Premier Financial Corp.

Tera Murphy - Investor Relations Don Hileman - President and Chief Executive Officer Kevin Thompson - Executive Vice President and Chief Financial Officer

Nick Cucharale - Sandler O'Neill and Partners Damon DelMonte - KBW Christopher Marinac - FIG Partners Daniel Cardenas - Raymond James

Thank you. Good morning, everyone, and thank you for joining us for today’s 2018 first quarter earnings conference call.

This call is also being webcast, and the audio replay will be available at the First Defiance website at fdef.com. Providing commentary this morning will be Don Hileman, President and CEO of First Defiance; and Kevin Thompson, Executive Vice President and Chief Financial Officer.

Following their prepared comments on the Company’s strategy and performance, they will be available to take your questions. Before we begin, I’d like to remind you that during the conference call today, including during the question-and-answer period, you may hear forward-looking statements related to future financial results and business operations for First Defiance Financial Corp.

Actual results may differ materially from current management forecasts and projections as a result of factors over which the company has no control. Information on these risk factors and additional information on forward-looking statements are included in the news release and in the Company’s reports on file with the Securities and Exchange Commission.

And now, I’ll turn the call over to Mr. Hileman for his comments.

Thank you, Tera. Good morning.

And welcome to First Defiance Financial Corporation first quarter conference call. Joining me on the call this morning to give more detail on the financial performance for the quarter is our CFO, Kevin Thompson.

Last night, we issued our 2018 first quarter earnings release, and now would like to discuss release and give you a look into the remainder of 2018. After the conclusion of our remarks, we will answer any questions you might have.

We are very pleased with the continued movement toward achieving our strategic goals. Net income for the first quarter of 2018 on a GAAP basis was $11.7 million, or $1.15 per diluted common share, compared to $5.1 million or $0.54 per diluted common share in the first quarter of 2017.

As a reminder, merger related costs were $0.27 per diluted share in the first quarter of 2017. Our first quarter 2018 results reflect strong profitability with an ROA of 1.6% compared to 0.79% in the first quarter of 2017, again impacted by merger charges and 1.26% in the fourth quarter of 2017.

Net charge-offs turned to recovery in the first quarter of 2018 reflecting a net recovery of $1.7 million, compared to a net charge-off of $190,000 in the first quarter of 2017 and net recoveries of $28,000 in the fourth quarter of 2017. Our overall core performance this quarter remains strong and starts the year off on a positive note.

We experienced year-over-year and linked-quarter annualized core net loan growth of 5.4% and 1.6% respectively. We are acknowledging the less than targeted growth rate; the quarter was impacted by several significant payoffs.

However, we expect the growth rate to increase in the future as the first quarter loan growth trend seemed to be seasonally weaker. Our ability to grow our loan portfolio remains a key piece of our strategic plan.

The lending environment is very competitive with rate and structure pressures leading to terms and conditions in the uncertain economic environment. We did not see any significant movement in local market rates after the recent Fed hike.

Despite this environment, it is encouraging for us to see contributions from our entire footprint and end the first quarter with a pipeline up from year end. We believe that we can still achieve our annual goal of upper-single-digit loan growth.

Total deposits were up 5% year-over-year and 8.9% on linked quarter annualized basis. We are also very pleased with our margin improvement this quarter with the first quarter -- over the first quarter of 2017 and on a linked quarter basis.

Credit quality metrics showed overall improvement this quarter from the fourth quarter of 2017. Overall, we expect to see stable to improving asset quality trend across the board in the near term.

We will continue to focus on asset quality through reducing the non-performing and classified asset levels in the future leading to improvements in our non-performing asset ratios. In regards to our capital management plans, we are also pleased to announce 2018 second quarter dividend of $0.30 per share, representing a 20% increase in an annual dividend yield of approximately 2.09%.

I will now ask Kevin to provide additional financial details for the quarter before I conclude with an overview. Kevin?

