Ryan Thomas - Vice President, Finance and IR Mike Price - President and CEO Jim Reske - Executive Vice President and CFO Bob Emmerich - Chief Credit Officer Mark Lopushansky - Chief Treasury Officer.

Bob Ramsey - FBR John Moran - Macquarie Collyn Gilbert - KBW.

Good day. And welcome to the First Commonwealth Financial Corporation Third Quarter 2015 Earnings Release Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded.

I would now like to turn the conference over to Ryan Thomas, Vice President of Finance and Investor Relations. Please go ahead, sir..

Thank you, Chad. As a reminder, a copy of today’s earnings release can be accessed by logging on to fcbanking.com and selecting the Investor Relations link at the top of the page. We’ve also included a slide presentation on our Investor Relations page with supplemental financial information that will be referenced throughout today’s call.

With me in the room today are Mike Price, President and CEO of First Commonwealth Financial Corporation; and Jim Reske, Executive Vice President and Chief Financial Officer. After brief comments from management, we will open the call to your questions.

For that portion of the call, we'll be joined by Bob Emmerich, our Chief Credit Officer; and Mark Lopushansky, our Chief Treasury Officer. Before we begin, I’d like to caution listeners that this conference call will contain forward-looking statements about First Commonwealth, its business, strategies and prospects.

Please refer to our forward-looking statements disclaimer on page two of the slide presentation for a description of risks and uncertainties that could cause actual results to differ materially from those reflected in forward-looking statements. Now, I’d like to turn the call over to Mike Price..

Hey. Thanks, Ryan. And welcome to our third quarter earnings conference call. Jim Reske and I appreciate your interest and investment of time in First Commonwealth.

Our earnings of $0.14 per share in the third quarter fell short of our expectations and particularly falling earnings of $0.15 per share in the second quarter and $0.16 per share in the first quarter. Let me begin by briefly sharing some highlights for the quarter and then just as importantly our path forward.

On a positive note, our loan portfolio grew $80 million or over 7% annualized in the third quarter. The commercial side of the Bank was the catalyst with our commercial real estate portfolio growing $74 million and the C&I portfolio growing another $27 million for the quarter.

I would also add that our commercial loan growth in 2015 has been balanced geographically with opportunities in Western PA, Cleveland and the Columbus market. The CRE growth has also been balanced by project type to include multifamily, office, hospitality and retail.

The second highlight is just simply our margins have stabilized over the last five quarters. Together stable margins and loan growth add up to topline, where net interest income that is beginning to grow in exhibit a positive operating leverage.

Our third quarter non-interest income fell largely due to a quarterly fair value adjustment on interest rate swaps that Jim Reske will elaborate on. The linked quarter swing here was large and roughly $1.4 million.

However, as we take a step back, our non-interest income to include our wealth revenue, some fees, deposit fees and interchange have strengthened throughout the year. Expenses are flat year-over-year and overcame some unusual items that Jim will also elaborate on.

And important item this quarter is credit, provision expense increased $1.6 million to $4.6 million. In short this increase is largely due to $6.1 million loan for the manufacturer whose revenue stream is tied to steel and mining. Although, our MPL and NPA numbers are still very favorable we saw some stress in select C&I credits.

Even though we do not have a lot of exposure in oil and gas, the low energy prices have had an impact on drilling activity in our footprint. This dampened results for the company that provides ancillary services for drillers. We have also seen a handful of companies impacted by the recent volatility in commodity prices.

Now the past forward for us, financially is clear. First, we will continue to focus on growing our topline and really realizing the investments in commercial banking, Columbus, Cleveland and mortgage banking.

We have some good momentum here and I'll just mentioned four items, commercial banking is performing well and has a deep meaningful pipeline, anticipated draws on already approved quality construction projects represent over $100 million in future takedowns. Our wealth is turning the corner in both trust and brokerage income are improving.

Traction in mortgage is driving gain on sale income. We have also had nice recent wins with hires in that business. The mortgage business also pushed through the breakeven point in the third quarter after making their first loan just one year earlier. We are also optimistic about continued growth in traction in Columbus and Cleveland.

Our First Community acquisition closed on October 1st and the system conversion weekend is set for November 6th and 7th. We've already attracted a good corporate banker as the Bank President and a high-performing mortgage loan officer.

