Alerus Financial Corporation

Hello, everyone, 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 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 statement. 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 feelings. I would now like to turn the conference call over to the Alaris Financial Corporation President and CEO, Katie Lawrenson, to begin. Katie, please go ahead.

Thank you. Good morning, everyone. Thank you for joining us today for our quarterly earnings call. Here in the Twin Cities today with me is Al Villalon, our CFO, Karen Taylor, our Chief Operating and Risk Officer, and Jim Collins, our Chief Revenue Officer and head of our Commercial Wealth Bank. Horace Wilson, our Chief Retirement Service Officer, is also joining us on the call. I'll start the call with some prepared remarks and strategic highlights for the quarter. Al will spend a few minutes hitting on the key financial highlights, and then we will address your questions. There is no question that this was a tough quarter for Alaris. We are not and will not be satisfied with our results until we are delivering superior returns. That being said, we also firmly believe success is not measured by a single quarter, and while the third quarter came up short, it was also a period of continued progress and execution of our key long-term strategic initiatives for our company. While the path to returning to top performance is not linear, the substantial strides we've made demonstrate our commitment to achieving our consistent top-tier performance. Our focus remains on driving shareholder value through steady growth, diversified revenue, positive operating leverage, and maintaining conservative underwriting standards. Let me begin with the transformational changes we've been making over the past year and a half as we build a premier commercial wealth bank. Over this period, we have added key talent, continued to diversify our loan portfolio, and closed on our largest acquisition to date. We have also managed through the challenging work of numerous restructurings, right-sizing, and exiting of several business lines which were not core to our focus. Regarding talent, we have worked with urgency on getting the right people in the right seats, and our great culture and best-in-class diversified business model has allowed us to retain top talent and recruit dozens of new team members to the company, including many key hires with areas of deep expertise. Our additions on the revenue-producing side are supported with key hires and continued investments in risk management infrastructure. These are all long-term investments that put some near-term pressure on operating expenses, but are critical to growing in the right way to support the consistent top-tier returns we expect to deliver in the future and have delivered in the past. A key strategic priority was and will continue to be to build strong mid-market and business-making C&I teams in our larger markets to support the well-established and successful teams in our North Dakota markets. Changes of this significance take time to show through to the bottom line, but the momentum is clear, with nearly 45% of year-to-date loan originations to C&I clients, compared to our pre-transformation origination percentages of 17%. We recently rolled out our formal private banking offerings after adding a team of professionals, and the synergies between wealth management, commercial banking, and mortgage are exceeding our expectations, particularly in deposit and wealth generation. We remain deeply committed to diversification and believe establishing verticals to augment traditional C&I banking is important to growing the client base and expanding relationships. We've added specialty areas of SBA, government not-for-profit, and most recently our equipment finance vertical. Turning to our most recent announcement, which was the receipt of regulatory approval and the closing of our home federal acquisition, both of which happened in the expected time frame, and a signal of our position of strength, relationship with our regulators, and capabilities in executing acquisitions. The Home Federal Partnership is our 26th acquisition in the past 20-ish years. Our playbook of integration is proven, and in this particular partnership, the conversion is more straightforward than the previous smaller banks we've acquired. We are so pleased with the leaders and the banking group that have joined us. Together as a bigger company, we are committed to getting better and achieving the results in our pro forma company and feel confident in our ability to do so. As for the results for the third quarter, Our deposit growth for the year is over 7%, and despite facing the headwinds of seasonal outflows, we held deposits flat by continuing to win new clients despite the incredibly competitive environment. We experienced some deposit migration, but it's important to note the majority was simply movement in between accounts. We continue to operate with no broker deposits and highlight our CD portfolio that is core clients with a rollover rate in excess of 96%. Loan growth was also robust during the year, with the majority of business coming from market share gains of long-established companies. Although the economy in our market continues to be strong, we remain highly selective. And in commercial real estate, where we run below regulatory guidelines in terms of concentrations, we are stringent with our dry powder, reserving capacity