Thank you, Don. Good morning, everybody.

As Don stated, net income for the first quarter was $11.7 million, or $1.15 per diluted share, significantly up from the prior year results of $5.1 million or $0.54 in the first quarter of 2017. The year-over-year comparison is a bit noisy, mostly due to the large loan loss recoveries in the first quarter this year and the completion of the Commercial Savings Bank or CSB acquisition and merger expenses in the first quarter last year.

But even when you clear away the noise, the progress in our performance is quite evident. First, I'm going to run through some of the details in our financials, and then I'm going to provide a summary at the end of my remarks.

Okay, starting with the balance sheet. After very strong growth in the fourth quarter of last year, first quarter 2018 growth was lower reflecting expected seasonality, but also a higher level of loan payoffs which constrained net growth on the loan side.

In total, loans had net growth of about $10 million in the first quarter after growing $73 million last quarter. Significantly, our new loan originations in the first quarter of $137 million were only $9 million less than last quarter, indicating our loan production remains strong.

While we do anticipate some significant additional payoffs here in the second quarter, we look for our net growth to pick up particularly over the second half of the year. As for deposits, we had an increase of about $54 million this past quarter after an increase of $77 million last quarter, so our momentum remains strong on the deposit side, supporting our opportunity for continued growth in our balance sheet.

Overall, we are very pleased with our balance sheet, our low-cost deposit growth, strong earnings asset mix, but perhaps a little extra room for more loan growth, all supporting our profitable margin, which leads me to the income statement. Our net interest income was $25.7 million for the first quarter of 2018, up from $25.4 million in the linked quarter and up $4 million or 18.7% from the $21.6 million in the first quarter last year.

The increase over the prior year first quarter is primarily driven by growth in average balances, which is enlarged a bit since the prior year quarter only included five weeks of the CSD balances acquired February 2017, but it also reflects margin expansion from a year ago as the loan portfolio yield has increased with the rate hikes over the past year. Deposit funding costs have been less impacted.

Our margin this quarter was 3.95%, up seven basis points from last quarter and up 14 basis points from 3.81% in the first quarter last year. On a linked quarter basis, our yield on earning assets was up 8 basis points as our loan portfolio yield rose to 4.65%.

Our cost of interest bearing liabilities was up three basis points on a linked quarter basis, mostly due to marginal rate impacts. Our earnings asset mix and funding mix remains strong; and with our balanced exposure to interest rate changes, we believe that our margin will continue to perform well considering our growth expectations coupled with the anticipated Fed actions.

Total noninterest income was $10.7 million in the first quarter of 2018, up from $9.9 million in the linked quarter, and up from $10.5 million in the first quarter of 2017. Recall that the first quarter 2017 included $1.5 million enhancement gain on a BOLI purchase.

In addition, the first quarter is generally when we receive our contingent insurance commissions, which were good this year totaling $1 million, however, down from a very strong $1.2 million a year ago. So excluding the non core and seasonal items from each year, noninterest income was up year-over-year about $1.9 million or 23.6%, mainly due to growth in all of our businesses further bolstered by our 2017 acquisitions.

Regarding mortgage banking, revenues for the first quarter of 2018 were $1.7 million, up $4,000 from both the linked quarter and first quarter 2017. The first quarter mortgage banking origination were $50.7 million, seasonally down compared to $63.8 million last quarter, but up from $48.9 million in the first quarter 2017.

Gain on sale income was $1.1 million in the first quarter of 2018 and essentially flat compared to the linked quarter in first quarter last year. In addition, the first quarter included a positive valuation adjustment to mortgage servicing rights of $37,000 compared to positive adjustments of $69,000 last quarter, and $33,000 in the first quarter 2017.

At March 31st, 2018, First Defiance had $1.4 billion of loan service for others, the mortgage servicing rights associated with those loans had a fair value of $9.8 million, or 76 basis points of the outstanding loan balance and service, and total impairment reserves which are available for recapture in future periods still totaled $396,000 at quarter end. As for noninterest expense, first quarter expenses totaled $23.3 million, up from both $21.1 million in the linked quarter and $23.1 million for the first quarter of 2017.

