2024 provision expense primarily reflects a specific allocation for a non-performing commercial loan relationship.

Additional allocations were needed to reflect loan growth, any change in a commercial loan environmental factor, while reduced allocations were made due to an improved economic forecast and changes in loan portfolio composition.

Noninterest expenses increased $1.3 million during the first quarter of 2024 compared to the first quarter of 2023, primarily reflecting increased compensation and benefit costs. Slide numbers 15 through 17 depict information on our investment portfolio.

There were only nominal changes to our investment portfolio during the first quarter of 2024, largely limited to ordinary purchases of municipal bonds and maturities of U.S. government agency bonds and municipal bonds. All of our investments were being categorized as available for sale.

As of March 31, 2024, about 63% of our investment portfolio was comprised of U.S. government agency bonds with approximately 32% comprised of municipal bonds, all of which were issued by municipal entities within the state of Michigan and a high percentage within our market areas. Mortgage-backed securities, all of which are guaranteed by U.S.

government agencies, comprise only about 5% of the investment portfolio. The maturities of the U.S. government agency in municipal bonds segments are generally structured on a laddered basis. A significant majority of the U.S.

government agency bonds mature within the next seven years, with over three-fourths of our municipal bonds maturing over the next 10 years. The net unrealized loss totaled $67 million as of March 31, 2024, compared to $64 million at year-end 2023 and $71 million as of March 31, 2023. Slide numbers 19 through 21 depict data on our deposit base.

You will note that we include sweep accounts in our deposit tables and calculations, as those accounts reflect monies from entities, primarily municipalities and other larger customers who have elected to place their funds in our sweep account that is fully secured by U.S. government agency bonds.

On Slide #21, we depict our deposit balances as of March 31, 2024, and year-end 2023. As a commercial bank, a majority of our deposits are comprised of commercial accounts. Noninterest-bearing checking accounts equated to 27% of deposits and sweep accounts as of March 31, 2024, similar to historical levels.

A large portion of these funds are associated with commercial lending relationships, especially commercial and industrial companies.

As typical, noninterest-bearing checking account balances declined during the early stages of the first quarter, reflecting withdrawals by commercial customers to make bonus and tax payments in partnership distributions.

We experienced solid growth within our money market and time deposit portfolios during the first quarter of 2024, reflecting growth from existing customers and initial deposits from new customers. The level of uninsured deposits totaling about 48% as of March 31, 2024, has remained relatively steady over many years.

On Slide #20, we provide information on depositors with balances of $5 million or more. At the end of the first quarter, we had 76 relationships which aggregated $1.2 billion. About 80% of the relationships, and approximately 83% of the total deposits, were with businesses and or individuals with the remaining comprised of public entities.

When compared to five years ago, we had 41 relationships with deposit balances over $5 million, aggregating $521 million. Of those 41 relationships, 32 continue to have balances over $5 million and have grown those deposit balances by almost $300 million in aggregate. We remain in a strong and well-capitalized regulatory capital position.

Our bank's total risk-based capital ratio was 13.8% at the end of the first quarter, almost $200 million above the minimum threshold to be categorized as well-capitalized. We did not repurchase shares during the first quarter of 2024. We have $6.8 million available in our current repurchase plan.

While net unrealized gains and losses in our investment portfolio are excluded from regulatory capital calculations, on Slide #18, we depict our Tier 1 leverage capital ratio and our total risk-based capital ratios, assuming the calculation did not -- did include that adjustment.

While our regulatory capital ratios were negatively impacted by the pro forma calculations, our capital position remains strong. As of March 31, 2024, our Tier 1 capital ratio declines from 12.3% to 11.3%, and our total risk-based capital ratio declines from 13.8% to 13%.

Our excess capital, as measured by the total risk-based capital ratio, is also negatively impacted. However, it totals a strong $150 million over the minimum regulatory amount to be categorized as well-capitalized.

