Mercantile Bank Corporation

Good morning, and welcome to the Mercantile Bank Corporation second quarter 2025 earnings conference call. All participants will be in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star, then one on a touch-tone phone. To withdraw your question, please press star, then two. Please note that this event is being recorded. I would now like to turn the conference over to Nicole Clatter, Chief Marketing Officer of Mercantile Bank. Please go ahead.

Hello, and thank you for joining us. Today, we will cover the company's financial results for the second quarter of 2025. The team members joining me this morning include Ray Reitzma, President and Chief Executive Officer, as well as Chuck Christmas, Executive Vice President and Chief Financial Officer. Our agenda will begin with prepared remarks by both Ray and Chuck, and will include references to our presentations covering this quarter's results. You can access a copy of the presentations as well as the press releases sent earlier today by visiting merckbank.com. After our prepared remarks, we will then open a call to your 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 filings. The company assumes no obligation to update any forward-looking statements made during the call. Let's begin. Ray?

Thank you, Nicole. My comments will focus on the factors driving our robust second quarter 2025 operating results and the key elements of our strategic partnership with Eastern Michigan Bank, which was announced this morning. Commercial loan growth for the first six months of 2025 was $114 million, or an annualized rate of 6.2%. This growth occurred despite customer reductions in loan balances, primarily from asset sales. which aggregated $154 million for the period, with $99 million attributable to the second quarter. We expect continuation of this trend with somewhat elevated CRE payoffs in the third quarter. Lending commitments are down slightly from the first quarter of 2025, but remain at a solid level of $437 million, and discussions in progress remain at historically high levels. Given the uncertainty inherent in the current economic environment, the pace at which these may turn into accepted commitments is also uncertain. Taken together, we expect loan growth of 1% to 2% in the third quarter and 3% to 5% in the fourth quarter. In the mortgage portfolio, we continue to successfully execute initiatives that reduce the volume of loans that reside on our balance sheet in favor of selling production in the secondary markets. Our mortgage team continues to build market share despite challenges from relatively high interest rates. Positive outcomes include a 23.4% increase in mortgage banking income for the first six months of 2025 compared to the first six months of 2024, and a decrease over the last year of $50 million in residential mortgages on the balance sheet. Asset quality remains strong as non-performing assets totaled $9.7 million at June 30, 2025, or 16 basis points of total assets. Past due loans represented six basis points of total loans at the end of the second quarter. Our lending teams are the first line of observation and defense to recognize areas of emerging risk. Our risk rating model is robust with continuing emphasis on current borrower cash flow, providing prompt sensitivity to any emerging challenges within a borrower's financial situation. That said, our customers continue to report strong results to date, despite the uncertainty and rapid change that has been present in the operating environment. Non-interest income grew significantly in several key areas during the first six months of 2025, compared to the respective 2024 period. As mentioned earlier, mortgage banking income grew 23.4%, as our team grew market share in a difficult interest rate environment. Service charges on accounts grew 18.1%, reflecting growth in our deposit base and increased activity levels. Payroll services grew at 15.2%, as our high-service model continues to build momentum in the marketplace. Credit and debit card income grew 3.7%. Interest rate swap income recovered significantly in the second quarter compared to the first quarter as borrowers' rate expectations aligned with use of the product. The deposit base of our company has been and will continue to be an area of significant focus. Our efforts to date have resulted in a 13% increase in local deposits at June 30, 2025, compared with June 30, 2024, which helped reduce our loan-to-deposit ratio from 107% to just under 100% over the same period. The strategic partnership with Eastern Michigan Bank provides a powerful supplement to our organic growth deposit gathering activities. In fact, Eastern Michigan checks several or multiple boxes based on mercantile strategic objectives. In addition to lowering the loan to deposit ratio, reducing the pro forma cost of funds and enhancing the balance sheet on balance sheet liquidity, We are afforded entry into new markets with a well-established franchise with proven leadership. Eastern has a clean credit profile and a strong track record of profitability. Mercantile and Eastern share a culture of excellent customer service and experience and investment in the communities we serve. And the combination of our companies will position us for continued growth and momentum. As noted in our release, we will be transitioning to Jack Henry in early 2027. One of the many unique traits that attracted us to Eastern Michigan is their decades of experience with our new core provider. Their institutional knowledge will help ensure that our transition is as frictionless as possible for our customers and employees. In addition to attractive strategic characteristics, the combination with Eastern has financially attractive traits, including double digit earnings accretion, mid single digit tangible book value dilution, and a mid-three-year earn-back period. We have waited for more than a decade since our last M&A activity for a partner like Eastern Michigan to come along, and our patience has been rewarded. We are pleased to be joining forces with our new colleagues at Eastern Michigan Bank and look forward to great success in the years ahead. That concludes my remarks. I will now turn the call over to Chuck.

