Alerus Financial Corporation (NASDAQ:ALRS) Q4 2022 Earnings Call Transcript

Alerus Financial Corporation (NASDAQ:ALRS) Q4 2022 Earnings Call Transcript January 26, 2023

Operator: Good morning or good afternoon, everyone and welcome to the Alerus Financial Corporation Earnings Conference Call. All participants will be in listen-only mode. 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 filings. I would now like to turn the conference over to Alerus Financial Corporation, President and CEO, Katie Lorenson. Please go ahead.

Katie Lorenson: Thank you, Emily and thank you, everyone for joining our call this morning. 2022 was the year of significant transitions in our company as I moved into my current role and spent a better part of the year building the executive leadership team, including our new Chief Financial Officer, Al Villalon, who joined me on the call today along with Karin Taylor, our Chief Risk Officer. In June we recruited a new chief banking and revenue officer who is also here with me today in the Twin Cities and in July we promoted from within two long tenured employees to round out the new executive team of Alerus. I am so proud of the professionals across the company who I get to work with every day as we take Alerus to new heights.

Recruiting and retaining talent beyond the executive leadership team is a key strategic initiative we remain committed to as we build our commercial, treasury and private banking franchise to support our historical strong client growth, scale and brand, we have already established in our wealth management, retirement and mortgage division. On Monday, we announced another win on the talent side with the addition of three high-performing commercial bankers to the Alerus team. And this week, we also welcomed our new Head of Treasury Management and deposit strategy to our company. Consistent with the rest of the industry, 2022 was full of unpredictable and unprecedented headwinds to our company. The power of the Alerus diversified business model, our collaborative on Alerus culture and our hard-working team members continued to focus on what we could control, attracting talent, acquiring new clients, expanding relationships with existing clients, managing expenses and constantly improving the client experience.

The results of these efforts across the company are creating embedded tailwinds for the coming years when the pressure points on the balance sheet and in the markets subside. Specific strategic highlights for 2022 included the acquisition and closing of Metro Phoenix Bank, our largest acquisition in company history and a transformational deal for our Arizona franchise. Another successful lift out of a team of bankers who exceeded our expectations and closed over $200 million in high-quality loans in 2022, less than a year with Alerus. In 2022, we surpassed the sales milestone with another record year of record levels of new business growth in wealth management and retirement while constantly building on the synergies from the businesses, including synergistic deposit balances reaching nearly $700 million at the end of 2022.

We remain committed to exceptional asset quality. And in 2022, we continued building on our strong foundation of credit and risk management to support our future growth, including the additions of regional credit officers, additional technology, enhanced administration and monitoring, robust stress testing and reporting as well as changes to loan policy. We strategically exited the payroll business, a small and no margin product, which we replaced with formal referral partnerships with other payroll providers, allowing us to focus on our core retirement and benefit product offering. We’ve done a good job in managing expenses while thoughtfully improving the processes and the client experience. Despite the inflationary headwinds, we continue to make progress in building efficiencies and scale in our company.

The company and the client rates have grown while expenses in the number of employees continue to trend downwards. Looking ahead to 2023, we have put the pieces together, and this team is focused on the fundamentals that drive sustainable long-term outperformance. We remain committed to the work of rightsizing our structure, investing in experienced talent entrenched in our markets and building our business. We remain committed to exceptional asset quality and are laser-focused on client selection as we grow. We will take the positive lending market share and grow our company through new client acquisitions, expanding and deepening relationships with current clients and reducing attrition by taking our service levels and the client experience to new heights, all while making the company more efficient and improving long-term shareholder returns.

With that, I will now turn it over to Al Villalon, Alerus’ CFO, for financial comments on the quarter.

Alan Villalon: 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. For the fourth quarter of 2022, reported average loans increased 4.3% on a linked-quarter basis. The increase in core average loans was driven by a 6.4% growth in commercial real estate and commercial construction. Average deposits declined 1.1% on a linked quarter basis as clients continue to put liquidity to work. Due to decline in deposits, we had to increase our short-term borrowings over $124 million, a 49% increase to fund continued loan growth and especially with the addition of Metro Phoenix Bank as we continue to expand in Arizona. I will discuss later the impact of these increased borrowings.

Turning to Page 15; credit continues to remain very strong. We had net recoveries of three basis points in the fourth quarter. Our nonperforming assets percentage was 10 basis points compared to 17 basis points in the prior quarter. Our allowance is 1.27% of period-end loans, which includes our recent acquisition of Metro Phoenix Bank. We will be transitioning to CECL in 2023. We are currently expecting a $5 million to $7 million day 1 allowance increase. This will impact our CET1 capital ratio by 20 to 25 basis points based on risk-weighted asset levels for the fourth quarter. Turning to Page 16; our core funding mix remains very strong. We saw an increase in our cost of funds due to rising interest rates. Given the further rise in interest rates and a highly competitive deposit environment, we have responded by increasing our deposit rates.

