Alerus Financial Corporation

Hello everyone and welcome to the Aliris Financial Corporation Earnings Conference Call. All participants will be in 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. Please note this event is being recorded. This call may include forward-looking statements and the company's actual results may differ materially from those indicated in any forward-looking statements. Important factors that could cause actual results to differ materially from those indicated in the forward-looking statements are listed in the earnings release and the company's SEC filings. I would now like to turn the conference over to Aliris Financial Corporation President and CEO, Katie Lawrenson. Please go ahead.

Thank you. Good morning, everyone, and thank you for dialing in to our call today. Joining me today is Jim Collins, our Chief Banking and Revenue Officer, and Al Villalon, our CFO. We ended the third quarter with net income of $9.6 million, or 47 cents of earnings per share. Included in the quarter were $1.8 million of merger-related expenses as we closed and converted the Metro Phoenix Bank acquisition during the quarter. Adjusted earnings per share, excluding the merger and integration-related expenses, was 54 cents per share. The integration of Metro Phoenix Bank marks a historic milestone as the company's 25th acquisition in system conversion. This strategic acquisition adds greater scale and the fastest-growing major MSA in the country. We look forward to watching the team's continued success and attracting more talent as one of the few community banks in the market. Highlights for the quarter included strong production and continued NIM expansion. Our retirement and wealth management divisions saw a decline in assets, but revenues displayed their durability in the face of ongoing volatile markets. We continue to emphasize the recurring non-capital intensive revenues of our fee income with over 80% of revenues in our retirement division tied to annual plan revenue and 87% of our wealth management revenue related to asset management and not transaction based. Production in both business units is exceeding expectations in prior year levels. Mortgage production headwinds continued during the quarter and gain on sale margins hit a low point. We have and will continue to adjust for the decline in business through expense right sizing. Expense management is a priority of the team, and solid cost controls were evident again this quarter as expenses excluding merger-related and unfunded commitments tied to loan growth were down for the quarter even while we added on the Metro team. Loan pipelines were robust coming into the third quarter, and our team members and clients were able to close many of the opportunities before the quarter end. Loan growth continues to be very planful and purposeful. More than four years ago, the company began to restructure the credit team and establish a robust credit infrastructure. We have invested in expertise and significantly improved our risk management. We have and continue to add and retain talented producers who deeply understand the segment they work in and their clients' businesses. We are focused on client selection and diversification. While we remain disciplined in credit underwriting and deal selection, we will also continue to attract talent to our franchise as we are uniquely well-positioned for sustainable and profitable growth. Aleris presents a compelling opportunity for teams and professionals to have continued success through the current and upcoming economic cycles. We have strong capital levels and resilient revenues to support superior loan growth. We are well diversified in our loan portfolio and well positioned in strong geographic markets. Our regulatory capital levels remain robust with fully funded reserves of 1.51% excluding the Metro Phoenix portfolio. Lastly, we have long prioritized core deposits and maintaining a strong core funding base as evidenced by our loan to deposit ratio of 78%. With that, I will hand it off to Al to discuss the financial details of the quarter.

