Old Second Bancorp, Inc. (NASDAQ:OSBC) Q2 2023 Earnings Call Transcript

Old Second Bancorp, Inc. (NASDAQ:OSBC) Q2 2023 Earnings Call Transcript July 20, 2023

Operator: Good morning, everyone, and thank you for joining us today for Old Second Bancorp, Inc.’s Second Quarter 2023 Earnings Call. On the call today is Jim Eccher, the Company’s Chairman, President and CEO; Brad Adams, the Company’s CFO; and Gary Collins, the Vice Chairman of our Board. I will start with a reminder that Old Second’s comments today will contain forward-looking statements about the Company’s business, strategies and prospects, which are based on management’s existing expectations in the current economic environment. These statements are not a guarantee of future performance, and results may differ materially from those projected. Management would ask you to refer to the Company’s SEC filings for a full discussion of the Company’s risk factors.

The Company does not undertake any duty to update such forward-looking statements. On today’s call, we will also be discussing certain non-GAAP financial measures. These non-GAAP measures are described and reconciled to their GAAP counterparts in our earnings release, which is available on our website at oldsecond.com on the homepage and under the Investor Relations tab. Now I will turn it over to Mr. Jim Eccher.

Jim Eccher: Good morning, and thank you for joining us. As customary, I have several prepared opening remarks and will give my overview of the quarter and then turn it over to Brad for additional details. I will then conclude with certain summary comments and thoughts about the future before we open it up for questions. Net income was $25.6 million or $0.56 per diluted share in the second quarter 2023. Adjusted net income was also $25.6 million, $0.56 per diluted share in the second quarter. This represents our second consecutive quarter of record earnings. On a same adjusted basis, return on assets was 1.74%. Second quarter 2023 return on average tangible common equity was 25.3% and the tax equivalent efficiency ratio was 46.84%.

Second quarter earnings were negatively impacted by a $1.5 million pretax security loss and strategic security sales as well as 362,000 of accelerated senior note issuance cost as we redeemed the $45 million outstanding senior note. The combined impact of these two items reduced diluted earnings per share by $0.03. Our financial results continue to be favorably impacted by elevated market interest rates with an $18.3 million or 40.5% increase in net interest income in the second quarter compared to the prior like quarter due to manageable funding cost increases along with significant expansion in asset yields across the balance sheet. The second quarter reflected modest loan growth of $12.2 million over the linked period and $390.5 million or 11% over the same period last year.

Loan prepayments accelerated and were stronger in the second quarter compared to the first quarter of 2023, resulting in net origination activity reduction relative to the prior quarter. Activity within loan committee moderated for the majority of the second quarter, although more recently, we have seen activity begin to show signs of significant slowing. Net interest margin contracted this quarter, largely due to increased funding costs on deposits due to increases in deposit pricing and certain time deposit product specials as well as the accelerated issuance costs associated with the redemption of our senior notes. Loan yields continued to expand during the quarter, increasing 21 basis points over the linked quarter and 174 basis points year-over-year.

The NIM remained strong at 4.64% for the second quarter compared to 4.74% in the — quarter of 2023. The margin has benefited year-over-year from balance sheet mix improvements, the impact of rising rates on the variable portion of the loan portfolio and continuing loan growth in 2023. The loan-to-deposit ratio is now at 85% compared to 82% last quarter and 68% as of June 30, 2022. As we noted last quarter, our focus now has shifted to balance sheet optimization. And I’ll let Brad talk about that in a moment. Credit metrics were essentially stable as nonaccrual loans decreased $2.6 million or 4.1% due to upgrades and paydowns on various loans while classified loans ticked up $2.3 million or 1.8% to $127.6 million. Ongoing evaluations of commercial real estate and office have not revealed significant deterioration at this point, and the trends within criticized assets are significantly more favorable this quarter relative to last quarter.

Photo by The New York Public Library on Unsplash

I believe we will have a few recently downgraded credits sufficiently addressed in the third quarter and could see more favorable trends present themselves going forward. Clearly, our focus remains on monitoring potential weakness in commercial real estate and specifically office. We have stressed all maturing credits under renewal rates and believe we don’t see broad-based risk. We have been proactive on refreshing valuations. And as a result, our outlook for credit has not changed. I think it’s important to remember that half of our commercial real estate exposure is owner-occupied, which we believe is unusual for a bank our size, and our office exposure is only about 5% of the portfolio. We simply don’t have a lot of this year, but we continue to watch it very closely.

