Alerus Financial Corporation

Good morning and welcome to the Alaris Financial Corporation Earnings Conference Call. All participants will be on 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 statement. Important factors that could cause actual results to differ materially from those indicated in the forward-looking statement 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's President and CEO, Katie Lawenson. Please go ahead.

Thank you. Good morning, and thank you for joining us today. I'm Katie Orenson, President and CEO, and I'm pleased to be here with our Chief Financial Officer, Al Hillelon, our Collaborating Officer, Karin Taylor, our Chief Banking and Revenue Officer, Jim Collins, and our Chief Retirement Services Officer, Forrest Wilkins. Each of these leaders continues to play a crucial role in driving our company's progress to transformational growth and top-tier performance. This quarter marks a significant step forward in our journey to deliver long-term, sustainable top-tier performance as we reported an adjusted earnings per diluted share of of 72 cents, which represents an adjusted return on assets of 1.41%. Our results reflect our efforts to build on the strength of our uniquely diversified business model, combining traditional commercial and private banking with the highly valuable and capital-light fee-based businesses in wealth management and retirement benefits. This business model not only differentiates us in the growing communities and client base we serve, it also provides resilience across economic cycles and the ability to outperform traditional banks. We're seeing encouraging momentum across our core businesses. The transformation in our commercial wealth bank is nearing completion, with our focus turned towards maximizing the capacity in our organization and infrastructure to further enhance profitability. While we continue to see the benefit of purchase accounting, we are replacing this with disciplined pricing on renewals of the core client base. During the quarter, deposit outflows were as expected from public and tax payments, while client retention in legacy layers and the recently acquired home's federal portfolio remained at high levels. We see robust opportunities in our lending pipeline, but we'll continue to be highly selective with our team focused on deposit-based opportunities and prioritizing full C&I relationships. We also took proactive steps to optimize our balance sheet, including the strategic sale of $60 million in non-owner-occupied CRE hospitality loans, which resulted in a next $2 million gain during the quarter. As a result of the sale, we were able to reverse related reserves on the portfolio, which allowed us to record no provision for the quarter. Reserve levels remain robust at 1.47% of loans, and notably net charges were limited to seven basis points when excluding the accounting entries of the hospitality loan sale. Industry-leading fee income of more than 42% will be the ultimate differentiator of our valuation. The cornerstone of our top tier fee income levels is our retirement and benefits business. Our talented team continues to execute on several key strategic initiatives to grow our business, secure meaningful partnerships, and make impactful operational improvements. We remain bullish on this business given the scale of the Secure Act 2.0 in addition to growing opportunities for M&A. The value of the retirement business is multifaceted due to the stability and durability it brings to our company's earnings with minimal capital allocation and balance sheet risk in addition to the tangible synergies we leverage in deposits and the capture of wealth business. Similarly, our wealth business has strong momentum and we're investing in talent and technology to deepen client relationships and expand our reach. As an enhancement for the business, we upgraded our wealth management platform which will allow us to continue to progress in our long-term goal of doubling the number of wealth advisors and growing our access under management at the same pace as our banking assets. It showed up to all of our team members and wealth advisors who made this conversion seamless for our clients. Results of our team's focus on expense management are evident, with another quarter of improvements in our efficiency ratio. We continue to balance our investments in talent and technology with long-term and sustainable improvements while optimizing everywhere. In short, we're making significant progress, This quarter's results were excellent, and I want to thank our team members for their continued efforts to return awareness to top-tier performance. We know this path is not linear and requires an unwavering focus on constant improvement and expense management. Our guidance for the year remains consistent with prior quarter's communication with the ultimate goal of achieving this quarter's level of performance consistently. The foundation is solid, the strategy is clear, and the opportunity ahead is compelling. Thank you again for your continued support, and I'll turn it over to Al to walk through the financials in more detail.

