Alerus Financial Corporation

Good afternoon. Welcome to the Aleris Financial Corporation Earnings Conference Call. All participants will be in listen-only mode. If 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 file. I would now like to turn the conference over to the Alaris Financial Corporation President and CEO, Katie Lawrenson. Please go ahead.

Thank you. Good morning, and thank you for joining Alaris' second quarter earnings conference call. Joining me on the call today is CFO Al Villalon, Chief Risk and Operating Officer Karin Taylor, Chief Banking and Revenue Officer Jim Collins, and our Chief Retirement Services Officer Forrest Wilson. I will kick off the call today with an overview of the results for the quarter, a recap of some strategic highlights, some additional color on credit during the quarter, and an update on our pending acquisition of HMN Financial. For the quarter, we reported net income of $6.2 million, or $0.31 of earnings per share. Operating results for the quarter generally exceeded expectations with continued improving trends across our diversified sources of revenue, driving impressive improvement in PPNR or pre-provision net revenue of 48% on a linked quarter basis. The team we are building continues to excel in adding full client relationships across our commercial, wealth, and private banking segments. Notably, we exceeded expectations for deposits at the end of the quarter with our fifth straight quarter of deposit growth in a very difficult and competitive deposit environment. A huge shout out to our team members who have done a fantastic job, again, sourcing new core deposit relationships, retaining inflows, and capturing liquidity events opportunities. This success allowed us to see deposit balances tick up and offset substantial seasonal outflows. Deposit wins were sourced from all markets and generally the result of our one hilarious approach to holistic opportunities to serve clients across the suite of commercial and private banking, treasury management, and wealth advisory services. In addition, we continue to build balances across our synergistic deposits, including our health savings accounts and wealth management and retirement money market portfolio. Our loan-to-deposit ratio ended the quarter at 88% and continues to be a high-quality deposit portfolio that is well diversified by size, geography, and type. We saw some growth in our CD base, which notably has a low level of CD-only clients. And as emphasized in the previous quarters, we continue to operate and fund our loan growth with zero broker deposits. For the quarter, we grew loans 4.2%. We remain highly selective and disciplined in both pricing and credit. and we continue to build a best-in-class team of bankers and risk management experts who have strong credit acumen and deep experience in vetting opportunities and working with entrepreneurs, business banking, and mid-market commercial clients. Consistent with our efforts and focus on commercial banking, we added a team of veteran equipment finance professionals in our Arizona market to complement our strengths in C&I and to continue adding to our already well-diversified loan portfolios. All these efforts resulted in an increase in net interest income of approximately 8% and adjusted net interest margin expansion of 13 basis points during the quarter. Moving on to fee income, which is the strategic differentiator for Alaris. It contributed to over 53% of total revenues and we ended the quarter at 43.6 billion of AUA and AUM. All core underlying businesses business lines saw fundamental improvement with total fee income increasing 8.1% during the course. Our retirement leader, Forrest Wilson, who joined us just a few months ago, has made an immediate impact, including assembling a talented retirement leadership team and addressing strategic opportunities, which we believe will continue to improve client retention, client acquisition, and overall profitability of this highly valuable division. The retirement industry national rankings were recently published, with Alaris moving ahead for the first time to a top 25 or better in all categories measured, including assets, plans, and participants. Our growing wealth management division delivered another solid quarter of results with continued momentum driven by strong core business within the mass affluence and the high net worth client base. New revenue pipelines remain strong and synergistic opportunities are building. We delivered a solid quarter of managing expenses, With expenses down slightly, while we continue to invest in talent, we remain committed to thoughtfully managing these investments through FTE Count. These disciplined efforts focused on constant improvement, leveraging our technology platforms better, and seeing higher production and revenue generation with a similar expense base are all part of our path to continued improvement in efficiency and profitability. During the quarter, we recorded a $4.5 million provision expense. resulting