On Slide 23, we share our latest assumptions on the interest rate environment and key performance metrics for the remainder of 2024 with the caveat that market conditions remain volatile, making forecasting difficult.

This forecast is predicated on the federal funds rate staying unchanged during the second quarter of this year and then declining by 25 basis points during both the third and fourth quarters. We continue to project loan growth in a range of 4% to 6%.

We are forecasting our net interest margin to decline during the second and third quarters, in large part reflecting continued growth in higher-costing money market and time deposits, along with a higher portion of our asset base invested in securities and on deposit with the Federal Reserve Bank of Chicago.

We expect noninterest income and noninterest expense to be relatively stable during the remainder of this year.

In closing, we are very pleased with our first quarter 2024 operating results and financial condition and believe we remain well positioned to continue to successfully navigate through the myriad of challenges faced by all financial institutions. Those are my prepared remarks. I'll now turn the call back over to Bob..

Thank you, Chuck. That concludes management's prepared comments and we'll now open the call for Q&A session..

We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Brendan Nosal with Hovde Group. Please go ahead..

Hey, good morning, guys. Hope you're doing well..

Good morning..

Good morning..

Maybe just to start off here, there was a pretty meaningful transaction announced in your neck of the woods yesterday afternoon.

I know it was less than 24 hours out since it was announced, but any preliminary thoughts on how it may impact kind of your market and Mercantile and where you might like to capitalize on any talent dislocation opportunities that might arise?.

Yeah. That is exactly our thought that there may be some opportunity surrounding this announcement and employees, customers will both be in play over some period of time and we will seek to take advantage of that..

All right. Perfect. Perhaps one more from me before I step back. Maybe just on the margin kind of longer term, I know the idea of an aggressive Fed cut or cuts keeps getting pushed out. But just kind of curious how you think about the margin, when and if the Fed does start cutting meaningfully.

Like, are you still very asset-sensitive in that scenario? Or you've taken enough margin pain over the last 12 months that Fed cuts aren't as impactful as they once may have been?.

Yeah, this is Chuck. I think one of the things that we've seen as was fully expected is our balance sheet fully repriced over the last few years. Our margin has settled down kind of back to its historical average of 3.5% to 3.6%. And as I stated a few minutes ago, it's kind of where we expect it to settle out as we get towards the end of this year.

I think, clearly, we look at our asset sensitivity and manage our deposit structure and our FHLB advances along with the overall interest rate structure of our loan portfolios and investment portfolio to try to manage through changing interest rate environments.

I think, clearly, if the Fed was to lower rates 500 basis points like they just raised them, it's a very different scenario than what it's really is being talked about out there is maybe some interest rate declines the back half of this year and maybe several more next year.

I am very comfortable with our margin -- our expected margin performance under the current market expectations.

Clearly, if the Fed was to very aggressively lower interest rates, that would have a bigger upfront impact, just because our assets would be priced faster than our liabilities, kind of going through the opposite of what we just went through and then everything else would catch up.

I think we've been working very hard and Ray kind of commented -- made a couple of comments on it in his prepared remarks of working with the deposit portfolio, wanting to grow that as meaningfully as we can, but also with an eye to helping to manage interest rate risk and changing interest rate environment, especially in a decline interest rate environment..

All right. Fantastic. Thank you for taking my questions..

You bet..

The next question is from Daniel Tamayo with Raymond James. Please go ahead..

Hey, good morning, guys..

Good morning, Daniel..

Maybe we just start on credit, obviously things still very strong for you guys. I mean, NPL trends slightly up, but still very low. But just curious first on your thoughts on where you might expect those NPL trends to continue from here. I mean, I noticed you took reserves up a little bit, a few basis points.

And just curious also kind of what the driver was for that and where you see -- might see reserves go?.

Well, in general, in the very near future, we have a few events that we're planning or that our customers are planning in helping us to reduce the NPLs that are on our books. And I'd expect that will continue in the foreseeable future in a similar sort of range that we're in now.

