First Merchants Corporation (FRME) Earnings Call Transcript

Thank you for standing by, and welcome to the First Merchants Corporation Second Quarter 2026 Earnings Conference Call. Before we begin, management would like to remind you that today's call contains forward-looking statements with respect to the future performance and financial condition of First Merchants Corporation that involves risks and uncertainties. Further information is contained within the press release, which we encourage you to review. Additionally, management would refer to non-GAAP measures, which are intended to supplement, but not substitute for the most directly comparable GAAP measures. The press release available on the website contains financial and other quantitative information to be discussed today as well as a reconciliation of GAAP and non-GAAP measures. As a reminder, today's call is being recorded. I would now like to turn the conference over to Mr. Mark Hardwick, CEO, Mr. Hardwick. You may begin.

Good morning, and welcome to the First Merchants Second Quarter 2026 Conference Call. Thanks for the introduction and for covering the forward-looking statement on Page 2. We released our earnings yesterday after markets closed and today's presentation materials are available via the link on Page 3 of the earnings release. Turning to Slide 3. You will see today's presenters and members of our executive management team. Joining me on the call are Mike Stewart, our President; John Martin, Chief Credit Officer; and Michele Kawiecki, our Chief Financial Officer. Slide 4 highlights our footprint and financial scale. We now operate 126 banking centers, reflecting the addition of Southern Indiana following the first savings acquisition. Total assets stand at $21.3 billion, with $15.5 billion in loans and $16.8 billion in deposits. Turning to Slide 5. Second quarter reported net income totaled $43.5 million or $0.70 per diluted share. Second quarter results were negatively impacted by two loans that were moved to nonaccrual status with specific reserves taken against them. We are disappointed by these two downgrades, and we are confident they are not representative of the overall portfolio. We remain confident in our outlook, as John will highlight later in the presentation, and we're happy to answer any questions that you might have during the Q&A session. Adjusted pretax pre-provision earnings increased to $84.6 million for the quarter, an increase of 7.5% over the first quarter of 2026. Net interest margin expanded to 3.38% and loan and deposit growth returned to more traditional levels. Year-to-date net income on Slide 6 totaled $71.2 million, excluding the mortgage loan sale from the first quarter, and acquisition-related expenses from both the first and second quarter, adjusted EPS totaled $1.77 per share. The previously announced mortgage loan sale is now complete, adding $271 million of liquidity to our balance sheet. Our integration and related expense savings are now complete and post well for next quarter. Our balance sheet continues to grow organically, reflecting strong production levels. Tangible common equity remains strong at 8.99%, and we continue -- as we continue our share repurchase activity throughout the first half of this year. All of these factors position us well for improved performance during the second half of 2026. And now Mike Stewart will discuss our line of business momentum.

Thank you, Mark, and good morning to all. Our business strategy is summarized on Slide 7. As stated on the top of the slide, building our midwestern strength by growing organically remains our primary objective as a company. Our 4 primary business units work together in delivering financial solutions for businesses and consumers focused primarily on the maps you see starting on Slide 8. Let's turn to Slide 8. After a flat first quarter of loan growth, the second quarter picked up the pace with nearly 6% annualized growth, both in the commercial and consumer business segments. The increase came within our 3-state footprint and was driven by the community, corporate asset-based and investment real estate teams working with our current client base and adding new names. Our Midwest economies continue to expand, our clients' businesses continue to grow and our bankers continue to win new relationships. The same is true for the consumer teams within small business, mortgage and private wealth. The full loan portfolio trend is summarized on Page 27 for your reference. We remain confident in our expected mid-single-digit loan growth through the end of 2026. Let's turn to Slide 9, deposits. Second quarter deposits grew at a 6.5% annualized rate. The robust commercial growth was primarily attributed to public fund increases due to seasonal tax collection and a large temporary deposit increase from a client's sale of their business. This client is working with our private banking team on investment management and trust service solutions for their family. The large consumer decline was also seasonal and primarily due to consumer tax refund payments being spent. The seasonality of tax payments between public entities and our consumer deposit accounts, depository accounts will normalize through the balance of the year. The 3% year-to-date decline in total deposits was due to declines in maturity deposit balances and the balance sheet repositioning of the first savings brokered deposits in the first quarter. On a year-to-date basis, consumer nonmaturity deposits balances grew 3% with net increases in households. Michele will be reviewing our continued net interest margin improvement, which was a direct result of the disciplined deposit and loan pricing. Michele?

