Alerus Financial Corporation

Good morning, and thank you, Bailey. Thank you to our research analysts for joining our call this morning, as well as our investors, employees, and directors for taking the time to listen in. We appreciate your interest and investment in Alaris. This morning, I will provide some commentary on Alaris' foundational strength in addition to the execution of our strategic evolution to a top-performing commercial wealth bank and a national retirement provider. Today, I am joined by Alaris' CFO, Al Villalon, who will discuss our financial performance and results for the quarter. In addition, Karin Taylor, our Chief Risk and Operating Officer, and Jim Collins, our Chief Banking and Revenue Officer, will join us to answer any questions you may have about the quarter. Alaris is well-positioned to emerge from the current headwinds as a clear winner in value creation and returns for our shareholders. We are building off the unique strengths of the company's diversified business model while optimizing our infrastructure to return the company to delivering strong profitability while continuing to grow a tangible book value. Most notably in our path to transformation is our continued and significant success in adding well-respected and widely sought-after bankers and professionals to our franchise. This momentum in attracting and retaining talent continued to build in the second quarter as we added more experienced mid-market and specialty commercial bankers. These team members joined the dozens of professionals we've hired this year and our tenured team of SBA, CRE, and business banking professionals. In the last six months, we've doubled the size of our treasury management team, And the team has hit the ground running as we have had early success in deposit wins, critical retention of relationships, and they continue to work closely with our mid-market and specialty commercial banking group. Last week, we lifted out a seasoned team of bankers in Minneapolis who will formally launch our private banking franchise. These team members will leverage our one alert business model and provide an integrated experience for the clients with wealth, mortgage advice, and products. Along with the continued momentum in talent acquisition, we are balancing our investments by optimizing our infrastructure with urgency. We remain disciplined in our investments and are focused on expense management. This was evidenced by our 4% linked quarter decline in non-interest expense. Today, we have reduced our total headcount in the company by 10% year-over-year, which includes the whole bank acquisition of Metro Phoenix Bank. Our fundamental strengths include our Fortress balance sheet, anchored by strong capital, credit and reserve levels, and a strategic and fundamental focus on diversification. This diversification is across the enterprise and multifaceted. Alaris' diversification is highlighted by our best-in-class business model with over 50% of revenues coming from fee income. Over 90% of those revenues are annuitized and recurring in nature and require minimal capital allocation, along with virtually no balance sheet risk. The majority of these revenues are derived from our national retirement and benefits business, which was again ranked in the top 30 in the country. These durable revenue streams will continue to support capital build and shareholder returns despite the challenging operating environment faced throughout the banking industry. Diversification goes well beyond our business model as portfolio diversification remains a critical strategy. Alaris' loan portfolio is diversified by loan type, geography, industry, asset class, loan size, and clients. Throughout the second quarter, we continued to conduct ongoing stress testing and review of our credit portfolio. Given the current environment, it is worth noting our investor CRE as a percentage of capital is at 173% compared to the regulatory threshold of 300%. Alaris' exposure to office is limited to 3.9% of loans, none of which are secured by properties located in the central business district. Asset quality remains pristine with minimal non-performing loans and a year-to-date net recovery. Reserves remain robust with 1.41% of total loans and $6.2 million of a remaining mark on the acquired Metro Phoenix portfolio. On the funding side of the balance sheet, our deposit portfolio remains well diversified among markets, products, and clients. Our uninsured deposits are 23.6% and a quarter of our deposits are sourced synergistically through our retirement and wealth management areas. We continue to see good retention of deposit dollars driven by our relationship approach. In our commercial client base, 68% of our deposits are integrated with treasury management offerings. We had several key wins and retentions during the quarter within the consumer wealth bank because of our holistic service model and constant collaboration between our wealth management and banking teams. During the second quarter, we experienced seasonal outflows from our public funds accounts. This activity was as expected, and we anticipate inflows in the second half of the year to