We recorded net charge-offs of $505,000 in the second quarter compared to $740,000 of net charge-offs in the first quarter. Other real estate owned reflected a $494,000 decrease in the second quarter to end at 761,000 in total based on three property sales in the quarter, net of one OREO transfer. The allowance for credit losses on loans increased to $55.3 million as of June 30th from $53.4 million at the end of the previous quarter, which is 1.4% of total loans as of June 30, 2023, consistent with the 1.3% total ACL to gross loans as of March 31st. Unemployment and GDP forecasts used in future loss rate assumptions remained fairly static from last quarter. I think investors should know that we remain confident in the strength of our portfolios and the credits in question are the same ones that we have discussed previously.

We continue to watch those closely. Noninterest income continued to perform well. And excluding losses on security sales discussed earlier, noninterest income increased $745,000 compared to the first quarter, driven by gains on MSR, mark-to-market, adjustments, wealth management income and an increase in credit card related income. Pretax losses of $1.5 million on security sales in the second quarter were incurred related to strategic repositioning within certain security types in our portfolio. Expense discipline continues to be strong, and we believe our efficiency is simply outstanding at this point. As we look forward, we are continuing on doing more of the same, which is managing liquidity, building commercial loan origination capability for the long term.

The goal is obviously to continue to build towards a more stable long-term balance sheet mix featuring more loans and less securities in order to maintain the returns on equity commensurate with our recent performance. I’ll now turn it over to Brad for more comments.

Brad Adams: Thank you, Jim. Net interest income decreased slightly to $63.6 million for the quarter ended relative to the prior quarter of $64.1 million, but increased $18.3 million or 41% from the year ago quarter. Loan yields continued to grow in the second quarter, though at a slower pace than recent periods and securities yields remained relatively flat since last quarter. Total yield on interest-earning assets increased 20 basis points over the linked quarter to 539 bps, partially mitigated by a 15 basis-point increase in the cost of interest-bearing deposits and a 47 basis-point increase to interest-bearing liabilities in aggregate. The end result was a 10 basis-point decrease in the NIM for the last quarter to 4.64 from 4.74.

As noted earlier, we redeemed the outstanding senior debt issuance on June 30th, which resulted in an acceleration of the deferred issuance costs. This had an approximate 3 basis-point negative impact on the margin during the quarter. Going forward, the senior note redemption net of an assumed 45 basis-point — or I’m sorry, $45 million dollar for dollar replacement funding costs would add about 3 basis points to the quarter with that being gone. Deposit flows this quarter showed modest leakage on the high end, along with typical seasonal decline that we always see based on tax payments for personal and business customers and commercial customers rolling out new activities in the spring. The nature and character of the declines thus far largely looks and feels like an inverse move of the flows into the Bank, we saw beginning in the latter half of 2020 and continuing through 2021.

Fortunately, we have the liquidity and the balance sheet flexibility to adapt. We’ll continue to remix and optimize rather than chase high beta deposits. We still aren’t lurching at anything, but we have made some fairly significant progress in reducing asset sensitivity over the last year, including reducing variable rate securities from more than a third to just over 20% of the portfolio. There has been some significant earnings and margin give-up associated with doing this, but it’s the right time to return to a more normal duration profile within the portfolio. With the level of inversion in the curve, we still aren’t in a hurry to place large bets on the path of interest rates. Duration is slowly being added to reduce asset sensitivity in numerous ways.

Effective duration on the bond portfolio is now an approximate 3.0 years, up significantly from six months ago. The loan-to-deposit ratio remains low, and our ability to source liquidity from the portfolio has increased relative to the color we gave you last quarter. It seems higher for longer as finally seen its way into the zeitgeist. I would like to remind you that longer duration portfolios in Old Second’s would have seen relative outperformance to ours given the sharp version from the short end. The mark on the securities portfolio remains high but will be recaptured relatively quickly. The net result is that Old Second should continue to build capital very quickly as evidenced by the 34 basis-point improvement in the TCE ratio over the linked quarter, which combined with the 59 basis points last quarter, that means what we have added 93 basis points of TCE in just six months.

