Alerus Financial Corporation

And welcome to the Alaris 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 Alaris Financial Corporation President and CEO, Katie Lawrenson. Please go ahead.

Good morning. Thank you, Bethany, and thank you to our investors and our analysts joining our call today. We appreciate your time and interest in Aleris. I know we always have good engagement by our employees listening in, and I want to take this opportunity to thank them for their dedication and their client outreach efforts throughout March following the bank failures. The efforts of our team across the company are instrumental in retaining and acquiring our holistic client relationships. This morning, I will provide some commentary on Alaris' strategic positioning in the current environment, along with some comments on the first quarter. Alaris' CFO, Al Villalon, will discuss our financial performance and results for the quarter. Afterwards, Karin Taylor, our Chief Risk Officer, and Jim Collins, our Chief Banking and Revenue Officer, and Barrett Lamb, our Treasurer, will join us to answer any questions you may have about the quarter. Let me begin first by highlighting Alaris' strong balance sheet and liquidity in light of the recent market events. As I will describe in more detail, our capital remains strong, our diverse and relationship-oriented deposit base grew 4% over the quarter, our sources of liquidity more than cover our uninsured and not collateralized deposits, and our asset quality remains sound. Despite the industry-wide challenging conditions, Alaris is strategically positioned to navigate the current operating environment. Alaris is one of the most uniquely diversified financial institutions in the country, with over 50% of revenue derived from fee income. of which a vast majority of this revenue is recurring and annuitized in nature, with little to no capital allocation. The value of these businesses is significant, especially in the face of rapidly changing interest rate environments. Diversification goes beyond the business model and revenue mix and is a fundamental tenant of our long-term strategies of this company. Alaris is well diversified within its client base in both the deposit and the loan portfolio. I'll start first with the deposit portfolio, which is 98% core deposit relationships, most with long-tenured relationships with the company. Insured deposits totals are 74% of total deposits, and although we saw migration from non-interest-bearing to interest-bearing, our overall non-interest-bearing balances of 26% remains above peer averages. Overall, our liquidity position remains robust, primarily driven by our highly granular deposit portfolio built through relationships. While we naturally have some large balances, most are part of full relationships with integrated treasury management solutions and services. Our fee income businesses not only contribute to our relationship-focused differentiated business model, but they also are leveraged to provide significant synergies. Most notably, over $750 million, or 25% of our deposit portfolio, is sourced through our fee income businesses, which helps mitigate funding pressure created by intense deposit competition. These deposits include low-cost HSA deposits in addition to retirement and wealth management money markets, which carry an index market rate but minimal acquisition or servicing costs. Growing our core deposit franchise has been a consistent and constant focus for this company and a key component of our one-o-layer strategy and initiative. This is evidenced by 68% of our lending relationships having a multi-product relationship with the bank and highlighted by our current loan-to-deposit ratio of 82%. consistent with our long-term average of 78%. The company's loan portfolio is also well diversified by type, by industry, and by market. Our non-owner-occupied office exposure is 3.9% of total loans. Alaris has a strong history of outperforming peers during economic downturns, with a long-term historical net charge-off ratio of less than 30 basis points. This quarter's net charge-off ratio was three basis points. Reserve levels remain robust at 1.41%, of allowance for credit losses to total loans. Our credit and risk management teams have completed a review of our office portfolio and conducted bottom-up stress testing on our commercial real estate portfolio. Our diversification strategy has also anchored the company in stable legacy markets while expanding to larger growth markets in Minnesota and Arizona. We will continue to be selective in our growth opportunities and add quality clients, relationships, and credits to our company while supporting our current clients through the cycle. Adding to the company's solid balance sheet, pristine credit quality and ample liquidity are strong capital levels, with CET of 13.3% and TCE levels around 7%, even when including unrealized losses on the HTM portfolio. While near-term margin pressure remains a headwind to earnings, we continue to execute on initiatives to fundamentally improve the profitability of this organization. We have added dedicated and experienced talent to the treasurer role, And while we are continually evaluating opportunities to reposition the balance sheet, we are also strategically focused on transformational opportunities that will return us to our 40-year historical performance levels of a greater than 1.25% ROA and a greater than 12% ROE. This transformation is focused on improving the long-term core organic growth of the organization, including enhancing synergistic opportunities across business lines, while consistently generating positive operating leverage. In January, we restructured our banking division and organized our team members to serve clients in their dedicated segments, improving our speed to market and the client experience. During the quarter, we added team members focused on mid-market commercial banking and treasury management. We recently completed an additional rightsizing as revenue headwinds persist. As a result of these moves, expenses have remained well managed despite inflationary pressures. We will continue to see opportunities to improve our efficiency, while attracting highly experienced and reputable revenue-producing talent to the company. While we have work to do and the battles in the near-term pressure on margins, we continue to build tailwinds in client acquisition and synergistic expansion on our wealth management and retirement platforms. The long-term value embedded in these businesses is substantial and a substantial differentiator in the community bank space from a client and a talent acquisition standpoint, as well as for delivering top-tier shareholder retention. These capital-like businesses will continue to contribute to Alaris' long history of historical cash dividend payouts, currently yielding over 4.5%, and once there is greater visibility on the economic front, potential share repurchases. With that, I will turn it over to Al for financial commentary on the quarter.