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At the end of the third quarter, our deposit beta was only 3.510 which is one of the lowest in the industry as we lagged deposit pricing through the first nine months of the year. However, competitive pressures escalated as many banks in our footprint saw their loan-to-deposit ratio exceed 100%. Due to escalated competition for deposits, we raised pricing several times, which increased our overall deposit beta tenfold to 36%, which is in line with our historical experience. Despite the competitive pressures, and deposits declined slightly, our funding base remains very strong and sticky as our loan-to-deposit ratio was at 83.8% with no broker deposits. On Page 17, our capital base remains very strong as our common equity Tier 1 ratio is at 13.4%.

As a frame of reference, the medium common equity Tier 1 for the largest financial institution subjected to the Dodd-Frank stress test was around 8%. On this slide, you’ll also notice that we have over $2 billion in potential liquidity, given increasing concerns of potential economic uncertainty, we are well positioned from both a capital and liquidity standpoint. Turning to Page 18, are key revenue metrics. On a reported basis, net interest income declined 4.8% on a linked quarter basis. The decline was driven primarily by increased funding costs as deposit pricing rose and as borrowings increased to support loan growth and our Arizona market, as previously discussed. Noninterest income declined 5.5% on a linked-quarter basis, mainly due to a decrease in mortgage I will go into detail about our fee income segments in later slides.

Turning to Page 19; net interest margin was 3.09% in the fourth quarter a decrease of 12 basis points from the prior quarter, which is lower than expected, primarily due to a rising cost of funds. As you’ll see in the last page of our earnings release, we saw our cost of funds rise across the board. Interest-bearing deposit costs increased 284% to 50 basis points. Money more market and savings deposit costs increased 248% to 139 basis points and short-term borrowings increased 59% to 382 basis points. Overall, the cost of our interest-bearing liabilities increased 120% to 145 basis points. We expected our liability costs to rise given our sensitivity, but the magnitude and speed were more dramatic given the competitive environment. Offsetting this increase purchase accounting accretion for the Metro deal impacted net interest margin positively by 10 basis points.

Turning to Page 20. Over $1 billion or over 30% — 37% of our loans are floating, as you can see at the top left of the slide. As you see, almost all of our variable loans are above their stated floors or have no floors. Now on the bottom left, you can see a waterfall for our net interest income and net interest margin. You’ll see that impact of our liability sensitivity in the waterfall table. The net effect of asset and liability rate changes negatively impacted net interest income by 4.7%. As we disclosed in our last — latest 10-Q, we are liability sensitive in the near term. In a plus 100 to 400 basis point scenario, we would expect our net interest income to be down 10% to 13% in the upcoming 12 months. Taking a step further, that means we have approximately a $12 million headwind embedded in our current balance sheet for 2023.

However, due to recent balance sheet strategies and remixing we should see our net income growth resume after one year even when assuming no loan growth. While net interest income will contract in 2023 under a static balance sheet basis, I expect this coiled spring and net interest income to bounce back in 2024. On Page 21, I’ll provide some highlights on our retirement business. AUM increased 5.1% due mainly to higher domestic bond and equity markets in the fourth quarter. Revenues were stable on a reported basis, but up 4.6% if you exclude onetime restatement fees, of $721,000 in the third quarter. This increase was in line with our expectations. Turning to Page 22, you can see highlights for our Wealth Management business. Revenues increased here by 6%, which was better than our expectations.

AUM increased 4.2% from the prior quarter, mainly due to improved equity and bond markets again and also strong production. Turning to Page 23, I’ll talk about our mortgage business. Mortgage revenues declined $1.6 million from the prior quarter due to lower originations as the environment remained challenged. Mortgage originations decreased approximately 45% from the prior quarter, while originations of $812 million for 2022 came in in line with our lowered expectations. As a reminder, the first quarter and fourth quarters of a calendar year are typically the weakest quarter for originations for us due to seasonality. Lastly, turning to Page 24 is an overview of our noninterest expense. During the quarter, noninterest expense decreased 11.3%, which was better than our original expectations of a mid-single-digit decline.

Compensation expense declined mainly due to lower mortgage compensation from a decrease in mortgage originations. Our tech expense declined due to timing of new contracts, and we do not expect that benefit to occur again. Our efficiency ratio improved over 500 basis points to 69.6% and we achieved a positive operating leverage that was previously guided to. Before I provide guidance, I want to highlight again that due to our near-term liability sensitivity, we have some strong headwinds in 2023 for net interest income. We are making changes to reposition and remix the balance sheet. That will take some time, but the coiled spring that I referred to earlier will take shape in 2024 and beyond. When interest rates eventually stop rising and actually declined that coiled spring will only become more powerful given our current positioning.