The second focal point in the path forward and particular important in this environment, we will have to be steadfast with expenses and continue to reconfigure work in certain areas. We need to pay for investments and keep expenses a flat to down. This will be hard work but we are committed to it.

Third, we need have consistently lower credit costs and they're vitally important to any bank, despite strain in handful of credits. I would be remiss if I did not sure that our total delinquency percentage for the portfolio and NPAs and MPLs are really at eight to 10-year lows. A couple of other items that maybe of interest to investors.

We had success this quarter in executing on various digital and payment initiatives. The team rolled out several new mobile enhancements, including consolidating our mobile remote deposit capture and person-to-person payments into our mobile banking app and adding some other functionality with mobile.

We also enabled Apple Pay and started to issue our EMV chip cards. So we had a lot of activity and I continue to be pleased with how quickly we can bring new features and solutions to the market.

Our effort last year to successfully roll out our technology platform and get the requisite savings has allowed us to invest in these new features in addition to adding a mortgage banking group and complete an insurance company acquisition while keeping our expenses flat.

So with that, I will turn it over to Jim to some more detail and color commentary..

Thanks, Mike. The third quarter was impacted by three items. First, we settled the disputed tax assessment with the state of Pennsylvania, which increased noninterest expense by $709,000. Second, we performed our usual quarterly mark-to-market of our swap positions, which resulted in a $783,000 reduction in noninterest income.

So this was a positive adjustment of $593,000 in the second quarter. The linked quarter swing was $1.4 million headwind. Third, provision expense reflected specific reserves for two commercial credits totaling $2.5 million.

As we mentioned in our earnings release we are proud to announce the completion of our acquisition of First Community Bank in Columbus, Ohio.

A legal closing of that transaction took place on October 1, so the one-time costs associated with the purchase of First Community Bank which we expect to total about $1.3 million will be reflected in the fourth quarter results, not third quarter results. Now I will turn to the major sections of the income statement.

First of all, net interest income at $47.6 million was up over the linked quarter and the same quarter year ago. Strong loan growth of $80.1 million in the third quarter helped to offset lower loan yields and maintain net interest income.

Our net interest margin in the second quarter was relatively stable at 3.25%, down only one basis point from the linked quarter and from the year ago period. The overall yield on earning assets was unchanged. Lower yield on loans were offset by higher volume and conversely lower volume on securities was offset by higher yields.

Yields are newly originated loans were actually up in the third quarter compared to last quarter but not enough to offset the effective runoff yields.

Overall loan yields declined 5 basis points primarily due to negative commercial loan replacement yields, which stands in contrast to the positive commercial loan replacement yields that the bank experienced in the first two quarters of this year.

However, the margins benefited from an improvement in the mix of earning assets as securities were only 21.5% of average earning assets in the third quarter as compared to 24% in the second quarter and the yield on the securities portfolio improved by nine basis points.

The total cost of deposits declined from 16 basis points to 15 basis points over the quarter. Total deposits decreased by $48.6 million over last quarter due to a $36.9 million decrease in more expensive time deposits, of which $11.4 million was intentional runoff of brokered time deposits.

Noninterest-bearing demand deposits increased by $9 million over the prior quarter and by $82.2 million over the prior year and currently comprised over 25% of total deposits.

Loan loss provision expense of $4.6 million in the second quarter increased by $1.6 million over the linked quarter primarily as a result of a $600,000 increase in general reserves and $2.5 million in specific reserves on two commercial loans as I mentioned earlier.

Nonperforming loans fell by $4.3 million to 89 basis points of total loans, down from 1% last quarter and nonperforming assets fell to 1.13% of total assets, down from 1.16%. The reserve coverage of nonperforming loans increased from 106.2% last quarter to 118.8% this quarter.

The bank’s ratio reserves total loans increased to 1.06% at September 30 and as general reserves as a percentage of non-impaired loans was relatively unchanged at 97 basis points. Our noninterest income continued to experience positive underlying trends despite the impact of the fair market value adjustment of our swap positions mentioned earlier.

We saw increases in a number of key line items compared to last quarter including trust, deposit service charges and mortgage banking. Mortgage has added $1.9 million in gain on sales year-to-date. When compared to the third quarter of last year mortgage, insurance, and retail brokerage and debit card interchange fee income have all shown improvement.