Thanks, Katie. I will start my commentary on page 11-0 of our investor deck that is posted in the investor relations part of our website. Given all the market uncertainty, this highlight shows how strong and stable Blurris is. We have a high-quality deposit base, superior liquidity, strong capital, and conservative credit. I will go into further details about each of these strengths later in the slide deck. Let's go to page 15 now. First, for the first quarter of 2023, reported average half of the quarter, which I will discuss later. Turning to page 16, credit continues to remain very strong. We had net charge-up of three basis points in the first quarter. Our non-performing In addition, we have a fair value mark of $6.9 million on the Metro Phoenix acquired loans. We incurred a day one adjustment in the allowance for credit losses of $5.9 million and an after-tax adjustment to retained earnings of $4.5 million. $4 million of the adjustment was related to loans, while $1.9 million was related to unfunded commitments. On page 17, Despite the highly competitive environment for deposits, our interest-bearing data was 36% at this point in the cycle. On a period-ending basis, our deposits grew 4% from the prior quarter. We saw very solid client retention and deposit inflows from our core commercial and consumer deposit base and from new clients as we continued to expand our presence in existing markets. We continue to not have any broker deposits. As you'll see on the right-hand side of the slide, our deposit base is well diversified. The strength in our unique and differentiated business model shined in the quarter as synergistic deposits grew 9.6% from the prior quarter to $758 million. Synergistic deposits sourced from our retirement and wealth businesses now account for 25% of our deposit base. On page 8 Non-interest-bearing deposits currently account for 29.5% of total deposits. As you'll see on the top right-hand chart, Alaris has typically operated with a higher percentage of non-interest-bearing deposits relative to the banking industry. On the bottom left part of the slide, you'll see that uninsured and not collateralized deposits account for only 25.1% of total deposits, or approximately 800 million. We also have about 800 million deposits. In addition to our on-balance sheet liquidity, we have another $1.4 billion of off-balance sheet liquidity. This brings our total liquidity to $2.2 billion. Our total liquidity to uninsured and uncollateralized deposits is 286%. We have substantial liquidity, as you can see, to cover those uninsured and not collateralized deposits. As we look forward to the second quarter, we do expect our usual seasonal outflow from our public funds. But for the remainder of the year, we continue to expect deposit balances to be stable or show modest growth. Turning to page 19, our capital base remains very strong as our common equity tier one ratio is at 13.6%. In comparison, our common equity tier one ratio is 5.5%. objected to the Saad Frank stress test. Our current tangible equity to tangible asset ratio is 7.6%. While only 31% of our securities are held to maturity, if we mark these securities to mark the market, our tangible equity ratio would still be around 7%. On the bottom right, you'll see the breakdown in the sources of our $2.2 billion in potential liquidity. Overall, we continue to remain well-positioned from both a liquidity and capital standpoint for weather, economic uncertainty, We currently have $770,000 share repurchase authorization in place. We will repurchase stock when market uncertainty subsides. Page 20 shows some key revenue metrics. On a reported basis, net interest income declined 12.3% on a link quarter basis. The decline was driven primarily by continued increase in funding costs. Non-interest income declined to continue headwinds on mortgage. I will go into detail about our fee income segments in later slides. Our fee income was 51.6% of total revenues. Our high fee income is a big differentiator, especially as over 90% of the fee income is recurring and annuitized in nature. Our strength continues to be providing holistic financial solutions to our clients. Turning to page 21, net interest margin was 2.7%. BASIS POINTS FROM THE PRIOR QUARTER. A 29 BASIS POINT INCREASE IN OUR EARNING ASSET