Thanks, Mike, and good morning, everyone. Slide 10 covers our second quarter's performance. There was meaningful growth in total revenues during Q2. Net interest income grew $7.6 million and noninterest income grew $1.6 million linked quarter after normalizing for the $29.8 million loss recorded on mortgage loans sold in the first quarter. Strong revenue growth, along with disciplined expense management, resulted in a overall pretax pre-provision earnings of $84.6 million, increasing $5.9 million over prior quarter and generating 2% positive operating leverage. Tangible book value per share of $29.80 increased $0.46 or 1.6% linked quarter. Slide 11 shows our year-to-date results. Lines 1 through 3 at the top of the page show that we continue to grow the balance sheet towards a more favorable earning asset mix as we've reduced our lower-yielding bond portfolio, along with lower-yielding mortgage loans during the first 6 months of the year and redeployed the capital into higher-yielding loans. Looking at the income statement. In the middle of the page, total revenue grew 18% when comparing year-to-date 2026 on a normalized basis to the same period in 2025 and with first savings contributing 12% of that growth. Pretax pre-provision earnings totaled $163.3 million reflecting growth of $25.2 million or 18.2% over the same period in the prior year. Year-over-year, tangible book value growth was strong, increasing $90 or 6.8%. Slide 12 shows details on our investment portfolio. The bond portfolio declined modestly as principal paydowns and maturities were offset by positive changes in portfolio valuation. Expected cash flows from scheduled principal and interest payments throughout the remainder of 2026 totaled $156.2 million with a roll-off yield of approximately 2.69%. We plan to continue to use cash flows generated from the bond portfolio to fund higher yielding loan growth for the remainder of the year. Slide 13 covers our held for investment loan portfolio. The total loan portfolio yield increased by 2 basis points from the prior quarter to 6.11%. During the quarter, new and renewed loans originated at an average yield of 6.28% compared to 6.18% in the prior quarter, demonstrating strong pricing discipline by our team. The allowance for credit losses is shown on Slide 14. This quarter, we recorded $33 million of provision due to specific reserves of $29.7 million that were established on two commercial credits, which John Martin will cover in more detail in his remarks. Net charge-offs totaled $3.9 million for the quarter. As a result, the allowance for credit losses totaled $241.6 million at the end of the quarter representing a coverage ratio of 1.56%. Slide 15 shows details of our deposit portfolio. The rate paid on deposits continued to decline to 2.07% this quarter, and our funding mix improved favorably. We used the proceeds of $271 million from the mortgage loan sale that closed in late June to reduce higher cost broker deposits and wholesale funding. Next, Slide 16 shows a favorable net interest margin trend. Net interest income on a fully tax equivalent basis of $165.3 million increased $7.6 million linked quarter and $26.1 million from the same period in prior year. While we have an asset-sensitive balance sheet and endured Fed rate cuts in the fourth quarter of 2025, and the yield on earning assets shown on line 4 only declined modestly, while the cost of funds shown on Line 5 has been reduced substantially. The pricing discipline on both sides of our balance sheet has created a nice margin expansion through the first half of this year. Next, Slide 17 shows the details of noninterest income which totaled $37.2 million for the quarter. Customer-related fees shown on the bottom right of the page, were strong with notable quarter-over-quarter growth in gains on sales of loans and derivative hedge fees. Moving to Slide 18. Noninterest expense for the quarter totaled $115.3 million and included $3.8 million in acquisition-related costs. The acquisition costs were primarily incurred in the professional and other outside services and equipment expense categories. The cost synergies we expect to gain from the first savings acquisition are on track. Slide 19 shows our capital ratios. The tangible common equity ratio was 8.99% and stable compared to prior quarter. Since the beginning of the year, we have repurchased just under 1 million shares for $38.3 million year-to-date. We remain well capitalized and are positioned to support continued balance sheet growth and disciplined capital returns. That concludes my remarks, and I will now turn it over to our Chief Credit Officer, John Martin, to discuss asset quality.