follow their typical seasonal patterns. We are pleased to report several large and quiet wins and overall net new accounts to Aleric were $83 million higher than dollars of closed accounts. We consistently monitor our deposit portfolio and do not see any unusual or unexpected activity. However, generally speaking, clients are continuing to draw down and spend their balances versus utilizing their lines of credit. In our fee income business, we saw a rebound in originations in mortgage and market values in retirement and wealth. Strategically, we have engaged an experienced consultant as we look to prioritize and maximize the opportunities within our retirement business. This engagement is targeted at efficiency and operational enhancements, which will position us to take our large nationally scaled business to the next level through organic growth and acquisition. We believe we have significant embedded value in this annuitized cash flow business with the passage And with the passage of Secure Act 2.0, we believe there's tremendous opportunity to continue to expand our client base and further improve margins and gain market share across the country. From a capital standpoint, we continue to build on our strong capital levels, with TCE of 7.72 and CET of 13.3. During the quarter, we were active in share repurchases, and we also continued our long history of paying a dividend, and in the second quarter, increased that dividend by 5.6%. While there continues to be near-term pressure on margins, we are prudently managing expenses with urgency across the enterprise. We're having significant success executing on our strategic plan, focused on key talent adds and restructuring. And each move we do is purposeful in positioning the layer to bring expertise and value-added knowledge to our clients in a fast, frictionless, and highly responsive manner. This differentiated approach in a diversified business model is leading to higher levels of client acquisition and client expansion. We are continuing to build tailwinds and synergistic expansion in our wealth management and retirement platforms and continue to believe the long-term embedded value in these businesses is substantial as a differentiator in the community bank space. We are focused on client and talent acquisition and delivering top-tier shareholder returns. With that, I will turn it over to Al to talk about our financial performance.

Thanks, Katie. I'll start my commentary on page 14 of our investor deck that is posted in the investor relations part of our website. Let's start on our key revenue drivers. On a reported basis, net interest income declined 6% on a linked quarter basis. The decline was driven primarily by continued increase in funding costs. Net interest income represents now 46.3% of revenues. Switching to fee income, non-interest income increased 2.1% on a linked quarter basis. as we saw improvement across all our fee income businesses. Fee income continues to provide revenue stability despite interest rate challenges. I'll go into detail about each of our fee income segments in later slides. Turning to page 15, net interest income was $22.2 million in the second quarter. Net interest margin was 2.52%, a decrease of 18 basis points from the prior quarter. A 27 basis point increase in our asset yields was offset with a 46 basis point increase in our rate for our liabilities. Impacting the net interest margin was about seven basis points of accretion from the Metro Phoenix deal. Based on potentially more Fed hikes, which was not in the Fed dot plots at the beginning of the year, we continue to expect our net interest margin to compress in the third quarter. The magnitude of compression will be determined by whether the Fed hikes by another 25 basis points from here. When the Fed pauses eventually, we expect earning assets yields to continue to improve with mix shift and loan repricing as our cost of funds stabilize. Let's turn to page 16 to talk about a loan portfolio. Total loans grew 1.9% from prior quarter, driven by growth in commercial real estate and residential real estate, offset by decline in construction and consumer loans. For 2023, we continue to expect modest loan growth. Turning to page 17, On a period-ending basis, our deposits declined 5.9% from the prior quarter. As we guided to in the last earnings call, we experienced a seasonal outflow by public funds, which was the main cause of a decline in deposits. Despite the seasonal outflow, client retention remained very high, and we continue to attract new clients. For the remainder of the year, we continue to expect deposit balances to rebound from the second quarter as we expect a seasonal inflow from public funds in the back half of the year and continued client wins. Turning to page 18, you can see a further breakdown in our deposit characteristics. Our synergistic deposits, so those funds sourced from our wealth and retirement businesses, grew 27% over the prior year and 7.5% over the prior quarter. The strong year-over-year growth in synergistic deposits was driven mainly by strong organic client growth within our wealth segment. Synergistic deposits sourced from our