YIELDS WAS OFFSET WITH A 78 POINT INCREASE IN OUR INTEREST-BEARING LIABILITIES. BASED ON THE LATEST FED DOT PLOTS, WE CONTINUE TO EXPECT OUR NAND INTEREST MARGINS TO COMPRESS AT A MORE MODEST PACE IN THE SECOND QUARTER. EARNING ASSET YIELDS WILL CONTINUE TO IMPROVE WITH MIXSHIFT AND LOAN REPRICING WHERE OUR COST OF FUNDS IS STABILIZING. TURNING TO PAGE 22, Over $1 billion or almost 41% 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. For 2023, we continue to expect modest loan growth. Turning to page 23, you'll see details about our investment portfolio. Currently, 69% of our securities are available for sale versus 31% in health and maturity. Within the health and maturity portfolio, 42% are in municipal securities, while the rest are in MBS. As we restructure and transform our banking division, we are strategically focused on growing commercial relationships, which will add higher yielding and variable rate loans with deposit and treasury management relationships. We will continue to let the investment portfolio run down from approximately 28% of earning assets Today, our investment portfolio has an effective duration slightly over five years. As we right-size our investment portfolio, we plan on maintaining a duration around three years. On page 24, I'll provide some highlights on retirement business. End-of-quarter assets under management increased 4% due to higher domestic bond and equity markets in the first quarter and continued client wins. Revenues declined on the link quarter basis mainly due to lower average assets during the quarter For the second quarter, excluding any market impact, we expect fee income from our retirement business to be up slightly. Turning to page 25, you can see highlights of our wealth management business. Revenues increased 1% or end of quarter assets under management increased 2.6%. We continue to see strong client acquisition in our geographical markets and retirement rollovers in our national and established markets as we execute on our one-letter strategy. We continue to retain deposit dollars with our synergistic wealth money market offering, which represents 30% of our synergistic deposits. For the second quarter, excluding any market impact, we expect the income from our wealth business to be up slightly. Turning to page 26, I will talk about our mortgage business. Mortgage revenues declined $454,000 from the prior quarter due to lower originations as the macro and local environment remain challenged. Mortgage originations decreased approximately 38% from the prior quarter, as the first quarter is typically slow. Inventory of homes available for sale continue to remain at a very low 1.5-month supply versus a typical level of 3 to 4 months in the Twin Cities. We do expect a pickup in the mortgage business in the second quarter. However, the increase in volume may be more muted than the NBA forecast of a 36%. Page 27 provides an overview of our non-interest expense. During the quarter, non-interest expense decreased 30 basis points from the prior quarter, which was in line with original expectations of expenses being stable. Compensation expense increased due to seasonality, but also due to a one-time expense of $900,000 related to talent acquisition and service expense. Despite inflationary pressures, we do expect expenses to be down low single digits for 2023 on a year-over-year basis. We continue to be focused on improving our profitability by reducing expenses, increasing capacity throughout our organization. We recently made continued progress in right-sizing our expense infrastructure through numerous initiatives. Some of these expense saves will be reinvested in efficiency improvement and revenue production initiatives. To summarize on page 28, we remain well-precision from both the liquidity and capital standpoint. We have ample liquidity to weather economic volatility, and capital ratios remain very solid, even if you factor in the unrealized losses from our health and maturity investments, as our tangible common equity ratio would still be around 7%. Credit remains strong. Lastly, we continue to see growth in our core existing deposit base, and with new customers as people value the holistic approach of our professionals and business value provides. With that, I will now open it up for Q&A.