Thanks, Katie. Turn to page 11 of our investor deck that is posted in an investor relations part of our website. On a reported basis, net interest income increased 4.6% over the prior quarter, while fee income increased 15%. The increase in net interest income was primarily driven by remixing of maturing loans being replaced by organic loan growth at higher spreads, while interest expense remained relatively stable. Our fee income remained over 40% of revenues, and the low of interest rate averaged at 19%. Let's dive into the drivers of net interest income in the next slide. Turning to Phase 12, in the second quarter, managers' income continued to reach new heights at $43 million, and our reported managers' margin increased another 10 basis points to 3.51%. Our managers' margin continued to show improvement. Our total cost of funds remained stable at 2.33%. We had 25 basis points of purchase accounting increases in the quarter. Of those 45 basis points, 9 basis points were from early payoff. We remain disciplined in pricing as we continue to not price on the version of the yield curve for loans. In the second quarter, we continue to see strong spreads, which contributed to the quarter's net interest margin expansion, and the average rate on the loan portfolio during the quarter increased eight basis points from the end of the first quarter. Let's turn to pay security and talk about our earning assets. At the end of the second quarter, we were sold and classified and held for sale over $60 million of hospitality loans. Net gain from the sale of all these loans was over $2 million. Excluding the loan sale and the intensification, loan growth was approximately 0.5% over the prior quarter, with the most growth in C&I and owner-occupied CREs. We remain focused on full relationships within the middle market and business banking space. For the remainder of 2025, we expect over $271 million of loan contractual maturities, which is almost 7% of total loan. Our best portfolio declines at $807 million, or just around 16% of earning assets. AOCI improves an unreliable loss of under $60 million. For the remainder of 2025, we expect over $45 million, or close to 6% of the total portfolio, of principal payouts with a yield in the low 2% range. We will continue to invest, but the balance sheet remains a low-yielding investment for higher-yielding loans. Turn to page 14. On a period-ending basis, our deposit shrank 3.3% as we saw expected seasonal outflow from public funds and our clients using liquidity to meet tax applications. Since 2010, the median decrease in deposits from one QDC due has been over 5%. We do expect that seasonal volatility continuing increases our average deposit account size has gone over 20% since the end of 2019 due to our focus efforts to grow in the commercial space. Lastly, since the hold of acquisition of Home Federal, our net retention rate remains close to 97%. During the phase 15, I'll now talk about our banking segment, which also includes a mortgage business. I will focus on the fee income components now since net interest income was previously discussed. Overall non-interest income from banking was $8.4 million for the second quarter. The quarter concluded a $2.1 million gain rate and a sale of hospitality loans. very low swap income this quarter, which tends to be lumpy from quarter to quarter. On page 16, I'll provide some highlights on the retiring business. Total revenue from their business was relatively stable at over $16 million. Retiring services continues to be a stable and reliable source of fee income and is not a capital-intensive segment. Passes under administration and management increased 0.3%, mainly due to market performance. We continue to see solid business production with over through the first half of 2025. During the phase 17, you can see highlights for our wealth management business. On a late quarter basis, revenues increased 6.6%, while end-of-quarter assets under management increased 2.5%, mainly due to market performance. During the quarter, we transitioned to a new platform that will deliver a better experience for both clients and financial advisors. With a new and highly regarded system, we not only provide the unique value proposition to our clients, but we also are able to differentiate ourselves in our recruiting efforts to add more law advisors. Day-to-day teams provides an overview of our non-existence expense. During the quarter, non-existence expense decreased 3.8% due to a seasonal decrease in benefits, less acquisition expenses in the quarter on a reported basis, and due to an insurance reimbursement. Our adjusted efficiency ratio was 52.4% versus 66.9% in the prior quarter. Most of the improvement in our adjusted efficiency ratio was driven by both core expense and revenue improvement. Turn to page 19, you can see our credit metrics. During the quarter, adjusted net charge-offs were only 7 basis points, which excludes the impact of the Hoppitelli loan sale. Non-performing assets remained stable at 98 basis points compared to the prior quarter. We continue to have close to $7.8 million in reserves related to the seasonal double count and approximately $50 million of fair value marks related to the whole federal acquisition. I'll discuss our capital liquidity on page 20. We continue to remain well capitalized with our common equity to one capital ratio to risk-weighted assets at 10.5% or a tangible common equity ratio of 0.5%. On the bottom right, you'll see a breakdown of sources of $2.7 billion in potential liquidity. We did utilize some broker deposits in the quarter to optimize our funding structure. Overall, we continue to remain well-positioned from both a liquidity and capital standpoint to support future growth. On page 21, I will now update you on our guidance for 2025. Our guidance for the year remains consistent with prior quarters and has not materially changed. While we continue to make improvements, given the seasonality we experience in our businesses, improvement is never linear from quarter to quarter. We are still expecting loans over mid-single digits for 2025, excluding loans moved to help for sale. Deposit growth over low single digits remains the same. For the third quarter, though, we will see continuous seasonal deposit outflows from our public funds. Net interest margin of 3.25% to 3.35%. Within this guidance, we are assuming several things. purchase account accretion in the back half of the year. We're expecting less in purchase account accretion for the remaining quarter due to accelerated payoffs already recognized. Currently, we're expecting 27 basis points of purchase account accretion in the third quarter, which is an 18 basis point reduction compared to the second quarter. For the fourth quarter, we're only expecting 22 basis points of accretion. Both accretion numbers are based on contractual payoff data. Second, we are not expecting any early payoffs, which has averaged over eight basis points over the past three quarters since the closing of the home federal acquisition. Lastly, we're expecting an increase in deposit costs by eight to ten basis points due to mischief in deposits and continued competition. We expect our non-existent income per year to be up low single digits now on a reported basis due to the gain on loan sales recognized in the first half. On the mortgage side, we expect mortgages to ease a little in the third quarter and hit a few low downturns in the fourth quarter. We expect our adjusted efficiency ratio to include one-time items to be below 68% for the 2025 as we continue to realize cost savings from home federal. In the upcoming third quarter, we expect our core expenses to be around $49 to $50 million as we recognize investments made in our core business lines in talent and technology. To summarize on page 22, we continue to build on the momentum we saw in the first quarter. Adjusted pre-provision net revenue grew 23.2% over the prior quarter. A current adjusted ROA of 1.41% and adjusted ROTCE of over 21% are definitely an awkward fellow in the banking industry. We see this as another thought quarter in the line of war to come. With that, I will now open up the Q&A.