The first quarter 2018 included $544,000 in other expenses for OREO write-downs, while the first quarter 2017 included expenses attributable to the merger and conversion of CSB which totaled $3.6 million, primarily in compensation and benefits expense and other expenses. Excluding these non-recurring items, noninterest expenses would be up $3.2 million or 16.2% mostly due to the operating expenses for the now completed 2017 acquisitions.

In addition, the first quarter 2018 reflected costs for non-executive employee bonuses of approximately $300,000. We indicated last quarter that we would be reinvesting some of the expected benefits of tax reform.

This represents our initial expenditure and we expect to be making additional investments going forward that should impact expenses at about the same level as this quarter. Regarding asset quality, obviously, the resolution through payoff of one of the large loans that we downgraded last year had significant and visible impact on our asset quality numbers of this quarter.

The payoff both reduced non-performing loans and generated a significant recovery. All in, loan loss recoveries for the first quarter total $2 million and after charge-offs of $316,000, net loan recoveries for the quarter were $1.7 million.

This contributed to a credit provision on the income statement of $1.1 million in the first quarter 2018. Last year's first quarter reflected $190,000 of net loan charge-offs and a provision expense of $55,000.

With the recoveries this quarter offsetting the large loan loss taken in the second quarter last year, our net charge-offs to loan ratio for the last 12 months is now less than two basis points. Our allowance for loan loss at March 31st, 2018 was $27.3 million, up $25.7 million March 31st last year, with the change primarily driven by the growth and loans, as the allowance to total loans ratio at March 31st, 2018 was 1.16 %, compared to 1.14% last quarter and 1.15% a year ago.

In addition, the remaining CSB acquired loans are currently carried at a discount of $3.7 million or 1.9% of balances. As for the non-performing balances, non-performing loans declined this quarter to $27.9 million from $30.7 million last quarter end, but were still up from $15.1 million at March 31st, 2017.

The year-to-year change is still primarily due to one of the two large credits downgraded in the second quarter last year, which we are pleased to say continues to show the performance improvement that we expected. Our OREO balance also decreased slightly this quarter to $1.4 million from $1.5 million last quarter, but was up from $705,000 in the first quarter last year.

And as noted earlier, we did take some OREO write-downs of $544,000 in the first quarter. Overall, non-performing assets ended the quarter at $29.4 million or 0.97% of total assets, still up from $15.8 million or 0.54% of total assets at March 31st, 2017, but back down below 1% which is where we want to be.

Our accruing troubled debt restructured loans this quarter were $13.7 million, down slightly from $13.8 million last quarter versus $9.8 million a year ago. With the change in the non-performing assets at quarter end, the allowance coverage of non-performing assets was 93% compared to 83% at December 31st, 2017, and a 163% a year ago.

Needless to say, we're pleased with what transpired in the quarter and remained confident in our overall portfolio strength and asset quality as we continue to pursue our growth strategies. A few comments on income tax expense.

Comparing year-to-year, the first quarter 2018 reflects the benefits of the new lower corporate tax rate of 21%, compared to the higher rate in the first quarter last year. In addition to the higher tax rate last year, taxes also included a $1.7 million expense in connection with the surrender of a BOLI policy.

Again, this expense nearly offsets the $1.5 million enhancement gained on the new BOLI purchase. Our expected effective tax rate going forward is still about 18.5%.

Looking at our capital position. Total period end stockholders equity finished the quarter at $379.2 million, up from $354.2 million at March 31st, 2017.

Our capital position remains strong with quarter end shareholders equity to assets of 12.56%, up from 11.99% last year. The bank's total risk-based capital ratio is approximately 12.7% at quarter end March 31st, 2018.