As I mentioned, fee income was negatively impacted by our normal quarterly credit evaluation of swap counterparties. These swings from quarter-to-quarter and as a result swap we have in place on approximately $395 million of commercial loans.

These loans have desirable variable-rate exposure and an origination generated swap fee income, but our exposure to the swap counterparties must be mark-to-market every quarter to reflect their fair value.

This quarter the swap adjustment was driven by a 40 to 50 basis point increase in corporate bond spreads, which in credit terms increases the calculated probability defaults of the swap counterparty.

The adjustment was also driven by a 47 basis point decrease in tenure swap rates between June 30 and September 30, which increases the calculated loss given default because we would hypothetically make it more expensive for the counterparty to unwind the swap if they did default.

Despite this mark-to-market adjustment, we are encouraged by the steady underlying growth trends in fee income.

Turning to noninterest expense, our total noninterest expense decreased by $400,000 compared to last quarter, but the quarterly comparison is strongly affected by two items in the second quarter, a $1.1 million right under the collection of OREO properties and a $400,000 write-down for the sale of a building.

This quarter expense was also impacted by the shares tax item I mentioned earlier. Adjusting for these items, “operating expense” was $39.2 million in third quarter relatively unchanged from $38.7 million in the prior quarter and below our $40 million target.

In fact, we have been able to achieve positive operating leverage over the past year as operating expense was up only $100,000 over the third quarter of last year while revenue was up $900,000 over the same period.

Of course, operating expense is a non-GAAP concept and a full reconciliation of GAAP figures can be found on page 12 of our earnings release supplement, which is available on our website. In other news, our effective tax rate was 29.35% at the end of the second quarter. And with that, we’ll take any questions you may have..

Operator questions..

Thank you. [Operator Instructions] Our first question comes today from Bob Ramsey with FBR..

Hey, good afternoon guys. First question for you, could you just remind me what it is it, that drives the Pennsylvania share tax expense? I am sure we have talked about it in the past. I just -- I don't have a good sense of it in my mind today..

Yeah. Actually I’ll give you some detail but you have to bear with me because it’s -- there is a little bit of detail behind it. We actually issued trust preferred securities in 2008. And this capital is accounted for as minority interest in non-controlled subsidiary. Since it was issued to a trust just like all trust preferred..

Yeah..

And at the time of issuance, this was not included in the total equity capital line and the bank’s call report. And so it wasn’t subject to the Pennsylvania shares tax, which taxes capital. In 2009, the call report format was modified and a new line item was added called total bank equity capital and that line did increase the minority interest.

The state of Pennsylvania really assessed share tax on us for the years 2011, ‘12 and ‘13 based on that figure. We argue that the shares tax is never intended to collect tax on the minority tax since the minority tax was specifically excluded from total equity capital at the time tax statute was drafted.

And we are very confident we will prevail on theirs. So we paid the tax and appealed but we didn’t believe any loss was probably at all. In addition, no cases on this issue had settled in Commonwealth Court in Pennsylvania through the end of the second quarter.

During the third quarter that court settled the first case with this issue was to set precedent probably other appeals of this issue going forward. And as we can tell, because some of this isn't public, this issue really affects about -- only about six banks in Pennsylvania. And in the third quarter, three of these banks settled with the state.

So since that happened, our counsel advised us that regardless of our confidence we’re prevailing we’re unlikely to achieve any better result than the settlement. And so we settled for 2011 and 2012 and we accrued the full cost for ‘13 settlement even though that remains pending. But all of it now has flown through the income statement..

Hey Bob. This is Mike. This is a separate issue from the shares tax issue and the stalemate between the state legislator and the governor. And this has been on and off the table, an increase in shares tax for Pennsylvania banks, and that will play itself out over the next quarter or two, I’m sure..

Okay, great.

Barring any change in the tax assessment rate without the sort of one-time true-up here, what is the right level for us to think about that tax on a forward basis?.

You are referencing shares tax..

Yes..

I think the latest we’ve heard from the state legislature that it’s going to -- unless the polls remains unchanged. I think the latest press with the governor taken out of the latest tax proposal. So we are hoping that remains unchanged although I do think it’s still open to debate..