Thank you. We will now begin the question and answer session. To ask a question, you may press star then 1 on your touch screen. If you are using a speakerphone, please pick up your handset before pressing the keys. to ensure your questions, please press star then two. At this time, we will pause momentarily to assemble our roaster. The first question comes from Jeff Arulis with GA Davidson. Your line is open, Jeff.

Thanks. Good morning. Al, I just wanted to circle back on it. I missed the margin piece there or components of it. It sounds like accretion was running a little high. Could you repeat? Did you outline third quarter accretion expectations and fourth?

Yes, I did. So, Jeff, for the third quarter, we're expecting 27 basis points of purchase economy accretion. And for the fourth, we're expecting 22 basis points. Neither of those numbers has any early payoffs embedded in it.

Okay. And I guess if we kind of unpack on a core basis, expectations for on the core side in the second half.

Yeah. Well, in the second half, we still expect at the end of the year to have core margin improvement. As you can see, this is spreads on both moments of deposit speed of our core, you know, Thanks, Martin.

Got you. Thanks. And then the, um, I think he's the non-interest income guy. You said the up low single digits is inclusive of the game this quarter? That is correct, yes. Okay. Got it. Um, Thanks. I guess hopping over to the credit side, I wanted to check back in on the larger construction credit. I think we were headed towards occupancy or listing for sale this summer, June and July. So I just wanted to check back in to see where the status of that is.

Sure, Jeff. This is Karen. The final certificate of occupancy was issued, and the property was listed for sale in the second quarter. That's a top listing. The project continues to reset. It's currently at 57%, and as that progresses, obviously it will become better positioned for sale. There's just some minor work left on the outside to complete, so it's in line with our expectations.

Okay, great. And I guess on the CRE side, Could you remind us what deal was that and then are more cleanup in that segment contemplated?

Are you referring to the loan sale or to this particular construction project?

The loan sale project in the hospitality side.

The hospitality loan sale was part of the home federal portfolio. You know, we saw an opportunity on that particular portfolio. The underwriting standards were a little bit more liberal than ours, and we had those loan marked, and there was a market for those loans. So it was a good opportunity. We'll continue to look for those opportunities to reduce risk in our balance sheet and make sure that our reverses are aligned with our strategic objectives.

Okay. I mean, I guess the question is, do you think you've re-influenced the areas where that underwriting was a little more liberal? Have you kind of attacked that piece, or is it a case-by-case?

No, we addressed that with our identification of purchase credit security rate as loans, and certainly this particular group of loans was in that category. Okay.

Great. Thanks. I'll step back.

Thank you. Your next question comes from Brendan Noble with Hofty Group. Please go ahead.