Now I’ll provide some guidance for the first quarter and for 2023. For the first quarter, we expect the following: we expect net interest income to be done — to be down high single digits. Our net interest margin should decline further as we expect the cost of funds increase led by the repricing of our index liabilities. Some of the increased interest expense will be offset by modest loan growth. On the fee income side, all segments will be heavily influenced by the macroeconomic landscape. While new business production has been strong in both wealth and retirement, revenues will be influenced by market conditions. More mortgage revenues will continue to be challenged as interest rates remain high and we are in a seasonally weaker quarter for originations.

On a reported basis, we expect noninterest expenses to be stable relative to the fourth quarter. We have begun rightsizing our infrastructure while also adding some talent that Kate referred to help drive future revenue growth and deposit growth. We expect credit to remain benign in the first quarter. Now I will comment on some metrics for the full year 2023. As discussed previously, net interest income will be challenged due to our liability sensitivity where most of the challenge will come in the first half of the year. To offset some of the 10% to 13% decline or approximately $12 million pre-tax headwind embedded in our current balance sheet, we expect some modest loan growth and deposit growth. We continue to expect the mortgage business to be challenged as the Mortgage Bankers Association purchase index is forecasted to be down 8% to 9% in 2023.

Excluding market impact, we do expect retirement fee income on a reported basis to be down a little due to the exiting of payroll, which had reported revenues of $1.4 million. As we reposition, remix, rightsize and add talent, we are focused on controlling expenses in 2023. 2023 will be a year when spring coils back but we remain confident that we will — with all the strategic initiatives being put into place during the year that we will spring forward noticeably in 2024 and beyond. As that coiled spring jumps forward after the challenge had been absorbed in 2023, we will return to our strategic goals of achieving EPS growth of 10% or more and a 12% — and an ROE of 12% or more. In 2024 and beyond, we expect continuous improvement in our efficiency ratio as we are laser-focused on investing in talent and infrastructure to make us more efficient in the way we operate, while continuing to offer a high-level service for our clients.

With that, I will now open it up for Q&A.

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Q&A Session

Operator: Our first question today comes from Jeff Rulis with D.A. Davidson.

Jeff Rulis: Katy, you alluded to the number of hires that you’ve made in the last year have been significant. And just trying to get a sense for if growth slows in ’23 and as roles have been filled is the hiring pace slow down? And I guess as that — the second question of that is how that translates to the expense growth in ’23. Maybe a question for Al on the second one. .

Katie Lorenson: Sure. Thanks, Jeff. In regards to the talent adds, we will continue to add professionals with expertise in our markets. We will balance that level of investment as we work through and reposition talent throughout the company in regards to the support side. And so from a — Al can give guidance in regards to the expenses, but that’s how we look at the talent additions. And in regards to growth, I will hand that off to…

Jim Collins: Thanks, Kate. This is Jim Collins. I will say that as we look at that talent that Katie just talked about, we’re looking at focused talent and specialized verticals to bring that value add to our customer base. We will consistently look for adding that talent in all of our markets, but we’re going to be a little picky, right? We’re going to make sure we’re adding the right team to us. We will offset that expense with expense saves or repositioning of different expenses already in the bank, but the intent is to harvest talent during this time when we can.

Alan Villalon: Jeff, it’s Al. So on the noninterest expense side, we are — as I alluded to in our call, laser focused on continuous improvement on our infrastructure. We are looking on trying to achieve some expense saves this year, and we are looking to have that reported noninterest expense to be down slightly on a year-over-year basis, but a lot of that will be determined on the timing of those expense saves. As we also do trying to add town to, and that’s going to be as well.

Jeff Rulis: Yes. Just trying to — I know that you kind of alluded to some Q4 maybe incrementally lower, but do we look at kind of full year close to $1.59, you’re down slightly as — is that a good number to think about for the full year, something inside of that number, absent maybe getting opportunistic hires in there?

Alan Villalon: Yes. When I look at like the 158.8-ish, we’re looking for that to be down year-over-year from that level. Correct.

Jeff Rulis: Okay. And then, Al, while I got you, the margin, just thinking about where that may trough. It sounds like further pressure in Q1, and you talked about the coiled spring thereafter. But trying to get a read on where that — where you think that bellies out.

Alan Villalon: Yes. That’s a good question there, Jeff. So I said it’s going to be in the first half. I’d say a good brunt of it will be felt in the first quarter, a little bit more in the second quarter, and then we’re hoping to rebound from there. But again, a lot of the timing is going to come from the interest rate environment. So I feel comfortable saying that in the first half of the year and maybe the first quarter, we’ll feel brunt of it and then a little bit less in the second quarter and then probably starting to rebound in the last — in the second half of the year. Again, timing will be determined in the mid- midpoint of the year based on what the curve does.