Alerus Financial Corporation (NASDAQ:ALRS) Q3 2023 Earnings Call Transcript

Alerus Financial Corporation (NASDAQ:ALRS) Q3 2023 Earnings Call Transcript October 26, 2023

Operator: Hello everyone, and welcome to the Alerus Financial Corporation Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions]. After today’s presentation, there will be an opportunity to ask questions. Please also remember that this call is being recorded. This call may include forward-looking statements and the company’s actual results may differ materially from those indicated in the 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 call over to Alerus Financial Corporation President and CEO, Katie Lorenson. Please go ahead.

Katie Lorenson: Good morning. Thank you, Bruno and thank you to everyone joining our call today. We appreciate your interest and investment in Alerus. Joining me today is Alerus’ CFO, Al Villalon who will discuss our financial performance and results for the quarter. Also on the call is Karin Taylor, our Chief Risk and Operating Officer; and Jim Collins, our Chief Banking and Revenue Officer. This morning I will provide some commentary on the continued execution of our strategic initiatives and ongoing momentum in building a highly valued franchise. During the quarter, we continue to feel the impacts of the challenging interest rate environment and intense deposit competition. However, the NIM improved during the quarter and overall the deposit balances held steady.

As our team members constant focus on clients and our relationship banking model was evident as commercial consumer and synergistic deposit categories all grew in the quarter and new accounts open again surpassed closed accounts. Notably, non-interest-bearing balances remained steady at 25% of our overall deposit portfolio and highly selective disciplined modest loan growth also continued during the quarter, as we added high-quality franchise building clients to our portfolio. The loan-to-deposit ratio remained manageable at just over 90% and I’d emphasize again that this is with no broker deposits at this time. Our uniquely diversified revenue mix of 58% fee income helped to stabilize the revenue headwinds caused by the net interest margin compression.

As a reminder within this fee income mix, approximately 90% is highly annuitized recurring and non-cyclical revenue with minimal capital allocation and balance sheet risk. Specifically, Alerus’ top 25 ranked national retirement services business delivers the majority of this fee income. The business is highly valuable and we remain committed to extracting this value by growing our scaled and highly profitable product lines of the business. Last year, we exited the payroll offering and this quarter we spun off our ESOP trustee business. These strategic divestitures allow us to direct resources and prioritization on the products and solutions where we continue to have the most opportunity for growth and delivering strong returns. The core business is growing with new plans and participants, which is the driver of most of the fees.

As such, core revenues are trending higher despite headwinds due to market conditions on AUA. Several initiatives appear to have early traction and new revenue and loss revenue are tracking with expectations. Synergies from the business remain highly valuable as a key source of deposits, and we have again surpassed $100 million of annual wealth management rollovers. Moving over to our Wealth Management business, which is again focused on advisory services and planning for high net worth client segment in our geographies and mass affluent brought our footprint nationally in connection with our retirement business. Over 90% of our wealth management revenues are annuities recurring revenues with an exceptionally high level of client retention.

During the quarter, we lifted out a team of private bankers and the formal launch and integration with Wealth Management has come together quickly. Our trend of retaining dollars in the company through our holistic client service model produced key Alerus wins again driven by company sales and referrals by employees of large commercial banking clients. Our mortgage business produced results consistent with the second quarter, but it remains a very challenging environment. Expense management remained a key priority throughout the company with year-over-year expenses down nearly 8% even in the face of inflationary pressures in wages contracts and increasing assessments and professional fees. We remain balanced in our investments in attracting and retaining high-performing revenue-producing talent to support future growth while prudently building a team aligned with our One Alerus culture of excellence and accountability.