Good morning, everybody. Hope you're doing well. Maybe just starting off on the loan sale piece. For the piece that closed in this quarter, you recorded a nice gain on that sale. Just kind of curious about the $50 million you sold in July. Any line of sight to a potential gain there?

No. Actually, it was just a very, very minimal loss on that one.

got it, got it. Maybe moving over to capital then. You folks created a fair bit of capital this quarter. Just with levels getting up to, you know, higher levels, just kind of curious how you think about deployment for the rest of this year and maybe your thoughts on the M&A landscape.

Sure. Good morning. My capital priorities remain consistent as we've discussed in the prior quarter. Growing 24 points in Q2 consistent with with where we had pro forma levels at post-home federal. We are targeting kids at age 10 or higher PCE, but priorities are organic value growth with franchise accretive clients, as well as maintaining our dividend history and M&A on the retirement side of the business, which is typically more of the bite-sized cash yields.

Okay, perfect.

I'm just going to sneak one more in here on the retirement business. You know, revenues were fairly flat for this quarter, but Al, you noted nice AUA growth, but it looks like participants were down a little bit. Maybe just talk about, you know, which of these two, AUA versus participants, had a bigger impact on revenues for this business this quarter.

Thanks. Forrest, I'm going to let you take this one.

Yeah, so can you, sorry, can you repeat that question really quick? It was the participants versus the AMA in terms of revenue. Yeah, we had some one-time effects on participants that affected us this quarter. We did some clean-out in our HSA business that was, that was very impactful to us in a negative way in terms of participant count. And that said, these were zero balance participants that we weren't making any revenue off of. So in the future, you can expect participant account, participant numbers to be going up as they have in the past and to see that trend continue. But there were some one-off events this quarter that led to that decline. Thank you for taking the questions.

We now have Damon Del Monte with KBW. Please go ahead, Damon.

Hey, good morning, everyone. Hope you're all doing well, and thanks for taking my questions. First question on the loan growth and kind of the outlook that's supporting that. Are you seeing more demand across your footprint in the way of, like, new credits and new customers coming on board, or is this the growth opportunities more from kind of leveraging your current client base?

It's leveraging the current client base, and it's taking market share. We're still not seeing a really solid, robust new generation of loans with clients and prospects necessarily. It's still... The staff that we brought in in all markets, it's really stealing market share from some of the other banks and increasing with our current client base.

Yeah, and is there any areas, any segments that are stronger than others that have better opportunity for the growth?

No, we're sticking to, you know, full C&I and really focused on that lower mid-market. So we're still really focused on manufacturing, wholesaling, and distributing. So that's really where we're focused. There's opportunities across the board in a lot of different segments, but with the team that is really zeroing in on that lower mid-market, that's where we're going to find most of our growth.

Got it. Okay. I appreciate that. And then, Al, with regards to the full-year margin outlook of the 325 to 335, is that, like, on a reported basis? So, including, like, you know, the benefit you guys got from the kind of the accelerated fair value accretion?

Yes, that is on a reported basis.

On a reported basis. Okay. Okay, great. Anything else to ask and answer? Thank you. Thank you.

We now have Nathan Rice with Piper Spangler. You're on your way, Nathan.

Hi, everyone. Good morning. Thanks for taking the question. In your prepared remarks, you referenced, you know, some technology upgrades and, you So just curious, maybe Katie, if you can kind of speak to how some of these technology initiatives could increase kind of the cap rate across new clients within the various franchises and just how you see, you know, opportunities to also increase existing client wallets here with all these upgrades as well.

Sure. I'll start and then Jim can add on where I'm at. So we did a full conversion of our wealth management business that was completed in the second quarter. It went very well. And this platform really improves the client experience as well as the advisor experience and the operational experience. And so we believe, you know, besides our differentiated recruiting proposition that we have to advisors, this platform allows us to kind of level us back in terms of their experience in addition to the opportunities that they have within our organization because of the retirement synergies.

I would say Katie's right on. The new platform on the wealth side will allow us to leverage our current staff and then allow us to recruit better and it will be a better client experience. It will also allow us better analytics to dive into that synergistic relationship and see where we can help our clients in the other areas that we have in the wires. The other piece is when we have a very solid project management group to grow our C&I and we're putting on a new online retail and commercial online system, which acts the same way as the wealth platform, better customer experience, better analytics, and a steeper market will be better.