from expected gradual credit normalization towards more historical levels from the past years of completely benign credit metrics. After 15 straight quarters of immaterial charge-ups or net recoveries, we had a charge-up of a non-accrual C&I loan that was nearly fully reserved for in previous quarters. Our allowance to loan losses remained at 1.31%, consistent with prior quarters, as we replenished the balance to account for loan growth and the impairment of a previously identified problem loan, which was moved to non-accrual during the quarter. This previously classified loan is a commercial real estate construction loan that has had missteps in the construction process. The market data supports the feasibility of the project, and the borrower has injected additional capital into the project. They have additional levers to pull to keep this project moving forward through stabilization. We continue and remain committed to prompt identification and movement in credits where there are challenges. And given the additional time needed to execute these options for this particular credit, we determined it was prudent to place this credit on non-accrual. We have reviewed our commercial real estate construction deals and all are performing as expected. The broader loan portfolio continues to perform well and overall classified loans trended down in the second quarter with material upgrades and payoffs. Our priority and core focus continues to be building our commercial wealth bank, and our loan mix will continue to trend to higher levels of C&I, which today accounts for approximately 30% of the portfolio, with another 30% to consumer and residential, and the remainder in a granular and well-diversified CRE portfolio. Overall, investor CRE levels at 213% remain well within regulatory thresholds and well under most of our peer groups. In addition to robust reserve levels at 1.31%, we remain well positioned with healthy capital levels with a CET1 of 11.7% and adjusted TCE of 7.91%. During the second quarter, we continued our long history and raised our dividend of raising our dividend and raised it by another 5.3%. Lastly, a quick update on the recently announced acquisition of HMN Financial. As a reminder, this is our 26th acquisition and the teams are working great together, leveraging the experience and the expertise to seamlessly integrate our two great companies. We are also progressing on schedule through the regulatory and shareholder approval process and we continue to anticipate a closing in the fourth quarter of this year, as indicated previously. I will now hand it over to Al Villalon, CFO, for additional recap and guidance.

Thanks, Katie. I'll start my commentary on page 13 of our investor deck that is posted on the investor relations part of our website. Let's start on our key revenue drivers. On a reported basis, both net interest income and fee income grew over 8% during the quarter. The increase in net interest income was driven primarily by strong organic loan growth, growth in non-interest-bearing deposits, and continued expansion of our core net interest margin. Growth in fee income was primarily driven by an increase in overall asset-based and non-market-based fees within our wealth and retirement business lines, and a seasonal rebound in mortgage. Fee income continues to be a large component of overall revenues and a differentiator for Laris. I'll go into detail about each of our fee income segments in later slides. Turning to page 14. Net interest income increased to over $24 million in the second quarter, primarily driven by improving loan yields and strong loan growth coupled with stable deposit levels. The Bank Firm Funding Program arbitrage was also created to net interest income by $459,000. Within the quarter, we recognized approximately 10 basis points of total accretion from the 2022 Metro Phoenix Bank Acquisition. Excluding purchase accounting accretion from the Metro acquisition and the impact of the BTSP, core net interest margin still expanded six basis points to 2.46% from 2.4% in the prior quarter. In the upcoming quarter, we still expect our net interest margin on both a core and reported basis to improve a couple basis points. Excluding the impact of MPB and our swaps, our ALM modeling shows our NII increasing mid-single digits should the Fed cut by 100 basis points. Based on Fed dot plots, we still see a path for our NIM to exceed 3% in 2026. Should the Fed cut more aggressively, we anticipate reaching 3% sooner. Let's turn to page 15 to talk about earning assets. Since the acquisition of Metro Phoenix Bank, we had our seventh consecutive quarter of loan growth. Over those seven quarters, we grew loans at an average unannualized rate of over 3% per quarter. We continue to let our investment portfolio run down as we remix low-yielding securities into higher-yielding loans. For the remainder of 2024, we continue to grow loans, even with 6% of our loans contractually paying down in the second half of the year. Turning to page 