for the highest quality sponsors with underwriting structures that fit within our time-tested underwriting standards and those relationships that deliver superior ROEs. Credit quality remains a key area of focus. Early identification of problem loans coupled with proactive and decisive actions are part of our credit culture. We continue to closely monitor and proactively downgrade loans where we see potential or emerging weaknesses. We monitor at the individual loan level on an ongoing basis every one of our large multifamily projects, and we do not see systemic issues in this portfolio. However, Normalization of credit in the broader portfolio continued during the quarter as two large relationships drove the increase in non-accrual loans, of which we believe we are adequately reserved. One of the loans was a long-term bank and wealth client who has experienced personal issues, and the other was an acquired CRE loan originated in 2021 that was identified as higher risk during our due diligence. Credit migration has come from the watch category and we have not backfilled despite continuously reviewing our portfolios through annual reviews, independent internal and external loan reviews. Charge-offs to average loans remain low for the quarter at four basis points and reserves to loans were stable at 129. Al will cover the margin in more detail, but I won't shy away from the reality of the magnitude of this. We did take a step back to 223 after a much anticipated step forward last quarter. Our long-term guidance remains intact. The NIM was impacted by non-accruals and continued pricing pressure on deposits. We have consistently discussed the impact of deposit competition in our market, where many banks face high loan-to-deposit ratios and a reliance on broker funds. The competition remains fierce, and we are focused here again on the long-term, retention and doing what's right. We have evaluated all exception price deposits on an account-by-account level, and we will be adjusting incentives to correlate with volume and pricing. Also, always a highlight for Alaris is our Wealth Management Division, which has consistently grown top-line revenue for many years. Our advisors are the best in the business, and our wealth business is deeply embedded in our business lines, with over 40% of our clients sourced from part of our retirement-focused business, and 20% of our wealth clients with a personal or commercial banking relationship. We know how special our wealth business is, and we are completely committed to continuing to invest in the business. We recently signed to move to a new technology platform that will transform the client experience and greatly improve the processes for our advisors and their support team. This technology upgrade will help build on our established success in recruiting advisors, as we offer a great user experience and the exceptional synergies advisors are able to leverage from our retirement business. Speaking of our retirement business and our ultimate differentiator when it comes to value creation, given the recurring nature of the business with minimal capital allocation. Here, too, we have new leadership, new team members, and an enhanced structure. The team had a record quarter of new revenue, and we see continued positive growth trends in plans and participants, which is where the majority of our new fees are sourced. National partnerships are one of the key initiatives in building our business, and we are pleased with the progress and the momentum we are seeing so far. We will continue to invest in this business with key talent additions and technology to improve efficiencies, increase automation, and strengthen overall margins in the business. Year-over-year core non-market-related revenues are up 5%. We are very bullish on the retirement industry and our business and view the recent legislation of Secure Act 2.0 as a key catalyst in continuing our trend of improving organic growth. Moving on to expenses during the quarter, which trended upwards due to a few factors. the addition of key hires, and the correlated severance and retirement-related packages, in addition to M&A-related expenses, which were $1.7 million. We had some lumpiness between the quarters related to FDIC insurance, and we had some increases in professional fees, which I would characterize as operational but not recurring. We believe each of our revenue-producing hires will contribute to an improving efficiency with higher levels of production and more profitable business. Platform and technology changes in our wealth and retirement business will also greatly improve our processes, which will lead to efficiencies, all of which will allow us to continue to effectively manage headcount in the company. In regards to capital levels, they bounced back closer to core with the payoff of the BPFP, and we grew book value by 4.6%. Our book value continues to include $63 million of AOCI that will be recaptured over the coming years. We believe in maintaining a fortress balance sheet and remain committed to our long history of delivering dividends to support returns to our shareholders. We have not been active in repurchases due to the recently closed acquisition, and our priorities remain focused on organic growth, but we absolutely understand the value of the sum of the parts of our business and will be active if deep disconnects on value present themselves. With that, I will turn it over to Al for specifics on the quarter.