Thanks, Ryan. Good morning to everybody. This morning we announced net income of $22.6 million, or $1.39 per diluted share, for the second quarter of 2025 compared to net income of $18.8 million, or $1.17 per diluted share, for the second quarter of 2024. Net income during the first six months of 2025 totals $42.2 million, or $2.60 per diluted share, compared to $40.3 million, or $2.50 per diluted share, for the respective prior year period. Growth in net income during both time frames largely reflected increased net interest income, lower provision expense, and reduced federal income tax expense, which more than offset increased overhead costs. Interest income on loans increased during the second quarter and first six months of 2025 compared to the prior year periods, reflecting strong loan growth that more than offset a lower yield on loans. Average loans total $4.7 billion during the second quarter of 2025, compared to $4.4 billion during the second quarter of 2024, equating to a growth rate of almost 7%. Our yield on loans during the second quarter of 2025 was 32 basis points lower than the second quarter of 2024, largely reflecting the aggregate 100 basis point decline in the federal funds rate during the last four months of 2024. Interest income on securities increased during the second quarter and first six months of 2025 compared to the prior year periods, reflecting growth in the securities portfolio and the reinvestment of lower yielding investments in a 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, declined during the second quarter of 2025 compared to the respective prior period, reflecting a lower yield. Conversely, interest income on other interest earning assets increased during the first six months of 2025 compared to the first six months of 2024, reflecting a higher average balance, that more than offset a lower yield. In total, interest income was $3.1 million and $6.7 million higher during the second quarter and first six months of 2025 compared to the respective prior year periods. Interest expense on deposits increased during the second quarter and first six months of 2025 compared to the prior year periods, primarily reflecting growth in money market and time deposit products. Average deposit totaled $4.62 billion during the second quarter of 2025 compared to $4.1 billion during the second quarter of 2024. The cost of deposits was down 18 basis points during the second quarter of 2025 compared to the second quarter of 2024. Interest expense on Federal Home Loan Bank of Indianapolis advances declined during the second quarter and first six months of 2025 compared to the prior year periods, reflecting a lower average balance that more than offset a higher average cost. And interest expense on other borrowed funds declined during the second quarter and first six months of 2025 compared to the prior year periods, largely reflecting lower rates on our trust-referred securities due to the lower interest rate environment. In total, interest expense was $0.7 million and $3.1 million higher during the second quarter and first six months of 2025 compared to the respective prior year periods. Net interest income increased $2.4 million and $3.6 million during the second quarter and first six months of 2025 compared to the respective prior year periods. Impacting our net interest margin was our strategic initiative to lower the loan or deposit ratio, which generally entails deposit growth exceeding loan growth and using the additional monies to purchase securities. A large portion of deposit growth was in the higher costing money market and time deposit products, while the purchase securities provide a lower yield than loan products. Our net interest margin declined 14 basis points during the second quarter of 2025, compared to the second quarter of 2024. Our yield on earning assets declined 30 basis points during that time period, largely reflecting the aggregate 100 basis point decline in the Fed funds rate during the last four months of 2024, while our cost of funds declined 16 basis points, primarily reflecting lower rates paid on money market and time deposits, which more than offset an increased mix of higher costing money market and time deposits. While average loans increased $299 million, or almost 17%, from the second quarter of 2024 to the second quarter of 2025, average deposits grew $519 million, or nearly 13% during the same time period, providing a net surplus of funds totaling about $220 million. We used that net surplus of funds to grow our average securities portfolio by $184 million and reduced our average federal home loan bank of Indianapolis advanced portfolio by $69 million. Our second quarter of 2025 net interest margin was two basis points higher than it was during the first quarter of 2025 and up eight basis points from the fourth quarter of 2024. Coming on the heels of an aggregate 100 basis point reduction in the Fed funds rate, during the last four months of 2024. We remain committed to managing our balance sheet in a manner that minimizes the impact of changing interest rate environments on our net interest margin. We recorded a provision expense of $1.6 million and $3.7 million during the second quarter and first six months of 2025, which generally reflects increased allocations on specific financially stressed lending relationships changes to economic forecasts, and loan growth. The recording of net loan recoveries and sustained strength in loan quality metrics continue to mitigate additional reserves associated with loan growth. Non-interest expenses were $3.6 million and $4.8 million higher during the second quarter and first six months of 2025 compared to the respective prior year periods. The increase largely reflects higher salary and benefit costs, including annual pay increases and market adjustments. Higher data processing costs also comprise a notable portion of the increased non-interest expense levels, primarily reflecting higher transaction volumes and software support costs, along with the introduction of new cash management products and services. We were able to reduce our federal income tax expense by $1.5 million via the acquisition of transferable energy tax credits during the second quarter of 2025. The recording of the tax benefit resulted in a second quarter effective tax rate of about 13% compared to a projected effective tax rate of 19%. We are scheduled to close on another transferable energy tax credit by the end of July, which will reduce our federal income tax expense by about $750,000. Additional acquisitions of transferable energy tax credits may be made from time to time subject to our investment policy, tax credit availability, and tax credits derived from our low-income housing and historic tax credit activities. We remain in a strong and well-capitalized regulatory capital position. our bank's total risk-based capital ratio was 13.9% as of June 30, 2025, about $218 million above the minimum threshold to be categorized as well-capitalized. We did not repurchase shares during the first six months of 2025. We have $6.8 million available in our current repurchase plan. On slide 23 of the presentation, we share our latest assumptions on the interest rate environment and key performance metrics for the remainder of 2025, with the caveat that market conditions remain volatile, making forecasting difficult. This forecast is predicated on no changes in the federal funds rate during the remainder of 2025. We are projecting loan growth in a range of 1% to 2% during the third quarter and a range of 3% to 5% for the fourth quarter. The third quarter forecast takes into account several expected larger balance CRE payoffs that Ray mentioned. We are forecasting our net interest margin to be in a range of 3.50 to 3.60% for the third quarter and a range of 3.55% to 3.65% for the fourth quarter. We are projecting a federal tax rate of 16% for the third quarter and 19% for the fourth quarter. The third quarter forecast takes into account the scheduled purchase of a transferable energy tax credit by the end of July. Expected quarterly results for non-interest income and non-interest expense are also provided for your reference. In closing, we are very pleased with our operating results and financial condition during the first six months of 2025 and believe we remain well positioned to continually successfully navigate through the myriad of challenges faced by all financial institutions. That concludes my prepared remarks. I'll now turn the call back over to Ray.