Obviously, it wouldn't take much to change ahead because the NPL amounts are so small. But there is good credit quality throughout all segments of our portfolio and we feel that the economies that we operate in continue to be strong and our borrowers continue to report good results..

This is Chuck, Danny. I would make just a couple of comments on the loan loss reserve. You're, obviously, using the CECL model. I think as everybody knows, there's really two area -- and there's a lot of different inputs there, but there's really two that would have the most significant input.

One, obviously, is the economic forecast, which we use a third-party independent forecast. Those continue to be relatively favorable, and I think match what the market is really expecting and even some of the Fed forecasts that are out there.

And of course, the other big driver would be our loan loss reserve is highly predicated on the grading system through our commercial loan portfolio. So, if we were to see meaningful grade changes that would have an impact on the reserve calculation as well.

Again, kind of based on our comments, we really don't see -- we're not really forecasting any significant change in the economy. And with that, we would expect the grades within our commercial loan portfolio to stay relatively steady as well..

Appreciate all that color. That's helpful. Maybe I'd just dig a little bit more into the office portfolio. I think I heard you guys say it was $271 million of non-owner occupied office.

Is that correct?.

Correct..

Okay. Is there anything else you can provide us in terms of data on that portfolio in terms of LTVs or occupancy rates or geography of the location of those office buildings? Just curious what other details you have on those loans..

Well, the majority of those loans are in Grand Rapids in terms of geography. In terms of credit characteristics, the vast, vast majority of them have personal recourse. All of them continue to have positive cash flow and debt coverage ratios at this time. We're watching that very closely.

The tenant situations in each of the projects appears to be stable and that's obviously something that can change, so we're watching that closely, but so far so good. And so, with those traits, we feel that there is some sustainability to that 6% of our loan portfolio..

Okay.

And have there been any transactions of office buildings in Grand Rapids that give you a sense for how much or if prices have moved in the last few years?.

None leap to mind in very recent times. I could be wrong about that, but I can't think of any at the moment..

Okay. Thanks for taking my questions..

You bet..

Thanks, Danny..

The next question is from Damon DelMonte with KBW. Please go ahead..

Hey, good morning, guys. Hope everybody is doing well today..

Good morning..

Good morning. Just wanted to start off with on fee income this quarter. It looks like treasury management, which I believe is captured in the other line item, was particularly strong.

I guess, first, Chuck, can you confirm is that the line that it was categorized in? And then secondly, kind of what's your thought on the outlook there over the next few quarters?.

Yeah. I think most of our -- when we talk about treasury management, there's kind of a handful of prongs there. From your normal day to day cash management, most of those fees are in service charges. They get blended in with earnings credit rates and those types of things. So, it's a very blended calculation that takes place.

We would also include our payroll, human capital management products, as well as our card products, our debit and credit products. That's dominated by commercial customers using them for their -- some of their cash flow needs. So, when we talk about treasury management, it's kind of those three categories -- broad categories that we think about.

We expect all of those to continue to grow as they have been as we continue to grow our customer base, especially in the C&I segment of our loan portfolio as we bring those customers on, get the full deposit relationships, and are able to also offer them all a myriad of different cash management, treasury management products.

On Page 23, we gave guidance in regards to our fee income. There was -- we had a very solid quarter for swap income, kind of like commercial loan growth that can be lumpy from quarter to quarter just given the attributes within that commercial loan portfolio.

But we're obviously very pleased to have that product, not only the income upfront, which is great obviously, but really the primary reason for getting into that product and staying in that product is to manage longer-term interest rate risk of meaningfully-sized credits. We're not going to offer -- we're generally not going to offer fixed rates too.

So, we feel that's a significant interest rate risk management tool, but obviously provides some solid fee income upfront. Very pleased with our mortgage banking operation in the first quarter. That performed very well, well above what we had budgeted. And the pipeline and the conditions are looking positive for that as well.