Okay, great. That's helpful. And then just turning a credit, you know, your non-performers are still, you know, almost 2x that of peers on a relative basis. You just look at the percentage of loans. So maybe, Kar, I'm just curious to get some thoughts on kind of the outlook for some larger resolutions and just opportunities to bring down non-performers going forward.

Yeah, good morning, Nate. You know, The numbers are really being driven by the same two large relationships that we've been talking about the last couple of quarters. And so, as I mentioned earlier, the construction deal is performing as expected in terms of meeting timelines. Realistically, that's probably an early 2026 resolution. The other one is that large residential relationship, and we are pursuing legal action on that. And I would expect that would also be a first half 2026 resolution.

Okay, great. And then maybe Al, appreciate all the commentary on the margin outlook, but can you just maybe update us in terms of the balance sheet sensitivity to a 25 basis points bed cut?

Yes. Made on a 25 basis points bed cut, we do expect earnings to improve about five basis points. As a reminder, though, our guidance does not have any rate cuts embedded in it.

Great. Okay. Great. I appreciate all the support.

Thank you. Thanks, Dave. Thanks, Dave.

Thank you. We now have David Long with Raymond James. Your line is open.

Good morning, everyone. Al, I just want to confirm on this deposit, what deposit costs are. Did you say up eight basis points in the third quarter? And then as a follow-up, just wanted to get a better understanding of what your assumptions are tied to that, and then also maybe some color on overall deposit competition.

David, what I guided to was about eight to ten basis points of deposit costs increase in the third quarter, and then stable from there going forward.

The deposit competition is tough, right? We have staffed up with a couple seasoned commercial deposit bankers and obviously I think I talked about earlier we have a solid treasury management group. So our strategy is still focused on full relationships of mid-market C&I and business banking. I think we have the pieces in place but the competition is tough and deposits are always hard to forecast but We're sticking to our strategy.

Right. And just depending on that data, too, I mean, if you're thinking about, you know, competition, we are expecting some mixture from the non-experience and the experience that's going to put that pressure as part of the 8 to 10 basis points increase that we're driving to.

Perfect. Thanks for that additional comment. Thanks, guys.

We now have a follow-up from Brendan Nosal with HubDegree. Please go ahead. Brendan, please could you ensure your line is unmuted locally before speaking?

seeding kind of outlook, because it looks like year-to-date you've got quite a bit of momentum. I think, you know, core fees are up, I don't know, 10 or so percent year-over-year through the first half. So, just kind of help me square up the progress you've made year-to-date versus that, you know, relatively stable fee outlook year-after-all of this year.

Right. Part of it, too, Brendan, is that, one, we're not, you know, forecasting any market outlook for the remainder of the year. Number two, We are expecting a seasonal downturn in our mortgage business. So the fourth quarter typically is one of our weaker ones for us. And now there's some pressure in the feed from as well. And we're expecting a little bit of a pullback maybe through the third quarter in mortgage. Okay.

Okay. That's helpful. Thank you.

Thank you. We have another follow-up from the line of Nathan Reyes with Piper Sandler. Please go ahead when you're ready.

Yeah, thanks for taking the follow-up. You know, it seems like there's been a good amount of M&A-related disruption in the Twin Cities lately, so, you know, just curious maybe what the upside is to hire some additional producers, maybe on the commercial or private world side, or if, you know, you think some of the share gains are possible just with the existing team's capacity.

I would say at this point we have capacity with our existing team, but we are always opportunistic, so if there comes a situation where we find the right person that can come into our culture and add some benefits to us right away, we would look at that. But right now, I would say we're pretty set with the team we have.

Okay, great. Thank you.

Thank you. I can confirm this does conclude our question and answer session. And I would like to turn the conference back over to Katie Lawrence for any closing remarks.

Yes, thank you. Thank you, everyone, for taking the time to listen and for your investment in Alaris. Thank you to our team members who continue to make Alaris better every day. While the macroeconomic uncertainty and competitive pressures remain, we're staying disciplined and focused on getting better and bigger. Managing credit risk proactively, maintaining strong capital and reserve levels, and investing in areas that align with our long-term strategy. While we acknowledge there's more work to do, we're confident in the path we're on, and we're proud of the incredibly talented team we have in place. Thank you, everyone.

Have a great day.

Thank you. This conference has now completed. Thank you all for attending today's presentation. You may now disconnect.