Thank you, Chuck. That concludes the prepared comments from management. We will now move to the question and answer portion of the call.

We'll now begin the question and answer session. To ask a question, you may press star, then 1 on your touchtone phone. If you are using a speakerphone, please pick up your handset before pressing any keys. If at any time your question has already been addressed and you would like to withdraw your question, please press star and then 2. At this time, we'll pause for just a moment to assemble our roster. And your first question today will come from Daniel Tamayo with Raymond James. Please go ahead.

Thank you. Sorry. Good morning, guys. Good morning, Danny. Maybe starting on the expense side, I guess just first curious if you could get just a little more detail on how the cost savings will play out in terms of the timing with the core system change happening in kind of end of 26, early 27, how much cost savings you'll get prior to that, and then the core savings change, system change itself, what kind of – cost savings you're expecting from that and the actual cost to go through that. I'm curious as well.

Thanks. Yeah, Danny, I'll take a shot at that first one. So with the acquisition of Eastern Michigan Bank, we're looking at that to be this cost savings to be staggered really between consummation expected in the fourth quarter and the first quarter of 2027 when we complete our core conversion. As we indicated in the deck, you know, we're expecting cost savings of almost $5.5 million, around 50% or so of that to be realized in 2026, a little over 90% in 2027 given that first quarter impact, and then all of it, you know, 100% of it certainly thereafter. Part of our synergies also is the deployment. of the excess liquidity that Eastern Michigan Bank has. Our calculations reflect bringing, if you look at their balance sheet, bringing their loan or deposit ratio up to 80%, which is about $150 million if you want to put it in balance sheet perspective of funds that we can basically take out of the investment portfolio and put into the loan portfolio. The February, 2027 expected conversion date aligns with the contract expiration of our current provider, the following month. So that's where that time he comes from and gives us an excellent runway preparing for that core conversion. And as Ray mentioned, the fact that the Eastern Michigan folks have been on Jack Henry for a very long time provides us with an intangible benefit. That certainly we weren't expecting when we started down the path of looking at a partnership there, but it's certainly significant. You know, we continue to evaluate the potential costs and cost savings that are associated with the core conversion. You know, we won't have a termination fee with our current provider because we are timing that with the expiration of the contract, and as you likely know, Those can be quite costly on those terminations. We are looking at our partnerships on digital banking and looking at moving that to Jack Henry as well. There would be some costs associated with that in the event that we do move that to Jack Henry, which is our hope and expectations, but we do have some hurdles that we have to overcome with Jack Henry on that. We are looking at some pretty significant cost saves, you know, starting in 2027 when the conversion is made. So, you know, it's hard to put specific numbers on some of these because we're looking out there a ways. But the cost saves are definitely there by switching to Jack Henry, but I would stress that, you know, looking at that core conversion, starting that process, the cost saves are great, but the number one reason for doing so was making sure that we had a core that was very reliable and provided both our employees and our customers with the best service, the best products out there. And to get that and also with what we think will be some significant cost saves, we're very excited with that change that will be upcoming in a year and a half.