The big item in the other income was we are -- we do have a relatively small investment in a local Michigan-based private equity fund that makes investments that qualify for CRA credit. That fund has been performing very well and we were able to run some of that -- reflect some of that within our income statement for the first quarter.

Again, some of those stuff gets a little bit lumpy from quarter to quarter, whether the swaps, mortgage banking or private equity, those types of things. But on Page 23, we gave our thoughts for the remainder of 2024 relative to the first quarter.

We are not expecting fee income to be as strong, but we do expect it to be solid and meaningful to our overall operations -- operating performance..

Got it. Okay. Appreciate that color and clarification on kind of how the treasury management fees are captured..

You're welcome..

Okay. And then, with respect to the margin and the outlook, I think Ray may have said it or Chuck, you may have said it in the prepared remarks about the kind of the revised outlook and kind of the driver of the lower outlook or lower range for the margin.

Was that more attributable to the ongoing efforts to bring on deposits? Or is that just a function of the asset sensitivity and maybe expectation of rate cuts later in the year?.

No, I think there's definitely a little bit on the rate cuts there Damon. As we mentioned, we've got a couple in the back half. But I think we're pretty well balanced when you're only looking at, say, 50 basis points of decline over six months. We don't really have any significant timing issues that are there.

I think the big thing with the margin going forward and you already kind of touched on it is the growth in our deposits base, which obviously we're trying very hard to grow local deposits.

And obviously, in this environment, most of that's going to come in the money market and the time deposit categories, which obviously are the higher cost deposits that we have in there.

Now having said that, we do expect our noninterest-bearing checking accounts to have meaningful growth as well, especially as our current customers rebuild after paying their payments that they do generally in January of each year, but also as we continue to get growth within the C&I segment of our loan portfolio. I think there is also some benefits.

We do have some, I would say, very low-yielding investments that are set to mature over the next several years.

And whether we reinvest those into investments or put those in the loan portfolio, more likely to go in the investment portfolio at this point in time, those will reprice very appreciably, which will help set off some of the extra costs or additional cost that we will have in our deposit structure.

And we do have some loans that were made three and five years ago that are coming up for maturity balloons that we will be able to reprice as well. So, on an overall basis, we think the margin will stay relatively steady.

I guess, I should add one more thing is, in addition to growing the investment portfolio as a percent of assets over the next several years, we are operating with a higher level of on-balance sheet liquidity, which while as I said, it's not a bad rate, certainly, it's a lower rate than what we would get in the loan portfolio.

So, there's a little bit of a dampening of our margin from that standpoint as well. But given the environment, our overall balance sheet structure, we think it's prudent to operate with a higher level of overnight liquidity at the current time..

Got it. Okay. Great.

And then just lastly, on the loan guide, is that in any way being constrained by trying to not outpace the deposit growth that you're targeting to achieve? Or is the 4% to 6% loan growth just kind of indicative of the market opportunities that are in front of you guys right now?.

That's a great question. We think that it does reflect the opportunities in the market. We're not dialing back our loan growth.

There may be a very sliver of selectivity within that where we look at our existing portfolio and say, "Hey, this relationship doesn't have the full characteristics that we're looking for in terms of deposits accompanying loans," and those may deselect out of the bank and have a bit of a dampening effect.

But the overall addition of new credits and new opportunities to the bank, we don't expect to see that decrease at all..

Got it. Okay. Great. That's all I had. Thank you very much..

Thank you, Damon..

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

Thank you, Gary. On a personal note, this is my final conference call as President and CEO of Mercantile Bank Corporation, as I will retire at the end of May. It's been my pleasure to interact with you on these calls over the years, with the last seven being in this leadership position.

Our company views these calls as important avenues of communication and transparency with our stakeholders. Ray and Chuck will be with you in July, reporting on our second quarter results and highlights. Thank you very much for your interest in our company. Best wishes to you all. This call has now ended..

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