Thanks, Katie. I'll start my commentary on page 11 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, net interest income decreased 6.1% over the prior quarter, while fee income grew 3.6%. The decrease in net interest income was driven primarily by lower purchase accounting accretion from the Metro Phoenix bank acquisition, an increase in non-accruals, and a higher interest expense due to a mixed shift from non-interest bearing deposits to interest bearing deposits. Growth and fee income is primarily driven by an increase in overall asset-based fees within our wealth and retirement business line, and from a gain recognized in the sale of one of our offices. Turning to page 12, in the third quarter, we can dive into net interest income a little bit more closely. Net interest income decreased to $22.5 million, and our core net interest margin decreased primarily due to three factors. The first one being lower purchase account increase for Metro Phoenix, as you can see above, decreased from 10 basis points to two. less net interest income due to higher non-accruals, and higher interest expense from an increase in interest-bearing deposits. At the end of the quarter, we repaid our borrowings from the BTFP as the Fed recently reduced interest rates. So going forward, our reported net interest margin will no longer reflect the drag from these low interest earning assets. We continue to see a path to our net interest margin reaching 3%. The path will not be linear as each quarter will have their different factors affecting net interest margin. For the migration of non-interest-bearing deposits to interest-bearing would drive our cost of funds higher. Turning to page 13, we can talk about earning assets. Since acquisition of Metro Phoenix Bank, we had our eighth consecutive quarter of loan growth, as loans grew 4% over the prior quarter. We continue to let our investor portfolio run down as we mix low-yielding securities into higher-yielding loans. Turning to page 14, on a period and basis, our deposits increased 0.8% from the prior quarter. While we saw seasonal outflows from our public funds, we continued to drive organic deposit growth to offset these outflows. Given the 2.7% growth in interest-bearing deposits and 6.3% decline in non-interest-bearing deposits, non-interest-bearing deposits are now 19.8% of total deposits versus 21.3% in the prior quarter. Given the stable deposit levels overall, our loan-to-deposit ratio was 91.2%, which is well below our target levels of 95%. We continue to not utilize any broker deposits for funding needs. Turning to page 15, I'll now talk about our banking segment, which also includes our mortgage business. I'll focus on the fee income components now since interest income was previously discussed. Overall non-interest income for banking was up to $600,000 or over 12% from the prior quarter. Most of the increase was from a gain recognized in the sale of one of our offices in the Minneapolis metro market. For the fourth quarter, we expect the overall level of non-interest income to decrease from third quarter levels as we expect mortgage revenues to slow on the back of a seasonal slowdown in originations. On page 16, I'll provide some highlights on our retirement business. Total revenue from the business increased 0.4%, while assets under management increased 4.7%, mainly as equity and bond markets continue to improve. Participants within retirement grew 1.5% during the quarter. New business production continues to be strong as over 500 opportunities were won this year. For the fourth quarter, we continue to expect fee income for our retirement business to be stable. Turning to page 17, you can see some highlights from our wealth management business. On a linked quarter basis, revenues increased 5.1%, while our end-of-quarter assets under management increased 5.4% due to continued improvement in equity and bond markets. For the fourth quarter, excluding any market impact, we expect fee income from our wealth business to be up slightly. Page 18 provides an overview of our non-interest expense. During the quarter, non-interest expense increased 9.5%. During the quarter, we did incur $1.7 million of one-time merger-related expenses related to recently completed acquisition of HMN Financial. Excluding these merger expenses, core non-interest expense increased 7.6%. Compensation and benefits saw an increase due to onboarding the equipment finance team, additional key hires, and from an increase in employee benefits. We also saw an $800,000 increase in professional fees excluding M&A-related activity due to increased examination and audit expenses. For the fourth quarter, reported expenses will increase due to merger of acquisition expenses related to Home Federal Deal. For 2025, we are still committed to achieving 30% cost as announced in the Home Federal Acquisition. Turning to page 19, you can see our credit metrics. As Katie covered a lot of this in her prepared remarks, I'll go to the next slide. I'll discuss our capital liquidity on page 20. We continue to remain very well capitalized as our common equity tier one capital to risk weighted assets is 11.1%. Our tangible common equity ratio also improved 85 basis points to 8.11% as we saw an improvement in unrealized losses. And we repaid the BTFP. Post-acquisition of Home Federal, we now have an outstanding share of over $25.3 million, which is in line with our original deal assumptions. Additionally, we also added over $868 million of loans and $952 million of deposits. 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 to support future growth or whether any economic uncertainties. Summarized on page 21, we continue to see strong organic loan growth and strong deposit growth, which offset any seasonal outflows. We continue to see positive momentum in our retirement and wealth businesses. Both our reserve and capital levels remain strong to weather any economic uncertainty. With that, I will now open up for Q&A.