Our ongoing emphasis on improving efficiencies is not an arbitrary directive to cut expenses it is a planful and purposeful effort to improve automation and optimize processes and procedures. We are working with urgency to leverage our operating platforms and the technology we have in place today to develop a faster more seamless client experience and consequently increase the production capacity of our sales and service teams. This progress is evident with our abilities to grow accounts and acquire clients with nearly 10% less headcount than a year ago. From a balance sheet standpoint, the theme of diversification continues throughout our granular loan and deposit portfolios, loan concentrations and uninsured deposits remain low. Key talent adds during the year include experienced professionals and deposit-rich verticals and segments of C&I banking, government and not-for-profit, medical and professional services and our treasury management team.

Credit quality remains strong with low levels of past dues and non-performing loans. Alerus experienced another quarter of net recoveries and our allowance-to-loan losses remained robust at 1.39% of total loans in addition to the CECL of approximately $5.5 million related to the Metro Phoenix acquisition. We remain highly selective in our lending and committed to franchise building relationships. Capital levels also remain robust with TCE of 7.72% and CET1 of 13.1%. During the quarter, Alerus returned $5 million to our shareholders through dividends and share repurchases. As we look ahead, the industry will continue to battle headwinds Alerus too has some remaining near-term pressures. However, we are building a stronger-than-ever franchise.

We are prudently adding new client relationships and improving profitability through ongoing infrastructure rightsizing and optimization. We are investing in key business lines, while exiting non-core or franchise-accretive products and offerings. Each move is purposeful and strategic in positioning Alerus to bring expertise to our clients in fast frictionless highly responsive manner, while delivering valued advice and experience which we believe will directly translate into value creation for our shareholders. And with that I will turn it over to Al to talk about our quarter and the financial performance.

Alan Villalon: Thanks, Katie. I’ll start my commentary on page 14 of our investor deck that is posted on the Investor Relations part of our website. Let’s start with our key revenue drivers. On a reported basis net interest income declined 8.3% on a linked quarter basis. The decline was driven primarily by continued increase in funding costs. Net interest income represented 41.8% of revenues. Switching to fee income; non-interest income increased 10.2% on a linked-quarter basis primarily driven by the impact of the divestiture of our ESOP trustee business within our Retirement and Benefit Services division. Excluding the ESOP trustee business, non-interest income grew 1.6% on a linked-quarter basis. I’ll go into detail about each of our fee income segments in later slides.

Turning to page 15. Net interest income was $20.4 million in the third quarter. Net interest margin was 2.27% a decrease of 25 basis points from the prior quarter. Impacting the net interest margin was about three basis points of accretion from the Metro Phoenix deal. During the third quarter, we saw improvement in our net interest margin after our index liabilities repriced in July. On a monthly basis July was the low point for net interest margin during the quarter. As the quarter progressed, we saw our net interest margin gradually improve. We ended the quarter with a net interest margin of 2.3% for the month of September which is higher than the 2.27% that we reported for the quarter. Based on the Fed hike last July, we do expect our net interest margin to compress another seven basis points to 10 basis points from the 2.27% since our indexed deposits will reprice in October.

A digital platform displaying a range of financial products and services.

Should the Fed be done with raising rates, we do anticipate our net interest margin to continue to improve gradually as our earnings assets continue to remix and reprice into higher-yielding loans. Let’s turn to page 16 to talk about our loan portfolio. Total loans grew 2.9% from the prior quarter driven by growth in C&I, commercial real estate and residential real estate offset by a decline in consumer based loans. We continue to see strong growth in relationship-based lending where we are providing multifaceted solutions to clients via our One Alerus strategy. For the remainder of 2023, we do continue to expect modest loan growth. Turning to page 17. On a period ending basis our deposits increased 0.7% from the prior quarter. Non-interest-bearing deposits still represent 25% of total deposits.