Thanks, Michele, and good morning. My remarks begin on Slide 20. Overall, the portfolio continues to perform within expectations and remains well diversified across commercial and consumer lending categories. Total loans ended the quarter at $15.5 billion. Commercial real estate concentration levels remain comfortably within regulatory guidelines and our credit portfolios continue to largely perform in line with expectations. Moving to Slide 21. Second quarter asset quality was impacted by two notable credits. The larger of the 2 relationships was a $28.1 million participation in a syndicated credit to an authorized wireless retailer. Subsequent to quarter end, we received new company-specific information that led us to place the loan on nonaccrual. While negotiations with the borrower remain active, the outcome has not yet been finalized. However, we expect to have substantially greater visibility into the likely resolution by the end of the fourth quarter. The second credit was a sponsor finance $13.7 million loan to a commercial and residential roofing contractor that had been moved to the watch list for 3 quarters. It was placed on nonaccrual in July after the sponsor informed us that they no longer intended to support the company. While meaningful in size, this credit is more representative of the type of periodic C&I migration we see from time to time within the commercial loan portfolio. As a result, nonaccrual loans increased to $118.2 million and nonperforming assets plus 90 days past due increased to $129.5 million or 0.83% of loans. Classified loans increased to $393.3 million from $357.1 million last quarter. While these metrics moved higher, the increase was driven primarily by a limited number of borrower relationships, most notably the authorized retailer and roofing contractor credits, rather than a broad-based deterioration across the portfolio. Looking ahead, we expect a meaningful portion of the loss content associated with these two nonaccrual relationships to be realized through charge-offs during the third and fourth quarters. As a result, while current quarter charge-offs remained a modest 10 basis points annualized, we currently anticipate full year 2026 net charge-off will trend into the 40 to 45 basis point range. Importantly, that expectation is largely driven by the resolution of these known credits and should not be interpreted as a change in our view of the broader portfolio, which continues to perform within expectations. Turning to Slide 22. Nonperforming asset migration increased during the quarter with new nonaccruals totaling $53.6 million. The two relationships described on the prior slide represented the primary drivers of those additions. Offsetting activity included $17.7 million of upgrades and payoffs along with $6.2 million of charge-offs and other resolution activity. These actions reflect continued active management of problem assets across the portfolio. In summary, the quarter was impacted by one significant relationship specific credit event and another larger more routine migration. We identified the issues reserved appropriately and continue to actively work the relationships. Outside of these credits, portfolio performance remains stable charge-offs remain low, and we continue to believe the overall risk profile remains sound. We remain focused on proactive portfolio management, early identification of emerging risks and maintaining the strong discipline that has consistently differentiated our organization. Thanks for your attention. I'll now turn the call back over to Mark Hardwick.

Thanks, John. Turning to Slide 21. I our long-term track record of shareholder value creation remains a key strength and a key priority for this management team. Slide 22 highlights our 11.5% total asset combined annual growth rate over the past decade, reflecting a consistent strategy of organic growth complemented by disciplined value-accretive acquisitions that expand our demographic and geographic footprint. We look forward to building on our Midwestern strength throughout the rest of 2026 by focusing on our people, clients, products and technology investments or simply running the core bank. Seeing this strengths translate into earnings per share and sustainable earnings growth and shareholder value remain our top priority. Thank you for your continued support and investment in First Merchants. And now we're happy to answer any questions that you may have.

[Operator Instructions]. Our first question will come from the line of Daniel Tamayo of Raymond James.

Thank you. Good morning, everyone. Maybe just starting kind of -- I appreciate all the color on the two credits that drove the issues on the credit quality side this quarter. But seeing as one of them was from the Shared National Credit book. Maybe for you, Mark, just curious kind of how you're thinking about that business line overall or that portfolio in terms of go forward from a go-forward basis? Are you still comfortable with it? Are you still growing that business? And then if you have any maybe details on reserves of the rest of the book in terms of of how that looks relative to the overall portfolio, that would be helpful.

Yes. Danny, I'll start and then if John or Mike won't add anything they can. We still like the business and like the balances that we have on our financials. And it's really because we focused on customers that are in our backyard. That happened to be large enough to participate in the SNC market. This particular customer is one where -- we've had a relationship with them. They're in the Michigan market, kind of in our backyard are involved in a couple of other local businesses that are unrelated. And those are the types of credits where we tend to have great relationships with management and continuous dialogue. And so -- and I think that's reflective of the entire SNC portfolio. We're not just buying credits to expand the balance sheet from -- outside of our core markets. and really not even outside of our current markets where we don't have a relationship focused on those customers that we're close to. The rest of the portfolio, I don't know that I have specific thoughts on it. It's not an area where we've experienced challenges in the past. And I'd open it to these two guys if they had anything else to add?

Yes, I would echo Mark's comments. This relationship expanded in ancillary businesses beyond the current exposure that was isolated to this particular borrower. We've got other loans, deposits, and that is how we approach the Shared National Credit portfolio, borrowers who, in aggregate, have more than $100 million in borrowings and have more than two banks make up that category. You can look at the total outstanding and the average balance, and it's relatively granular. So we try to approach it in a granular approach where we do use that as a lever to expand a relationship, and that really is our strategy.