I guess what I am -- maybe I’ll ask it a little differently.

So assuming it is unchanged, I mean is about $1 million a quarter the right level for First Commonwealth just sort of looking back historically?.

Yeah. That is importantly $1 million a quarter..

Perfect. Shifting gears, net interest income, certainly nice to see a little bit of loan growth this quarter. As you all kind of talked about, securities balances were lower and so you didn't see as much growth in earning assets. Just curious how you are thinking about that mix shift trade off on a go-forward basis.

Is the plan to continue to sort of bring down security balances or are they at a level that they are flat or up from here? How are you thinking about overall earning asset growth?.

Well, the securities fell in part because at the time there really wasn’t an attractive alternative that we could purchase at what we felt was an acceptable yield. I think ideally we probably keep them flat or let them leak down a little bit but really continue to grow our loans at a similar clip to this quarter..

Yeah. That’s right. I mean the preference long-term is to have a better earning asset mix by having good solid loans that replace securities over time. Particularly, in the third quarter, we had about $125 million of very low yielding agency securities that were called and the yield on those were 71%.

And so with those off the books that actually increased these securities yield. We also had a little bit of success on purchasing some municipal securities and looking through into the fourth quarter, we picked up some municipal securities from our acquisition of First Community in Columbus.

So that should help the securities portfolio yield little bit..

Okay, great. And obviously on margin, as you guys highlighted, you have certainly gotten to a level where it looks like there is a lot more stability there which is nice to see. The mix shift helps.

I mean in the current rate environment until the Fed does whatever it does is maybe a basis point of compression a quarter a good way to think about give or take the trajectory?.

Well, I think -- we think of it as not a kind of steady trend of 1 basis point compression a quarter but rather balancing around a little bit in the mid 3, 2 range. So right about where we are in the 3, 2s.

As we talked about in the past several quarters, some of this just reflects about the replacement yield picture which just swings but changes quarter to quarter. So if the Fed doesn’t move and there is no change in rate picture. I think it’s going to hover right around in that range..

Yeah. And we have been a little asset sensitive and we have taken a little duration and we’re putting about 20% of our mortgages on the books and then as well as we’ve taken a little duration on the commercial real estate at five to six years and that’s been growing nicely. So I think we’ll be able to combat that somewhat, Bob.

And if you look at it over the last five quarters, I think one quarter that was an outlier with the Federal Home Loan Bank dividend but otherwise it’s been right in 3.22 to 3.25 or 3.26, I think is the range..

Yeah..

As per memory..

Okay. No, that’s right and it makes sense. That’s good. I will hop out and give someone else the chance to may hop back in. Thank you.

Thank you..

The next question comes from John Moran with Macquarie..

Hey, John..

How’s it going?.

Good..

Good. Hey. Just on OpEx and you kind of alluded to it here in your prepared remarks but a pretty good outcome here this quarter, sub-40. Is 40 really -- and I think you sort of said, book is going to be a challenge but we are spread fast here, we want to see it flat to down.

40 is still the kind of boogey, right? I mean that’s what we ought to be thinking about in terms of run rate there..

It’s been boogey this year. Obviously, we just did an acquisition. We are still trenching a little bit going forward. So, if there is new guys, we can give that next year. But for now, we are still trying to absorb those new costs, running as efficiently as we can..

And then with the mortgage businesses, we ramp up there to our plan. There could be some pressure on that. We are going to try to take some future costs out to compensate for that and pay for that investment. But we are trying to keep it tight and as flat as we can..

Okay.

And the First Community adds, if I’m remembering correctly about a $1 million a quarter and then you guys were targeting a conversion sometime in November, is that correct?.

Yeah. We are going to convert share in 10 days and in terms of the numbers around First Community..

It’s not a $1 million a quarter of NIE, of non-interest expenses but more like half a million. I mean, it’s a relatively small acquisition. So, we are trying to clear as we can on the overall financial impact. I think what we said at the announcement that it’s about penny a share accretive..

Right..

So, penny a share overall is $1.2 million, $1.3 million of net income a year are share based. But it does gives us a strategic access to converse market where we expect to grow..

Right..