Our healthy capital position continues to support our strategies for growth and shareholder value enhancement. Now I'd like to provide an overview and recap of our EPS from our perspective.

The $1.15 per share earned in the current year quarter includes a credit provision of $1.1 million, which resulted from recoveries in the quarter of $2 million. If not for the recoveries, we would have had a provision of an expense of about $900,000.

So the benefit from the recoveries to earnings was about $0.15 per diluted share at the new marginal tax rate of 21%. In addition, we had some OREO write-downs totaling $544,000 which had an after-tax per share cost of about $0.04 per diluted share.

So adjusting for these two items, our first quarter results would be about a $1.04 per diluted share. Looking at last year's first quarter, these results included $0.27 per diluted share impact of merger and conversion expenses, and $0.02 per diluted share reduction resulting from the repositioning on our bank owned life insurance portfolio.

Now adjusting for those items in the first quarter last year, our EPS would be $0.83 per diluted share. So comparing the $1.04 this year to the $0.83 last year, the difference actually rounds down to $0.20 per diluted share or 24.5 % increase.

If you break these results down further, you'd find that the adjusted pre-tax pre provision EPS would be up about $0.165 or 14%. The adjusted provision actually reduces earnings about $0.08 and the change in taxes increased earnings about $0.12.

Again, all totaling a $0.20 about 25% increase. So in summary, we're off to a very good start to 2018.

Our balance sheet is solid. Our margin is performing well.

Our operating profitability is strong. Our asset quality is improving and our outlook for the year remains very positive.

That completes my financial review. I'll now turn the call back over to Don.

Thank you, Kevin. I am very pleased with the results as core and the core earnings improvement.

We continue to focus on several key areas that we believe are very important. As noted, we want to include core balance sheet growth with the focus on loan growth and deposit growth.

Overall revenue growth, expense control and improved asset quality. We will continue to look to make progress in these areas throughout 2018.

We have restructured key leadership positions to allow for more direct responsibility for growth in the metro market areas of the company, which include Fort Wayne, Indiana, Toledo and Columbus, Ohio. All of our metro markets did see loan growth for the first quarter, and we anticipate a rise in loan demand over the course of the year.

Overall, loan growth was contained by contraction in our legacy markets this quarter. While lending environment remains very competitive, we feel we can accomplish loan growth without making significant concessions in rate and other terms through a strong process of relationship building and quality client focused service.

We are pleased that we have maintained a positive trend in the margin as well as the growth loan yield. We understand it will be challenging to drive growth in loans and maintain the old management and understand some trade-offs will probably be necessary as we move through the year and we are heavily focused on relationship management pricing.

Our delivery and service model is effective in helping achieve this balance. Improving asset quality was more challenging than expected, but we feel comfortable with where we ended the quarter with NPAs at 0.97% of assets.

We continue to strive to lower this ratio throughout 2018. We are concentrating on deposit growth initiatives to overcome challenges in attracting core deposits at the correlated pace with loan growth.

As I mentioned last quarter, we expanded our physical branch presence in Sylvania, Ohio, as part of the Toledo Metro market, and we plan to open our downtown Fort Wayne, Indiana office around the 1st of May. Throughout 2018, we will continue to look to enhance customer experience through enhancements of our digital channels.

Our customers' expectations especially pertaining to these digital delivery methods continue to rise and we believe it is important to strengthen our technology capabilities to exceed their expectations while providing a live interactive experience for clients in our offices. We are encouraged by the recent performance and look to constantly drive our performance to initiatives that will help us obtain the goal of being a consistently high performing community bank.

We feel that the performance of the organization reflects our focus on shareholder value, and at the same time our commitment to be a strong community partner in the areas that we serve. We remain dedicated to all of our customers and shareholders and we appreciate the trust you have placed in us as we build a stronger First Defiance.

Thank you for your interest in First Defiance Financial Corp. And we thank you for joining us this morning.

We will now be glad to take your questions.

Good morning, gentlemen. How are you doing?