We will now begin the question and answer session. To ask a question, press star then one on your touchtone phone. If you're using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then two. At this time, we will pause momentarily to assemble our roster. Our first question, comes from the line of Jeff Ruiz with DA Davidson. Please go ahead.

Thanks. Good morning. Wanted to check in on the margin. Al, I continue to recall your oiled spring commentary. Just I guess first question would be, do you have a March net interest margin average and then And then, you know, I guess as we look at 2Q, I think you talked about some compression, but the balance of the year and timing in terms of the sensitivity, just update from where you left us off, Al, in the prior quarter.

Thanks for the question, Jeff. So for end of March, our NANGES margin was around 2.59%. Going for the second quarter, we do think there'll be a little bit of compression from there. but I would say that the worst is behind us. You know, we're probably thinking that with our 60% of our deposits being indexed with the last Fed, you know, predicted Fed hike of about 25 basis points, that will price our money market index deposits in July. And then from there on forward, our assets should be priced higher. So that coil spring is in effect still.

Okay. Appreciate it. And then... more of a housekeeping you know pretty good detail on the expenses and fee income i guess in the um uh let's see the the the fee income side there was a that bully benefit um what was that about a million in in the quarter and and i guess could we effectively back that out uh going forward yes you can do this you can back that up okay But if it's about a million, give or take?

Yeah, 1.2 million.

Okay. Got it. And then a last one. Maybe, Katie, just looking at the credit statistics, I mean, they're phenomenal. And I know this is work you've done years prior in terms of addressing some shoppier credit figures and now – certainly in a great spot, and you talked about your exposures going forward. Just wanted to check back in on credit, and I know that we're all sort of girded for maybe tougher economic times, but your thoughts on credit overall and from your perspective, how you're positioned.

Hi, Jeff. This is Karin. I'll take that question. We've obviously benefited as the rest of the industry has over the last couple of years and had historically low asset quality issues. We continue to expect that credit will normalize over time and that we'll return to more historical metrics. That said, with the work that we've done on our portfolio, we believe we're really well positioned to withstand a downturn.

And I would add, thank you, Karin, I would add from a talent standpoint and from the risk management and the credit team infrastructure standpoint, that's what we've been working on for the past four years is building that team to take the organic growth and move up market on the lending side and the credit side. So I believe in all facets we are well positioned to do so with the right clients.

And I guess on a related front then, Katie, we heard your comments about maybe guarded on a buyback or on hold, but capital priorities and thoughts on fee income acquisition or anything else, should we also consider that things are on hold for right now, or what is the update there?

Sure. We are clearly in a very strong capital position. We have a long history of paying a strong dividend. So that is also a priority for us. When it comes to buybacks, the environment is uncertain right now, but we will absolutely move forward if the financial metrics make sense. We do see continued opportunities on the commercial banking side in terms of taking market share, again, growing with the right companies and the right people, even in this environment. On the acquisition side in the retirement space, we're actually seeing more opportunities and we're seeing less competition as some of the PE firms and their cost of capital has increased significantly. So still very active in that space, but remaining very disciplined in our pricing.

Okay. I'll step back. Thanks.

Thanks, Jeff.

Thanks, Jeff.

Thank you. Our next question. comes from the line of Eric Spector with Raymond James. Please go ahead.

Hey, this is Eric. I'm on the line for David Feaster. I appreciate you guys taking the question. You guys talked about it a little bit in the prepared remarks, but it was nice to see the team higher in the quarter. I'm just curious how you think about hiring near term. Obviously, expense controls and focus is now a time to be greedy and maybe pick off some talent. I'm just curious if you have any thoughts on the hiring front and maybe what you think is attracting folks to Alaris.