Great. Thanks for all that color, Chuck. Appreciate it. And then maybe looking at the Eastern Michigan loan portfolio, you know, just curious if there's anything in the overall book that you guys are going to plan to roll off or, you know, not interested in maintaining, and then kind of thoughts on where you're looking to really grow that book on the eastern side of the state.

I'll take a swing at that, Danny. So the book that they have is high quality. It's served them well for a long period of time. And importantly, it has been part and parcel to growing that superior deposit base that they have. So our initial inclination is not to change anything in that loan book in any sort of material way. As we go forward, we see an opportunity to do more in the mortgage banking business in that footprint. And also on the larger size end of the business, there'll be some opportunities there as well where we can bring some added capacity to the marketplace. So I'd say those are the two primary opportunities to grow their loan book.

Okay, great. Well, I'll step back. Thanks for taking my questions. Thanks, Danny.

And your next question today will come from Nathan Race with Piper Sandler. Please go ahead.

Hey, guys. Good morning. Congrats on the deal. Thanks for taking the questions. Thanks, Nathan.

Thank you.

Thinking about kind of the deposit and loan growth outlook going forward, over the last 12 months, your deposit growth has been twice that. if not more than what you've grown loans at. So just curious how you're thinking about, you know, additional intentional growth within the securities portfolio. And just if you expect, you know, deposit growth to maybe more so just keep pace with loan growth, just given the excess liquidity and the improvement to the loan deposit ratio that will be additive on the deal.

Yeah, I think from a deposit standpoint, we've always had our foot on the gas pedal, and we'll continue to match that. We're really excited about the markets that we're in and the loan growth opportunities that they have always provided, and we expect for them to provide going forward. So while we are working hard to get that loan and deposit ratio down to 95% or maybe even a little bit lower, and certainly the partnership with Eastern Michigan Bank gets us there kind of in one swoop, You know, we want to definitely refine our deposits. You know, right now part of our deposit portfolio is broker deposits, and we would certainly love to. It's a great market, and it has served us well, but we would certainly like to have local deposits versus broker deposits. So we definitely want additional local deposit growth to help us extinguish that portfolio. But, you know, the expectation is that our loans on average will grow You know, call it 5% to 8% in any given year. And even when we get to our loan or deposit strategic spot where we want to be, call it 95% or maybe a little bit less than that. If we're growing our loan book, we're going to have to still continue to grow our deposit book by that same 5% to 8%. So it's not a destination. You know, this has always been part of our company. While we have always operated with a relatively high loan or deposit ratio, You know, we don't want people to think that we're not growing our deposits because we have grown our loan book very aggressively over this company's relatively short life. And deposits have quite frankly, you know, have kept pace over many, many of those years. So deposit growth is always a key focus of this company and will continue to be so going forward.

Okay, great. That's helpful. And then just, you know, thinking about Eastern Bank, it seems like they're kind of under-penetrated on the CNI side of things, particularly relative to your franchise. So just curious if you anticipate any cost saves maybe being reinvested in some commercial hires across that footprint and just how you're kind of thinking about the CNI growth opportunities over there.

Yeah, as we think about the C&I opportunities, we think about it across the entire footprint. There's certainly some within theirs, but as you look at southeast Michigan, west Michigan, the lakeshore, there are pockets in all of those markets where we could grow our lending presence even further and believe that we have the opportunity to do it. So there's no absence of pockets where we can grow our loan portfolio and to get this boost of liquidity will enable us to have the fuel to do that. So, in short, there's abundant opportunities to grow our commercial loan portfolio.

Okay, great. If I could just ask one last one on the pro forma balance sheet composition. Chuck, I think in the deck you guys alluded to repositioning a portion of the securities portfolio. So just curious, you know, how much do you expect to kind of remain in cash just to fuel loan growth going forward?