16, on a period-ending basis, our deposits increased 0.4% from the prior quarter. While we saw our usual seasonal outflows from our public funds, we continued to drive organic deposit growth to offset these outflows. Importantly, non-interest-bearing deposits grew 1.3% in the quarter and remained stable at 21% of total deposits. During the quarter, our deposit activity was impressive as average account size wins were double the size of accounts lost during the quarter, and we continued to experience a net increase in overall accounts as well. Given the stable deposit levels, our loan-to-deposit ratio was well below our target level of 95%. For the third quarter of 2024, we continue to expect a seasonal outflow of approximately $80 to $100 million. While these outflows of pressure deposit balances in the upcoming quarter, we do expect deposit levels to be slightly higher from current levels at the end of the year. Turning to page 17, I want to talk about our banking segment, which also includes our mortgage business. I'll focus on the fee income components now since I already covered net interest income. Overall non-interest income from banking was up 1.4 million or 39% from the prior quarter. Most of the increase was attributed to a seasonal rebound in our mortgage business. During the quarter, we also recognized $628,000 in swap fees as we've continued to grow our mid-market C&I banking business. As a reminder, this swap income is client-driven, so it tends to be lumpy and unpredictable. For the third quarter, we expect the overall level of non-interest income to decrease slightly from the second quarter levels, as we expect mortgage revenues to slow and non-interest income to be closer to a normalized level of $1.5 million. On page 18, I will provide some highlights of our retirement business. Total revenue from the business increased 2.7% from the prior quarter, driven by both asset-based and non-market-based fees. End-of-quarter assets under management increased 2.3%, mainly due to improved equity and bond markets. Participants within retirement grew almost 1% during the quarter. For the third quarter, we do expect the income from retirement business to be stable. Turning to page 19, you can see the highlights of our wealth management business. On a linked quarter basis, revenues increased 4%, while end-of-quarter assets under management decreased 1.7%, mainly due to an outflow from one custody client in the quarter where we charged minimal basis points. For the third quarter, excluding any market impact, we expect fee income from our wealth business to be up slightly, given the continued improvement in the markets. Page 20 provides an overview of our non-interest expense. During the quarter, non-interest expense decreased 0.7%. During the quarter, we also incurred $560,000 in one-time merger-related expenses related to the pending acquisition of HMN Financial. Excluding these merger expenses, core non-interest expense decreased 2.1%. We now expect total expenses for 2024 to grow mid-single digits when compared to 2023 on a reported basis, as further merger-related expenses will be incurred. Turning to page 21, you can see our credit metrics. We had net charges to average loans of 36 basis points in the quarter, primarily related to a non-performing loan, which already had an individual reserve allocated in the prior quarters. Our non-performing assets, the total assets percentage was 63 basis points compared to 17 basis points in the prior quarter. This is still below the industry average for regional banks of approximately 73 basis points over the past decade. As Katie mentioned, the increase was related to one previously identified construction loan that was moved to non-accrual status. I will discuss our capital and liquidity on page 22. We continue to remain very well capitalized as our common equity tier one to risk weighted assets is 11.7%. We also maintain our status as a dividend aristocrat. We increased our dividend consistently over the last 20 years. On the bottom right, you will see the breakdown in the sources of over 2.5 billion in potential liquidity. Overall, we continue to remain well positioned for both liquidity and capital standpoints to support future growth or weather any economic uncertainty. To summarize on page 23, we had a robust second quarter as pre-provisioned net revenue improved over 48% from the prior quarter. We continued to see strong organic loan growth and strong deposit growth that offset any seasonal outflows. Our net interest margin continued to improve as we continued to see a path where margins improved to over 3%, even if the Fed remains on pause. Our fee businesses also drove and improved returns, which continues to differentiate us in the industry. We remain focused on driving revenue growth and managing expenses, leading to positive operating leverage improvement during the quarter. Both our reserve and capital levels remain strong to weather any economic uncertainty. And with that, I will now open up for Q&A.