Client retention remains very high and we continue to attract new clients. For the remainder of the year we expect deposit levels to remain stable. Turning to page 18, you can see a further breakdown of our strong deposit base. Our synergistic deposit those funds sourced from our Wealth and Retirement businesses grew 21% over the prior year and 2.7% over the prior quarter. The strong year-over-year growth in synergistic deposits was driven mainly by strong organic client growth within our Retirement and Wealth segments. Synergistic deposits sourced from our retirement and wealth business now account for 26.5% of our deposit base. Within synergistic deposit HSA balances grew to $175.7 million, a $1.3 million increase over the prior quarter. HSA now accounts for over 23% of our synergistic deposits.

HSA is a low-cost funding source and grows gradually over time due to its sticky nature. As you can see here continued growth in our synergistic deposits shows the strength of our unique and differentiated business model. Turning to page 19, you’ll see details about our investment portfolio. Currently almost 68% of our securities are available for sale versus 32% in held to maturity. We did see unrealized losses increase as interest rates rose during the quarter. The duration of our investment portfolio remains slightly over five years. 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 to talk about our fee income businesses.

On this page I’ll provide some highlights on our Retirement business, which accounted for approximately 38% of our total revenues. End-of-quarter assets under management decreased 1.4% mainly due to lower equity and bond markets. Participants within retirement have grown over 3% year-to-date. Revenues increased over 17% on a linked-quarter basis mainly due to the divestiture of our ESOP trustee business. On the bottom right of this slide excluding the impact of the ESOP trustee business in both quarters, core retirement and benefits revenues were up over 3% on a linked quarter basis. On a go-forward basis $15.3 million is the right launch point for our Retirement and Benefit Services division. For the fourth quarter excluding any impact we do expect fee income from our Retirement businesses to go up slightly from the $15.3 million.

Turning to page 21, you can see highlights from our Wealth Management business. On a linked quarter basis revenues decreased 3.3%, while end-of-quarter assets under management decreased 3.5% due to challenged equity and bond markets. Like retirement, wealth provides a strong source of funding for the bank as it accounts for over 29% of our synergistic deposits. For the third quarter excluding any market impact, we do expect fee income for our Wealth business to be up slightly as well. Turning to page 22, I’ll talk about our Mortgage business. Mortgage revenues decreased 13.6% from the prior quarter, as originations were stable but fair value hedges impacted results. Mortgage originations receivable from prior quarter, which is slightly better than MBA Purchase Index, which saw a 4% decrease.

For the fourth quarter, we do expect mortgage originations to decrease over 30%, as we enter a seasonally weaker quarter for our mortgage business. Page 23 provides an overview of our non-interest expense. During the quarter non-interest expense increased 2.4%. Compensation remained stable while professional fees increased due to high leap of fees related to the divestiture of our ESOP trustee business. Despite inflationary pressures, we continue to expect expenses to be 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 capacity throughout our organization. [indiscernible] continued progress on rightsizing our expense infrastructure through numerous initiatives.

Some of these expense saves will be reinvested in efficiency improvements and revenue production initiatives. Turning to page 24; credit continues to remain very strong. We had net recoveries of 9 basis points in the quarter. Our non-performing assets percentage was 23 basis points compared to 7 basis points in the prior quarter. And our allowance for credit losses on loans to total loans remained stable at 1.39%. I’ll discuss our capital and liquidity on page 25. During the quarter, we repurchased $1.2 million of outstanding stock at an average price of $17.98. Our capital remains well above the regulatory minimums even after share repurchases done during the quarter. Our common equity Tier 1 capital to risk-weighted assets is over 13%, which is over 300 basis points above the 9.9% stress minimum required by the largest financial institutions subjected to the Dodd-Frank Stress Test.

On the bottom right, you’ll see the breakdown of – in the sources of $2 billion in potential liquidity. Overall, we continue to remain well-positioned for both the liquidity and capital standpoint to weather any economic uncertainty. To summarize on page 26, we are focused on making fundamental improvement and improving returns for our stakeholders. Our capital remains strong and we remain committed to returning capital prudently. Our diversified business continues to be to provide stability in a challenging macro environment as almost over 50% of our revenues come from fee income. Should the Fed remain on pause, we do expect our net interest margin to fully improve as asset repricing and remixing should improve as earning asset yields improve.