So first, some nice margin expansion this quarter and I heard you expect the margin to continue to perform well, but I was hoping you could expand on your outlook for the NIM and if you are seeing any funding pressure on the horizon.

We've been very fortunate and experienced limited pressure on the deposit side. I mean that's really where a lot of the benefits of the margin is coming from, is the limited change in our funding costs compared to what we're able to achieve on the asset side.

As rates continue to rise when we continue and our outlook always to be very cautious on that end and expect that the pressure has got to increase, and the question is how much. And that's a little tougher to tell, but I think given where we're at, we still expect our margin to be very strong as we go through the remainder of the year, and it'd be significant, still very significant contribution to our profitability overall.

Okay, great. And then I just wanted to clarify your commentary on the expenses.

So last quarter, we talked about some of the plans to reinvest some of the savings from tax reform back into the business, and with some of that coming through this quarter with the bonuses, is it fair to say you expect to reinvest another 700K back into the business and for that to be ratably? Is that -- am I thinking about things correctly?

Yes. Maybe a little more, again, it was roughly $300,000 a quarter over the remainder of the year.

I mean that's--

Right. I think we said a $1 million but it's between a $1 million or $1.2 million that over the course of the year we expect to reinvest.

Okay, thanks. And then lastly, I just wanted to get some more detail on the trust line.

I know you changed the accounting method in the fourth quarter, which makes the year-over-year comparables a little bit difficult, but is your expectation for trust income to remain around current levels at a good go-forward rate?

Well, we like to think it will continue to grow, but it's not going backwards if that's what you mean.

Yes, no, I think that would be a good consistent approach to it that it should be equal to or better than what we are in this quarter.

Hey, good morning, guys. How's it going today?

So my first question just dealing with the margin. Kevin, could you just drill a little bit deeper on that reported 3.95% and kind of outline what the core margin was x accretable yield?

The contribution from the acquisition, in terms of marks on our margin this past quarter was pretty nominal. I want to think, if I remember the right number, it's like $60,000, so our core margin it's pretty much there.

We did have some interest recoveries but even they -- let me think about $160,000, so that helped some but nothing, no significant benefits to the margin other than our core balance sheet.

So the quarter-over-quarter increase then was truly driven by an expansion on the loan yield sides.

Correct.

And I am assuming that's driven by the Fed hike we got in March or is that also just better pricing you're seeing on different loan categories?

It's a cumulative thing, Okay, as rates have gone up and loans are renewing and repricing and new business, I mean I think there's a cumulative build-up that we are experiencing in our portfolio, and that's been a net pick up needless to say. And so that's been a positive by the deposit side, like I said we've been able to contain our pricing changes effectively so that the benefits from the loan pricing continue to expand our margin.

Got you, okay. And then what are you expecting for additional rate hikes this – for the remainder of the year?

One or two more increases.

I think we've got two more expected, but again one later in the year which probably would have less effect on the current, no, but the current year's results.

Got you, okay, that's helpful, thank you. And then I think you guys alluded to seeing additional expected payoffs in the second quarter and then loan growth kind of ramping up and over the back half of 2018.

Are you -- so looking at something like a low-single-digit growth rate for the second quarter and then kind of double-digit growth in the back half of the year that kind of nets you out to that to the upper single digit level?

I think that's a fair representation. We're going to see it, we expect pickup but more marginally in the second quarter than we expect in the second half of the year.

Right. And we give you a little color in the payoffs.

So we got a couple large that have sold their businesses. So it's not -- and actually they're still competitors, so it's more of a business decision and those are just a couple substantial balances that we know of.

Right. It's a business environment.

It's been pretty active in other markets which is a good thing overall.

Okay, all right. And then I guess just lastly could you just give a little bit of an update on your expansion efforts in the Columbus, Ohio marketplace?

Yes. That -- we still continue to grow in there primarily driven by -- leading with loans.