Yeah, I think when we look at that, you know, that investment portfolio, and certainly that's where the excess liquidity stands, they've done a great job of managing that portfolio. It's got a relatively short duration. It matches up with mercantiles quite nicely. And it's got a lot of laddered maturities, which provide for, you know, relatively constant cash flow coming off that portfolio. So we don't have any expectations of having to sell any of the securities. But as those securities mature, we'll certainly look at our loan pipelines in relation to our cash at the Fed and determine if we need to reinvest those proceeds in the securities or if we can need to use those cash flows to fund the loan growth. Certainly expected most of it to be the latter. over the next couple of years, but we'll just manage that as time comes.

Okay, great. I appreciate all the color. Thanks, guys. You're welcome, Nathan. Thank you.

Again, if you have a question, please press star and then 1. And your next question today will come from Damon Del Monte with KBW. Please go ahead.

Hey, good morning, guys, and thanks for taking my questions here. Just a question on the expense guide and the outlook. Chuck, does that incorporate any additional costs that are going to have to go into the system conversion? Has that been quantified yet?

No, we definitely have a schedule of when we expect expenses to come up between now and the first quarter of 2027. We're not looking at relatively any significant expenses for the most part for the remainder of this year related to that. There could be some maybe at the very end or maybe in the very beginning of next year, and we'll be able to give you more details on that in October. But the guidance that I provided do not reflect any significant costs related to the conversion through the rest of this year.

Got it. Okay, that's helpful. Thanks. And then with regards to the outlook for fee income for the back half of the year, I think it's like $9 million to $10 million per quarter. Can you just kind of walk us through a little bit of the step down from this quarter's result to that $9 million to $10 million range? Is that mortgage banking, or is that maybe more from the interest rate swap income?

The answer is yes. It's in both of those. We had very strong quarters, as Ray outlined in his preferred remarks, in both the swaps and the mortgage banking. And we do expect some step down in both of those relative to the second quarter. But I think that's much more of a comment made to the very strong second quarter that we had versus any, you know, disappointment or, you know, sad face with regards to what we think the next couple quarters will be.

Got it. Okay. That's great. And then I guess on the timing of the closing – I know there's a lot of hurdles to get over, but I mean, do you think this is more of a beginning of the fourth quarter or kind of like right at year end type of an event just from a modeling perspective?

Yeah, we're looking at it in the back half of the fourth quarter, you know, kind of either November 30 or maybe right at year end. As you indicated, it's going to be primarily predicated on when the regulatory agencies give approval. But given what we've seen over the last quarter or two, you know, we're hopeful for you know, to get this wrapped up by, like I said, November 30th or by year end.

Okay, great. And then, yeah, I guess I think that's it. Everything else was covered. Okay, thank you very much. Appreciate it.

You're welcome, Damon.

You're welcome. We'll conclude our question and answer session. I would like to turn the conference back over to Ray Reitzma for any closing remarks. Actually, pardon me, it looks like we have Nathan Wraith with Piper Sandler here for a follow-up. One sec. Nathan, please go ahead.

Yeah, I appreciate you taking the follow-up. Just going back to the margin guide, you know, Chuck, curious if you can update us on kind of your sensitivity to short-term rates from a margin or NII perspective. I noticed the guidance for the back half of the share doesn't include any changes in rates on the short end.

Yeah, so we modeled that because I don't think anyone knows exactly what the Fed's going to do and when they're going to do it. Everybody's got opinions on that. So we thought it would be easiest just to not – measure or to assume any change and then, you know, then we can talk about what would happen. We would look at a, you know, for every 25 basis points the Fed would cut, we'd probably be looking around a three or four basis point reduction in the short term of our margin. Okay, great. That would be the upfront relationship there.

Okay. Very helpful. And then if I could just ask one more, you know, this deal, it's not a massive one, you know, around 8, 10% of your asset base, but just curious your thoughts on additional M&A opportunities and kind of just what the environment looks like along those lines.

Yeah, Nathan, you know, we have taken 11 years since our last acquisition to do another one. And this one was uniquely strong. If we find another one like that, great. We'd proceed, you know, to pursue that. And if not, the search will continue. It's the same discipline that we use to, you know, get to this point after 11 years and end up with a uniquely strong partner. So, you know, the discipline that we've described in previous calls will continue and we'll see where it falls from there.

Okay. I appreciate it. Thanks again, guys.

Thank you. I'd now like to hand it back to Ray Reitzma for any closing remarks. Thank you.

I'd just like to thank you for your participation in today's call and for your interest in Mercantile Bank. That concludes today's call.

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