As we sit here today, we have approximately $649 million in undrawn borrowing capacity, an additional $400 million in unpledged securities. In short, liquidity at the Bank remains excellent, and the holding company is in a strong position as well. We may seek permission to resume stock repurchases this year as well. Margin trends from here are projected to be relatively stable over the remainder of the year with benefits from one more rate hike and continued asset repricing not expected to outpace the increased reliance on overnight borrowings by much. Provision for credit losses on loans of $2.4 million was recorded during the quarter, and net provision for credit losses was $2 million in the second quarter of 2023 due to a $427,000 reversal of provision on unfunded commitments during the quarter.

I would expect loan growth to be roughly consistent with provision growth over the near term, though that could change with significant worsening in the macro environment. Noninterest expense declined $1.1 million from the previous quarter, driven by lower salaries and employee benefits as well as computer and data processing expenses. I continue to expect quarterly wages and benefits to be between $22 million and $23 million going forward in the near term. Given the revenue performance, employee investment costs have been running high, but we will maintain the ability to dial it back as conditions warrant. With that, I’d like to turn the call back over to Jim.

Jim Eccher: Okay. Thanks, Brad. In closing, we are confident in how we’ve constructed our balance sheet and the opportunities that are ahead for us. We are paying very close attention to credit and expenses. We believe our underwriting has remained disciplined, and our funding position is strong. We have the balance sheet and liquidity flexibility to excel in a higher rate environment. Capital levels should continue to grow and maintain levels above targets, and we will look to be aggressive in adding talent and relationships. So, that concludes our prepared comments this morning. So, I’ll turn it over to the moderator, and we can open it up to questions.

See also 20 Countries With Highest Rate Of Down Syndrome and 25 Poorest States in America.

Q&A Session

Operator: Thank you. [Operator Instructions] Our first question is coming from Terry McEvoy with Stephens.

Terry McEvoy: Jim, one of your prepared comments you said and as you were talking about the CRE portfolio, there’d be more downgrades in the third quarter, but you expected a favorable outcome. Could you just maybe run through that statement one more time, so I understand exactly what you’re getting at correctly?

Jim Eccher: Yes. No, just the opposite, Terry, we’re starting to realize some resolutions on some previously downgraded credits and we expect — and I’ve already seen a few upgrades in this quarter, so — in the third quarter. So things are trending in the right direction.

Terry McEvoy: Okay. Good. It’s been a long morning already. Maybe, Brad, a question for you, that your interest-bearing deposit costs were really low at just 40 basis points in the second quarter. As you think about the second half of this year and just the competition for deposits, where do you see that trending? And what’s maybe baked into your kind of comments on the margin?

Brad Adams: So, I think it will tick up a little bit. I don’t think it will be as big a move as we saw first quarter to second. Most of that — most of that increase happened in March. We have a big advantage here in that I think most people realize now what — how granular the deposit base is, it just doesn’t require a lot of movement. I think we will see some uptick. I think that we are exceptionally comfortable at a level under $500 million in borrowing — overnight borrowing position. If it gets above that, we’ll probably put out more CD pricing. And consistent with that belief, I just don’t think margin does a whole lot. I would call it plus or minus 5 basis points here. It may be a little bit better in the third with a rate hike or with a little bleeding over into the fourth.

But we’re going to continue to sell down the variable portion of that securities portfolio, which is a significant give up. It seems that others have come around to the idea of hire for longer. And so now there is a bid on that, whereas before when we bought it, we were the only ones that wanted it. And as everybody thought, rate cuts were coming this year, nobody wanted to touch it then either. So, our ability to move down that position is markedly better today than it was even a month or two ago, and we’ll continue to do that. So margin upside will probably be given up on just kind of reducing asset sensitivity at this point in the cycle.

Terry McEvoy: And maybe a quick follow-up. What do you need to see or hear to begin repurchasing stock? Brad, you kind of hinted at it, but is it remediation on some of those CRE properties? Is it confidence on funding costs? What are you waiting for or looking at?

Brad Adams: No. I mean, we’re building back capital very quickly here. Obviously, I think everybody is aware of how punitive the purchase accounting marks are in an M&A type environment. And it’s just a question of what the best return on marginal capital generation is. There are scenarios whereby M&A can work. There are far more scenarios where it doesn’t. I think people know we’re disciplined on that front and won’t do anything done. But it’s a function of things continuing to look poor in terms of other investment opportunities and the speed at which capital builds. And then also just the overall credit outlook. That feels pretty good. We’ve got a whole heck of a big reserve on office exposures, and we feel pretty good about where we sit.