We do have a full-service office, but it's a little slower to grow the deposits in there, but there still is a focus. But so I would see consistent growth in Columbus and stronger loan growth.

And as I said, the metro markets are where we did have the growth this quarter. We were contracting in our legacy market, and so their support allowed for overall loan growth for the company in the first quarter.

Got you, okay. And then do you have an update as to what the outstandings are in the Columbus market?

I believe it's like a $190 million right now. It was the leading -- I know it was the highest growth market for us this past quarter, which I believe was up $24 million right.

Thanks, good morning, guys. I just want to follow up on the loan growth in the non legacy or I should say newer markets.

Would that be a primarily coming on the commercial real estate side or would you have a blend of C&I and other related loans within the portfolio?

It would be primarily [weightress] on the CRE portfolio going forward here right now. That's a migration we're focused on to try to have a little bit more blend going forward.

But most of that growth in the first quarter was in CRE.

Okay and then what's the outlook for potential recoveries of past charge-offs? Don is that something that they could be out there or with this chunk here to close the end of them?

I think there should be some little at a lower level. There's still some opportunity there.

Clearly, this was the biggest one.

Nothing like --

Nothing close to this magnitude.

Yes, okay.

Okay and that was all related basically to one, the large credit that we --

Wrote down last year.

Wrote down in second quarter of last year. So it kind of just came back through.

Got you, got you. And then if you looked out a couple quarters would you envision the loan to deposit ratio changing much?

I know it came down this quarter with the deposit growth but just curious if that would bump up to elevated levels or do you want to manage it here in this sort of low to mid 90s?

Our expectation has been that it probably will float it up a little bit. Not hitting a 100% necessarily but probably more in the upper 90s over time.

And so that's our expectation, but we've, again been very fortunate with our deposit growth. And if our deposit growth continues very strong and keeps that ratio down a little bit.

I think I'd be okay with that. Operator, I think we have another question.

Just a couple quick questions there for you guys. In terms of charge-offs, I mean you guys as you stated in your comments, Kevin, extremely low.

How are you guys thinking about charge-offs levels on a go-forward basis? Do we start to see them return to maybe a more normal level or is it possible that we kind of still keep them in sub 10 basis points on a go-forward basis at least to the remainder of 2018?

Yes. We're still thinking sub 10 basis points.

Our planning generally around five basis points based on this near term horizon still.

Right, great. And then maybe just in terms of deposit growth outlook.

I mean do you think it can be consistent with the loan growth objectives that you stated at kind of the higher single-digit loan growth or could you actually even perform better than that?

Yes. I'm not sure I would expect as we talked about if the loan growth ramps up to a double-digit level, I'm not sure I would expect the deposit growth to quite get to that level.

I think if we can sustain the pace we're on, I think we'll feel pretty good about our results for the year. That's kind of where I think our thinking is.

Yes, all right, good. And then maybe just a quick update on M&A.

What you guys are seeing? Is it a quiet environment right now?

Are there a lot of discussions? And what do you feel your prospects for announcing a deal within the next 12 months look like?

Yes. It was a little quieter here over the last three months I think in activities.

Our expectations that it will be a little bit more noisy, if you will. We still feel good about our prospects.

We think we're well positioned as our value and our stock is at these levels. I think we become more attractive as an acquirer.

So we're still pretty optimistic about our opportunity to do something in the near term, Dan.

Is the appetite kind of more for the metro markets or is that still up for debate?

That's still up for debate. I think clearly we'd like to look at all opportunities where it might fit best with us and our franchise and how we operate in around our potential.

We will be definitely looking at probably the same thing everybody's going to be looking at. The loan to deposit mix, the funding sources that we have available in an acquisition, what we look like at a combined basis and the loan growth opportunities and capabilities.

So those both those things would be important as I'm sure they're important to everybody.

Thank you for joining us today as we discussed our quarterly results. We appreciate your time and interest in First Defiance Financial Corp.

Have a great day.