And we have 25 corporate bankers now and we've added three in Northern Ohio and we are looking. We have one and looking to add another one in Columbus and really supplement a pretty robust portfolio of probably over $200 million in Central Ohio and now well over a $100 million in Northern Ohio.

So, we like our traction there and so we are adding some costs. But we really in that business and corporate banking, we really expect some nice operating leverage and growth..

Okay. That's helpful. The other one, I just wanted to kind of circle back on the replacement yields. And I think they were running north of the book yield for the first half of the year and then we dropdown a little bit here.

is there anything going on with either, mix or just, if this is just general competition that you guys are kind of following the flow and the market?.

Actually in this quarter, our gross yield on the loans went up. But the loans that fell off were just higher-yielding than in prior quarters. So that differential was greater even though it affected. I think this past quarter, our three-month average, particularly on the corporate side is really outrunning our 12 months.

So, do you remember?.

Yeah. I do so. Like we’ve just heard new loan origination for the total loan portfolio, we put our loans in total at 13 basis points higher rates in the third quarter than we did in the second quarter. So that’s good. This loan replacement yield story really reflects some of the some of the lumpiness we have with prepayments in the commercial portfolio.

So it’s going to be positive for a couple quarters and then negative for couple quarters. And lot of that like we talked about many times, lot of that portfolio, about $1.3 billion of the total $4.5 million of loans is linked to LIBOR.

So, retires will be in a good position but the replacement yield story is really, not so much driven by contractual payoffs in the way that you could see it slow and steady, hard for me to predict. It’s really driven by prepayments and that’s more difficult to predict. So, we think it will bounce around it..

Got it. That is definitely helpful. So the actual production yields were higher linked quarters. it’s just that what fell out was even higher. Okay.

And the only other one that I wanted to kind of circle back on and you guys sort of hit it around credit quality and some weakness in manufacturing tied to mining, not a big direct oil and gas exposure but second order kind of outcomes.

Any sort of traditional, sort of color that you can provide around that would be helpful?.

Yeah. The company that we had the allocation on -- just as a manufacturer of engineered type products and their sales have really dropped precipitously. They sold primarily the steel and mining and they have gone from probably been cut in half and over a two year period, they went from probably 10% margins to breakeven and now showing a little loss.

They have a little leverage on their balance sheet and they are working through it. They put a little equity in, maybe a $1 million or so. We have a $6 million loan here now with the $1.9 million allocation. This is a company that -- a lot of us on the team knew 20 years ago and you just work with them and we work through it.

And so we had probably another story like that that’s probably a company third the size and that was the other part of the specific reserve about a $600,000 reserve on a $1.6 million loan. And so we are just seeing a little strain there. It doesn’t mean the companies won't work through it and we won’t be able to work with them.

But you’ve seen commodity prices, aluminum, petroleum, dropped 20%, 25% in probably the second quarter and it’s just spilling out on some good companies that have some leverage..

Great. I was just going to ask. You will see some disclosure on this in the 10-Q as we published, as we have in past quarters. But just to give a picture overall, we talked about overall exposure to oil and gas at $145 million, that’s total commitments. Actual outstanding loan balances are about $70 million.

And about 81% of those are not too direct oil and gas expiration there, ancillary businesses as Mike talked about. Within that it’s really only about four credits that are all past rated, above $40 million worth in ancillary business sector that we think we might have some exposure here to, lower oil and gas prices..

That’s helpful. And then just kind of a follow-up to that. In terms of second order sort of spillover impact, just in general slowness, with completions down and rig count dropping off a cliff and there everything else.

Are you guys seeing a lot less activity in that part of the footprint that’s impacted? Or is it still reasonably healthy and things that have been drilled or trying to continue to produce obviously?.

Yeah. Just two thoughts there, the pipeline infrastructure has probably -- there is still a nice investment there. I think once that is done, it could be a little bit more of a drop-off actually.

But there has been a precipitous drop in drill count nationwide and then our part of the vineyard and what’s buoyed it a bit is just the pipeline infrastructure. So in 5 or 10 years, 3 years, you can get the gas out of the field and there is significant investment there still..

Sure. Okay. Got it. Thanks very much for taking the question..

You bet..

[Operator Instructions] The next question is from Collyn Gilbert with KBW..

Hi, Collyn..

Hello.