With that I’ll open it up for Q&A.

See also 13 Best Auto Components and Parts Stocks to Buy Now and Dividend Aristocrats Ranked By Yield: Top 25.

Q&A Session

Operator: [Operator Instructions] We do have our first question. It comes from Jeff Rulis from D.A. Davidson. Jeff, your line is now open. Please proceed.

Jeff Rulis: Thank you. Good morning. Just a quick question – on the – Al on the margins, I just want to make sure I got this right. You talked about kind of another leg down 7 basis points to 10 basis points given the index deposits. So I’m trying to meet that with kind of the commentary about if the Fed pauses – is that kind of more of an idea well into 2024? If you could just guide me through Q4 and 2024 expectations on the margin?

Alan Villalon: Yes. Thanks, Jeff. So for Q4, we do expect about 7 basis points to 10 basis points of margin compression but we do expect our exit rate to improve from basically from October to December. So as we go into 2024, we do expect net interest margin improvement throughout 2024, even if there’s another Fed hike in there.

Jeff Rulis: Okay. And the pause…

Alan Villalon: And a Fed hike we’re anticipating right now. Go ahead.

Jeff Rulis: Sorry. If we do not have a hike that’s net better for the margin.

Alan Villalon: Correct. Correct. And what I was going to clarify is that we are anticipating based on the Fed up plus another 25 basis points of Fed hike.

Jeff Rulis: Got you. Okay. Thank you. On the credit side just wanted to kind of get where the type of loans that the non-accruals, where those came from kind of how the legacy relationship is? Just a little more detail on what was added.

Karin Taylor: Sure. Jeff, this is Karin. Yeah, that’s a commercial credit. And it’s in our Arizona market. It’s – I would say, it’s a part of what we expect in terms of just credit normalization. The issues this credit is experiencing are unique to the credit. It’s not indicative of a broader issue.

Jeff Rulis: Thanks. So it was really centered in one credit then was the increase?

Karin Taylor: Yes. The entire increase is in one credit.

Jeff Rulis: Okay. Got it. I guess just one last one. Just the buyback appetite that seems like a little pickup this quarter, but as we look out and balancing sort of capital and the environment, where do you stand on that as we head into Q4?

Alan Villalon: So, Jeff, we have the buyback is in place but we are watching price because we want to make sure that the payback is within our — within three years of what we typically look at.

Jeff Rulis: Okay. I’ll step back in the queue.

Alan Villalon: Thank you, Jeff.

Operator: Our next question comes from David Feaster from Raymond James. David, your line is now open. Please go ahead.

David Feaster: Hey. Good morning, everybody.

Katie Lorenson: Good morning.

Alan Villalon: Hey, David.

David Feaster: Hey. Maybe just starting out on the funding dynamics from your perspective and just some of the trends you’re seeing, obviously, it’s incredibly competitive. I’m just curious some of the deposit initiatives that you’re putting in place to drive core deposit growth. And then how are core deposits and deposit costs trending across your footprint? I appreciate the balances are expected to be stable. But just I’m curious how the core deposit side is trending and whether you’re able to see that mix improve or are CDs going to be the stop gap near term? And just how you think about cost?

Katie Lorenson: Sure. I’ll start. This is Katie. From an initiative standpoint, it is all about the talent that we’re attracting into the organization. And so as I mentioned earlier, mid-market C&I bankers — bankers focused in the deposit-rich verticals as well as continuing to invest and build on our treasury management team. And so that has been key to the wins as well as the retention. From a mix standpoint, we certainly are seeing an increase in the CD book. I will say the majority of that business is multiple relationships. And so continue to be core client business. We also are able to retain dollars. We’re seeing increases in our wealth management money market fund but the dollars are staying with the company which we believe is a key positive.