Jim Collins, I'll take that one. This is definitely the time that we're going to continue to look for more talent. As we see banks that tend to have to buy brokered CDs and tend to have to reduce their accrued compensation, that gives us the opportunity to go after talent in the marketplace. As talent gets nervous and we're well-positioned, we're definitely in all of our markets going after top-tier talent.

Okay. What do you think is attracting folks to Alaris? What's your guys' competitive advantage? Do you have any thoughts on that end?

Certainly our markets, we are in fantastic markets. The infrastructure that's been built in this organization the past five years puts us in a great position with the balance sheet. We already have great employee base now, and we're poised for a lot of growth. So being in a situation to accelerate that growth by just adding talent, I think, is what's encouraging most people to talk to us. Obviously, our values and our culture is fantastic, one of the reasons I came here. But really, it's the fact that profitable way. That's what energizes top producers, and that's why they're interested in talking to us.

Got it. I appreciate the color. And then just kind of going off that, just curious if you have any thoughts on the loan growth side of things and where you're seeing strong risk-adjusted returns and how new loan yields are trending so far this quarter. Just kind of general color on your loan growth outlook going forward.

Certainly the pipelines are a little soft for everybody. But as I said earlier, I mean, this is our opportunity to take talent and market share from other banks. You know, we're pricing six and three-fourths to seven and a half. That's kind of the market right now in most of our markets. But again, I think with where we're positioned and as we pick off talent, we'll have good loan growth to our budget. Certainly won't be gunning for double-digit loan growth in this economic times, but we certainly will build a team that will perform that later in later years.

Got it. Appreciate you guys taking the question and congrats on a good quarter. Step back. Thank you.

Thank you. Our next question comes from the line of Nathan Race with Piper Sandler. Please go ahead.

Yep. Hi, everyone. I appreciate you taking the questions. Maybe balance your dynamics. It sounds like you guys have a pretty strong pipeline of deposit gathering across both the synergistic deposit platform and also kind of in footprint within the Twin Cities. So just curious, you know, with that, you know, pretty solid deposit growth outlook, particularly relative to some years, is there an opportunity to widen the wholesale borrowings that were added to the balance sheet over the back half of last year?

So, Nate, in terms of the borrowings, I mean, we are trying to work those down right now because, you know, we're borrowing at FHLV overnight. So we're trying to, you know, with some of the core deposit growth we're seeing, you know, we'd like to pay those down, but also try to, you know, maintain some ample cash levels just in case there's any liquidity needs in the short term.

Okay. Got it. And then just kind of thinking about the drivers for loan growth and just kind of the profitability of the loan growth that you guys have generated recently, just given the incrementally higher cost of funds look like a lot of the growth in the first quarter was commercial real estate driven. So just curious that, you know, there's going to be a mixture of changes in terms of kind of the type of growth that you guys are willing to add to the portfolio going forward, just given kind of the incrementally higher cost of deposits and wholesale. funding these days?

I will tell you, our major focus is mid-market, lower mid-market C&I. So we're aggressively hiring and going after in that niche, so more lines of credit, equipment term debt. That's really where we see our focus, and hopefully that will yield some of that growth later on this year and going forward, but that's certainly our focus. There will still be some CRE growth for sure. We have a great team and we're in great markets and we have the opportunity of seeing some of the nicest deals in the markets. So we will have continued CRE growth. But again, the focus will be mid-market C&I.

Okay, great. And Jim, just how does that C&I pipeline stack up coming out of the first quarter? I know a lot of these team additions were pretty recent. But just kind of any thoughts on just kind of overall C&I growth expectations over the course of this year and just, you know, how we should just generally be thinking about the overall rate of loan growth for 2, 3Q and 4Q.

Sure. Obviously, we just went to line of business, you know, just under three months ago and then added some solid mid-market players right in that same timeframe. CNI is a little bit longer lifecycle to recruit into a banking organization. And we will continue to add talent in that space. So those pipelines will generally start growing. But again, you have some issues with obviously rates, with non-solicitations that nobody will break, and just overall time to engage with those customers. But certainly we will generally see that trend getting, the pipeline getting and then into 2024.