retirement and wealth businesses now account for 26% of our deposit base. Continued growth in our synergistic deposits shows the strength of our unique and differentiated business model. On this slide, too, you'll see our uninsured deposit exposure. Our liquidity coverage to uninsured and not collateralized deposits now exceeds 300%. Turning to page 19, you'll see details about our investment portfolio. Currently, almost 69% of our securities are available for sale versus 31% in held to maturity. Within the held to maturity portfolio, approximately 42% are in municipal securities while the rest are in MBS. We continue to let the investment portfolio run down and remix the balance sheet towards commercial lending relationships that will add higher yielding loans and treasury management relationships. On page 20, I'll start talking about our fee income businesses. On this page, I'll provide some highlights on our retirement business, which accounts for approximately 32% of our total revenues. End of quarter assets under management and administration increased 4.9% due to higher domestic equity markets in the second quarter and continued client wins. Participants within retirement have grown 2.5% year to date. Revenues increased 2.6% on the linked quarter basis, mainly due to higher average assets and organic growth. Our retirement business continues to be a strong source of funding for the bank. Retirement now accounts for over 71% of our synergistic deposits. For the third quarter, excluding any market impact, we expect fee income for our retirement business to be up slightly. Turning to page 21, you can see highlights of our wealth management business. On a linked quarter basis, revenues increased 4.9%, while our end-of-quarter assets under management and administration increased 5%. We continue to see strong client acquisition in our geographic markets and from retirement rollovers in our national and established markets as we execute on our one-a-layer strategy. Like retirement, Wealth provides a strong source of funding for the bank as it now accounts for over 28% of our synergistic deposits. Next quarter, Excluding any market impact, we also expect the income here for our wealth business to be up slightly. Turning to page 26, I'll talk about our mortgage business. Mortgage revenues increased over $1.2 million or 69% from the prior quarter as originations rebounded from a seasonally low quarter. Mortgage originations increased over 43% from the prior quarter, which was slightly better than the MBA purchase index, which saw a 39% increase. For the third quarter, we expect mortgage originations to remain stable versus the MBA purchase index forecast of 1% growth, as inventories of homes for sale remain low in the Twin Cities. However, we continue to expect a seasonal decline in originations in the fourth quarter. Page 23 provides an overview of our non-interest expense. During the quarter, non-interest expense decreased 4% as we remain committed to improving our profitability. Compensation expense decreased due to reduction in headcount while professional fees increased due to higher FDIC assessments. Despite inflationary pressures, we do expect expenses to be now down low to mid single digits for 2023 on a year-over-year basis. We continue to be focused on improving our profitability by reducing expenses and increasing our capacity throughout our organization. We recently made continued progress in right-fiving our expense infrastructure through numerous initiatives. Some of these expenses will be reinvested into efficiency improvement and revenue production initiatives. Turning to page 24, credit continues to remain very strong. We had net recoveries of seven basis points in the second quarter. A non-performing assets percentage with seven basis points compared to five basis points in the prior quarter. Our allowance for credit losses on loans to total loans remains stable at 1.41%. The Solver Reserve currently provides over 1,300% coverage to non-performing loans, as you can see on the bottom left. I'll discuss our capital and liquidity on page 25. Our capital remains well above regulatory millions, even after the share purchase done during the quarter. On the bottom right, you'll see the breakdown in the sources of the $2 billion in potential liquidity. Overall, we continue to remain well positioned from both a liquidity and capital standpoint to weather any economic uncertainty. To summarize on page 26, we remain committed to making fundamental improvement and improving the returns for our stakeholders. Despite the challenging headwinds from our rapid rise in interest rates, our fee income businesses continue to provide stability to our revenues and continue to be a strong source of funding. Our capital remains strong, and we remain committed to returning capital prudently. With that, I'll now open it up for Q&A.

Thank you. We now begin the question and answer session. To ask a question, you may press star then one on your touchtone phone. If you are 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 today comes from the line of Ben Gerlinger from Hovde. Please go ahead, Ben. Your line is now open.