Just a follow-up, while you’re on the track of the credit discussion, do you happen to have or can you tell us what the reserve is on those $70 million of outstandings tied to oil and gas?.

I can’t do that probably on the fly..

Okay..

But probably can get back to you on that and I’ll see you within a week here..

Okay. All right. That’s good. And then just on the credit discussion, I think it’s been, I think almost every quarter I think so far this year. There has been somewhat of a specific reserve added to the portfolio and I know that the narrative is this kind of one-off the certain situations here and there.

Is that how you feel as you look into 2016? Or I’m just kind of curious how kind of the trends that we’ve seen thus far this year maybe impact how you’re thinking about things next year?.

Yeah. Great question, Collyn. I think that when you look at the complexion of our portfolio on the commercial side, which is about 62%, 63% of the overall portfolio, it’s pretty equally split between commercial real estate and C&I. And on the commercial real estate side, these are good times.

And so, we don’t have, I think any non-performers right now in commercial real estate. And we've underwritten pretty tightly through the cycle. On the C&I side, we are seeing just a little of the settlement with oil and gas. And I think it’s just the nature of C&I. There might be more little cuts and bruises.

I think it’s really caused by commodities and commodity prices I think this year. I think until probably the first quarter of last year or so that we are were still a little bit of a spillover from the last lending cycle, that's pretty much all gone.

But I think it’s the nature of C&I in that portfolio that if we get into another commercial real estate cycle, I think I like having the C&I asset. It's a little harder work. You have to have a secured credit department to follow it. But I think it's probably a more consistent stream of credit costs..

Okay. Okay. That’s helpful. And then just on the mortgage banking line, the $1.2 million that you guys put up this quarter, was that all mortgage banking or was there a commercial loan sale in there, just trying to think about that line going forward..

Yeah. It’s about little over $800,000 of that was mortgage banking. There was a resolution of the prior credit, there was a gain on sale from OREO properties about 350 or so..

So if you look at that line year-to-date, I think Jim, now that it’s 1.8, 1.9 of that 2.2 and we’re portfolio and about 20%, and selling about 80%..

Okay.

And your expectation is that application volume and origination volume will still be a strong in the fourth quarter and kind of in the out quarter just given what some of the internal initiatives that you all are doing?.

Yeah. We’re probably at a rate right now of $35 million to $40 million a quarter and we feel that that will continue to grow and should accelerate a bit with the acquisition in Ohio and some talent we’ve got in there. And as we look to next year, we think the purchase refinance mix and the portfolio in sale mix will stay about the same..

Okay. Great. Thank you very much..

Thank you..

[Operator Instructions] The next question is a follow-up from Bob Ramsey with FBR..

Hey, thanks for taking the follow-up.

Just had a couple things, the increase in criticized loans this quarter, was that sort of some of this commodity driven softness if you will or was there anything else in the criticize increase?.

It was. There was probably four credits across the bank that had that kind of exposure that we saw some strain with..

Got it.

Remind me on fee income, the insurance line, I think is seasonally weaker in the fourth quarter, can you just remind me how much of an impact we should be sort of penciling in there?.

I guess, I wouldn’t characterize it as necessarily, it’s going to be seasonally weaker for us in the fourth quarter. We actually tried in that business line to take some of our insurance that we agency business that we do for ourselves and spread it out over the 12 month period or move some of that seasonality.

So with the acquisition we took the insurance agency last year, it’s up nicely year-on-year, but it’s probably going to be more of a steady progression on the current seasonality or thinking about going forward..

Okay. I know that’s helpful. And I guess looking out there is a lawless seasonality in ’14 and earlier, so maybe the business has evolved. On the tax line, what is a good tax rate to use only go forward basis. You guys have comment a little bit under sort of what I thought these past couple quarters.

I’m just curious if we should still be thinking 30% or whether it might be a little bit under that?.

Yeah, they are same that we think our effective tax rate right now is 29.35%. So if you’re modeling about 30%, you’re probably in the right ballpark..

Okay. That’s all I got. Thank you..

Hey, thanks, Bob..

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

Thank you for your time. I know this is a busy time of the season for you. And just appreciate your thoughtful questions. And look forward to being with a number of you over the course of the next quarter or two. Have a great day..

The conference is now concluded. Thank you for attending. You may now disconnect..