Mike Stewart here. One last comment. All what Mark said, John said. That being said, we're doing a complete portfolio review of our shared national credit. We have to. We need to understand better asset coverage versus cash flow lending. So there'll be analysis on that, but I want to reinforce what Mark said. We have access to management there companies in our backyard. We feel like we have an understanding of how we can work with them beyond just a purchase of a loan. Clearly disappointing. But we'll do a portfolio review and make sure that we feel absolutely comfortable with our approach.

Thanks for all that color from all of you. Appreciate that. I guess, next for Michele. Just if you can give us -- I know you mentioned that cost savings are on track for savings, but any kind of outlook that you might be able to provide on the expense numbers and maybe still how you're thinking about where that might land post integration efforts.

Yes. So our quarterly run rate, I think the guidance that I gave last quarter was that we thought through the remainder of the year, our total expense run rate would be between $111 million and $114 million per quarter, and I still think that's good guidance. If you strip away some of the noise that we had this quarter, we kind of landed at that 111 spot. And so clearly with some hiring that we're doing and so forth. There will be a little bit more -- a little bit higher expense balance, but I think that range is still good.

And our next question will be coming from the line of Russell Gunther of Stephens.

First, please, just a quick follow-up on the expense commentary. Helpful to get the reiteration for the rest of this year. As we think about the go forward, what's the safe kind of normalized growth rate to assume based on franchise investment you're considering hiring initiatives, et cetera.

Well, this year, just on kind of a normal organic growth, it was between 3% to 5%. And that just reflects us investing in the business, investing in talent, we've talked, I think, historically about some places like our asset-based lending team and other commercial hires that we've had. And I think that range on a go-forward basis will still hold true. Just because we will continue to do some hiring, invest in technology, et cetera.

Okay. Excellent, Michele. Thank you for taking that one. And then switching gears to the margin. It would be helpful to get a sense for how you're thinking about the back half of this year, whether or not you guys are contemplating any Fed hikes in your outlook. And maybe just starting on the loan side, where you expect yields to be able to trend begin there, please?

I'll start with margin. So we're assuming no Fed rate changes through the remainder of the year. And if that's the case, we would expect margin to increase maybe a couple of basis points in the back half of the year. we are seeing some spectacularly high CD specials from competitors in our markets. So pricing deposits is always a variable in terms of being able to maintain our deposit costs and so forth. But we've got some tailwinds. We've got some fixed rate assets, both on the loan and the bond side that will be repricing. And so we feel pretty good about being able to achieve stability to up a couple of basis points. And so Mike, I don't know if you want to talk a little bit about loan yields. I mean loan yields. When you look at our new and renewed loan yield, that's still above our overall portfolio yield. And so that's also helping to drive our net interest in.

I think you gave a big sum in all that. I think that, that will be consistent on a go-forward basis.

Okay. Thanks for tackling both sides of that margin question for me, I'll step back.

It really was pleased, though, to see the new and renewed you said last quarter it was $618 and up to $628 this quarter. And it does create momentum over the portfolio yield at $611.

And our next question will be coming from the line of Damon DelMonte of KBW.

I hope you're all doing well today. Just wanted to start off with fee income and maybe the outlook there, Michele. I think mortgage banking or gain on loan sales had a solid quarter. Just curious how the pipeline is shaping up here in the third quarter and kind of maybe what you could expect moving off of this quarter's $37.2 million level?

Yes. I mean I think for the full year, we would expect noninterest income to be up 10% over prior year. There's always a little bit of seasonality in the mortgage business, but we did have a really nice solid quarter with gains on sales and mortgages this quarter, I would expect the same next quarter as well.

Okay. Great. And then I guess, with regards to capital management, maybe a question for Mark, and kind of your thoughts on continuing with the buyback. Good to see you're active again here in the second quarter and capital levels remain healthy. Didn't know if the two credits weighed on your balancing act of how you allocate capital or not and if we could expect more buybacks going forward?

Yes. We expect to continue buyback activity through the remainder of the year, assuming our stock price stays in this similar range. And the $100 million approval that we received recently, those approval from the Fed and our Board was announced. And we just continue to generate capital. I mean we have -- we need call it, 30% or 40% of it to support loan growth, use about 1/3 for dividends, and the rest is available for other purposes. And at least at this point, we think share repurchase is still a really good use of that capital.

And our next question will be coming from the line of Brandon Nosal of Hovde Group.

Maybe to circle back to credit and the syndicated loan. Can you just fill us in on where that credit was risk rated last quarter like what's changed in their operations that drove the downgrade? And then if there are any other read-throughs from that situation to other commercial credits or other syndicated credits you have?

Okay. I'm sorry, I didn't catch your name.