Thanks, Katie. I'll start my commentary on page 14 of our investor deck that is posted on the investor relations part of our website. For the third quarter of 2022, reported average loans increased 23.1% on a linked quarter basis. Excluding the impact of PPP and Metro, average core loans increased 8.1% on a linked quarter basis, which was in line with the guidance provided. The increase in core average loans was driven by 10.3% growth in CRE and 3.8% growth in CNI. We saw a pickup in commercial loan demand as clients pulled forward loan growth in anticipation of further rate hikes. Excluding the impact of Metro, average deposits declined 2.7% on a linked quarter basis, due to the seasonal decline in interest-bearing deposits in the second quarter that lingered into the third quarter. While average balances were down in the quarter, we did see the typical seasonal increase during the fall, as end-of-period core deposits, excluding Metro, were up 1.7%. Turning to page 15, credit continues to remain very strong. We had net charged up to seven basis points in the third quarter, which showed no change from the prior quarter. Our non-performing assets percentage was 17 basis points compared to 16 basis points in the prior quarter. Our allowance is 1.34% of period end loans, which included the acquisition of Metro Phoenix Bank. On page 16, our core funding mix remains very strong. We saw a small increase in our cost of funds due to rising interest rates. Given the further rise in interest rates, we have responded by increasing our deposit rates more recently. We have been strategic in lagging our deposit costs in this rapid raising interest rate environment. However, we are seeing more competitive pressures and we have started to respond by offering competitive deposit rates. Despite the competitive pressures, our funding base remains very strong and sticky as our loan to deposit ratio is at 78.3%. On page 17, our capital base remains very strong as our common equity tier one ratio is at 13.6%. As a frame of reference, the medium common equity Tier 1 for the largest financial institutions subjected to Frank Dodge stress test was 8.0%. On this slide, you'll also notice that we have over $2 billion in potential liquidity. Given increasing concerns of potential economic uncertainty, we are well positioned from both a capital and liquidity standpoint. Turning to page 18 are some key revenue metrics. On a reported basis, net interest income increased 24.3% on a linked quarter basis. Excluding the impact of PPP and Metro, net interest income increased 5.7%, mainly due to higher loan growth and higher net interest margin. Non-interest income declined 7.6% on a linked quarter basis due to lower mortgage and wealth management and slightly higher retirement revenues. This was a little worse than expected as the markets and higher mortgage rates pressured these segments again. I'll go into further detail about those segments in later slides. Turning to page 19, net interest margin was 3.21% in the second quarter, an increase of 23 basis points from the prior quarter. There was no purchase account increase in the reported net interest margin. Excluding the impact of Metro, our core net interest margin was 3.04%, an increase of six basis points from the prior quarter, which is consistent with the guidance we gave of margin expansion. Core net interest margin benefited from higher investment portfolio yields, along with higher loan yields from our commercial real estate and C&I portfolios. Turning to page 20, $978 million, or over 42% of our loans, are floating, as you can see at the top left of the slide. As you see, almost all of our variable loans are above their stated floors or have no floors. On the bottom left, you can see a waterfall of net interest income and net interest margin. Better volumes and rates, as previously mentioned, positively impacted our results. On page 21, I'll provide some highlights on our retirement business. AUM declined 3.8% due mainly to market volatility with S&P 500 and aggregate bond index both down 5.3% in the third quarter. While AUM declined, we did see the number of participants increase to approximately 457,000 versus 450,000 in the prior quarter. Revenue has increased 1.9% from the prior quarter due to a one-time document restatement fee of $721,000. from the Secures Act. Turning to page 22, you can see highlights of our wealth management business. Revenues declined approximately $700,000 from the prior quarter as lower insurance sales, brokerage commissions, and AUM levels impacted our results. AUM declined 17.2% from the prior quarter, mainly due to a decrease in custody assets from our temporary account. The temporary custody account was related to the sales of business by one of our commercial clients. Executing on our one-a-layer strategy, the team converted numerous participants into wealth management opportunities. Going forward, the custody account rolled off, but the annualized revenue picked up from these wealth management opportunities will exceed the custody revenue. Excluding this custody deal, AOM declined 2.8% due to market volatility. Turning to page 23, I'll talk about our mortgage business. Mortgage revenues declined 2.3 million from the prior quarter, due to lower originations and gain on sale margin as the environment remained challenged. Mortgage originations decreased approximately 15% from the prior quarter as the Mortgage Bankers Purchase Index saw a similar decline of approximately 19%. While originations are tracking slightly higher than 2019 levels, the environment has become more challenging as the 30-year mortgage has eclipsed 7%. Lastly, turning to page 24 is an overview of our non-interest expense. During the quarter, non-interest expense increased 7% mainly due to the inclusion of Metro. We also saw an increase in professional fees due to higher M&A expenses of $1.8 million in the quarter. Other expenses increased as a result of higher provision for unfunded commitments as we saw an increase in commitments related to the growth in commercial real estate. This higher provision will be part of other expenses upon implementation of CISO in 2023. Excluding the impact of Metro and merger-related costs, non-interest expenses were down 0.4%, which was in line with our expectations of core expenses being flat over the prior quarter. Now I'll provide some forward-looking guidance for the fourth quarter. We're expecting loan growth on an average balance basis to moderate in the quarter. While we expect growth in our Arizona market, especially with Metro, we expect some headwinds in our more seasoned markets. We saw some pull forward of loan growth in the third quarter ahead of further rate hikes as we have previously experienced loan growth of 18.2%, excluding Metro and PPP since the end of 2021. We expect net interest margin to be stable. We are anticipating rising deposit costs due to further Fed rate hikes will offset any improvement from loan yields. We do expect three to five basis points of loan accretion from the Metro deal. On the fee income side, we expect the following. Mortgage volumes will likely decrease in 4Q as we only expect $800 million of total originations for 2022. We typically see a seasonal slowdown in the Twin Cities in the fourth quarter. The seasonal slowdown coupled with higher mortgage rates and continued low inventory levels in the Twin Cities will continue to pressure our mortgage business. Wealth revenues will be stable as we're not anticipating any equity or bond market growth. And then for retirement, excluding the one-time primary statement fees from the SECURES Act in third quarter results, we expect retirement revenues to increase by low single digits. Credit, we expect credit to remain strong and continue to expect charge-offs to be below historic levels. And finally, on a reported basis, we expect non-existent expenses will be down mid-single digits. Overall, this decline in expenses will drive positive operating leverage in the fourth quarter. With that, let me open it up for Q&A.