Okay, great. And if I could just ask, just in terms of some of the success you guys are having in terms of rolling over some of your retirement clients onto the wealth platform, I know this is more of a longer story component to the Alera story, but has there been any recent changes in terms of the capture rate in terms of onboarding clients from the retirement platform into wealth more recently?

Hi, Nate. I'll take that one. This is Katie. I would say the business has been pretty consistent. Again, our focus on any approach to a client is what is best for them and what aligns with their goals and how can we help them be most successful with those goals. And so it is an opportunity at times with clients, but at other times they may want to move in, for instance, to transition to the money markets like we saw this quarter. So consistent outreach, great engagement with the client base, And then the results are in various components of the company's division.

Okay, got it. And just another question, just going back to deposits, you know, obviously non-just bearing was down in the quarter and it's, you know, come down from around 30% deposits, closer to 20% over the last year or so. Any thoughts on just if we're nearing a drop there or still seeing, you know, clients, you know, move into higher cost products? products, I should say, and perhaps kind of what inning are we in in terms of some additional attrition and just the proportion of that deposit bucket?

This is Barrett. I can take this one. We did see non-interest-bearing deposits decrease from 26% in the quarter. We do, as I believe we have in the investor presentation, we remain at a higher level than the industry. So I think if you look at maybe what the risk is, I think that puts it into context. But I think we expect to stay above industry.

Okay. If I could just ask one more on just kind of the reserve trajectory and just maybe for Karin. I don't think the criticized classifieds trends were disclosed in the slide deck, so perhaps any update there and just kind of how you're thinking about the reserve or ACL trajectory, I should say, from here.

Yeah, the criticized, classified, combined remained about the same quarter over quarter. In terms of the trajectory of the reserve, it's really going to depend on loan growth and the economic forecast. that we're using within the methodology.

Okay, great. Appreciate you guys taking all the questions and all the color.

Welcome. Thanks, Dave. Thanks.

Thank you. Our next question comes from the line of Damon Del Monte with KBW. Please go ahead.

Hey, good morning, everyone. Thanks for taking my questions. I wanted to just start off with expenses. Alex, you know, if you exclude the severance and the talent acquisition costs, I think that puts operating expenses somewhere around $37 million. Can you just talk a little bit about your outlook over the coming quarters? You know, are there some opportunities to maybe reduce some of the expense base or kind of how do you see that playing out?

Yeah, Damon, we still have, we're still looking at initiatives. We just have enacted some here in the past month. You know, there's definitely more wood to chop there when it comes to expenses. But, you know, there's going to be a little, like, volatility from quarter to quarter, but we do expect it to be down overall single digits for the year.

Okay. All right. And going off of last year's, was it like, what, 158, 159? Yes. Correct.

Using that as a starting point.

Okay. That's helpful. Thanks. And with respect to the margin, I apologize if I missed this in the release, but what was the accretable yield included in the margin this quarter?

Yeah, there was about two basis points for Metro.

Two basis points. Okay. And is that something we should model going forward? I know it's kind of tough to do, but is that kind of what your schedule looks like?

Yeah, I would say that's about right.

Okay, great. And then you kind of touched on this with the loan growth outlook. You know, you said it appears that, you know, it would be kind of modest growth from this point forward. So should we kind of factor in kind of low single digits on a quarterly basis after, you know, this quarter's stronger start?

Yeah, I'd say low single digits is fine. That's the comment around modest.

Okay. All right, great. That's all that I had. Everything else was asked and answered. Thanks a lot.

Thanks, Damon.

Thank you. This concludes our question and answer session. I would like to turn the conference back over to Katie Lawrenson for any closing remarks.

Thank you. And thank you everyone listening in and for the questions. I'll close with Alaris is a resilient company. fundamentally differentiated business model and a strong foundation. We will continue to take a long-term view and will be protective of credit, capital, and our culture as we consider growth and work with urgency to continue to implement efficiency-enhancing opportunities. We thank you, our shareholders and our clients, for the trust that you put in us and our team members for your constant efforts in taking Alaris to new heights. Thank you and have a good day, everyone.

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