Old Second Bancorp Inc (OSBC) 2021 Q3 法說會逐字稿

Good morning, everyone, and thank you for joining us today for Old Second Bancorp, Inc.'s Third Quarter 2021 Earnings Call. On the call today is Jim Eccher, the company's CEO; Gary Collins, the Vice Chairman of our Board; and the company's CFO, Brad Adams.

I will start with a reminder that Old Second's comments today may 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. 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 under the Investor Relations tab.

Now I will turn it over to Jim Eccher.

Good morning, and thank you for joining us today. I have several prepared opening remarks and will give my overview of the quarter and then turn it over to Brad for additional detail. I will then conclude with some summary comments and thoughts about the future before we open it up for questions.

Net income was $8.4 million or $0.29 per diluted share in the third quarter. Earnings this quarter were favorably impacted by a $1.5 million reversal of provision for credit losses due to more favorable unemployment projections over the next year. However, earnings were negatively impacted by an MSR valuation mark-to-market loss of $282,000 due to decreases in market interest rates and merger-related costs incurred in the third quarter totaling $425,000. In regards to the balance sheet, loans were essentially unchanged on a core basis this quarter, excluding approximately $35.5 million of PPP loans forgiven by the SBA during the third quarter. Only $34.7 million PPP loans from both the first and second round remain outstanding as of September 30.

Approximately 83% of all PPP loans originated have now been forgiven. Loan growth has certainly been a bit of a disappointment for us this year, but I am encouraged that our pipeline at quarter end is by far the strongest we have seen since the pandemic began. We are seeing significant pipeline builds in equipment leasing, health care and CRE, although C&I activity and line utilization remains somewhat soft. We have a new CRE team that started with us in the third quarter and a senior leasing officer was added in October. Given these factors and a strong pipeline, I'm optimistic we can see a solid loan growth, net of PPP in the last quarter of this year. Expense discipline continues to be strong with a slight increase noted in noninterest expense for the current quarter compared to the prior quarter due to growth in occupancy, furniture and equipment costs as well as computer and data processing costs.

Exclusive of merger-related costs of $425,000 occurred in the quarter, noninterest expenses increased 1.4% over the prior quarter. Nonperforming loans increased by $5.9 million compared to the prior quarter with 2 loans added to nonaccrual status. However, past dues declined. And although there was an uptick in nonperformers, total classified assets declined 7.3% compared to the linked quarter. We remain confident in the strength of our loan portfolios. Details are available in the earnings release tables on these changes. Loans under modification stand at approximately 0.5% of the loan book today, and we are working closely with our borrowers to understand each and every situation. Of the original $237.8 million of loans, which were on COVID-19 related deferral at some point in the past year, $229 million or more than 96% have either returned to payment status or paid off as of September 30.

As of the most recent quarter end, 12 loans totaling $8.8 million in balances are currently on deferral status. Concurrent with our earnings release, Old Second also filed loan portfolio disclosures that will give investors additional detail on the composition of the loan portfolio, current modification breakdowns and reserve levels. Exclusive of PPP loans, the reserve currently stands at 1.47% of total loans. During the third quarter of 2021, $1.5 million of provision for credit losses on loans was reversed, $47,000 of reserves for unfunded commitments was reversed based on a review of the line utilization trends and $237,000 of net charge-offs were recorded in the third quarter, resulting in a net decrease to the allowance for credit losses, including unfunded commitments of $1.7 million.

Our outlook is cautiously optimistic as the underlying economy continues to improve, albeit with significant uncertainties. We believe that we are more than adequately reserved under base case scenarios, but continue to modestly overweight more pessimistic scenarios given the high degree of uncertainty. I'll turn it over to Brad now for more color in his prepared comments.

Thank you, Jim. Net interest income increased $664,000 relative to last quarter and $109,000 from the year ago quarter. Margin trends stabilized with securities portfolio growth mitigating continuing increases in liquidity. The reinvestment rate on the portfolio purchases was slightly less than 100 basis points as we continue to avoid duration at this point in the rate cycle. Continue to have strong deposit inflows and substantial excess liquidity persisted for the entirety of the quarter. The cautious strategy to deploy a portion of that liquidity will continue in the short term. If loan growth improves, which we currently expect, our margin trend should improve significantly. If the excess liquidity flow reverses, our margin outlook would improve dramatically. If excess liquidity persists, net interest income trends will benefit, but margin will remain artificially depressed as we continue to invest in the short duration, lower-yielding assets.

I think it's important to note that our excess liquidity has resulted primarily from retail flows, which I expect will be absorbed quickly once the pace is stimulus lessens. So I don't believe it's prudent to add significant duration at this point. If economic conditions continue to improve and loan growth returns to a level commensurate with that growth, our margin outlook would improve. I continue to remain surprised that loan demand has not followed reported economic conditions, though, as Jim mentioned, that appears to be changing. Some total of that discussion is that we currently expect loan growth trends to meaningfully improve, which will continue to result in net interest income growth.

We do not currently expect liquidity flows to lessen and which should leave the margin artificially depressed. In short, we remain cautious and patient. Noninterest income increased from last quarter with an increase of $291,000 quarter-over-quarter and gain on sale and mortgage loans, and a reduction of $750,000 in the MSR valuation loss recorded. Wealth management income remained strong with $2.4 million in both the current quarter and prior quarter. Securities gains net of $244,000 were also recorded in the third quarter. Those were minimal in the second quarter.

Provision for credit loss reversal of the net $1.5 million was recorded in the third quarter compared to $3.5 million last quarter. The economic outlook for us assumes continued improvement with an unemployment rate projection remaining at approximately 5 1/4% to 6 3/4% through September 30, 2022, and over the remaining life of the loans. This is a decline from the previous estimate of 5 1/2 to 6 3/4 from last quarter. I recognize that our assumptions are probably still more pessimistic than most at this point and expect the severity of these assumptions to be lessened in the coming quarters.

I'm extremely pleased with how credit has performed. I continue to be pleased with the direction in classified assets. Credit metrics have remained stable to improving for a number of quarters now, and the number of credits that I would have been concerned about have been resolved favorably. Our efforts in the coming quarters will be focused on helping our customers and funding quality loan growth with the expectation of a stable to improving margin assuming liquidity remains robust and risk spreads remain unreasonably tight. Expenses are well controlled at this point, and we will continue to review for efficiencies as the year progresses.

With that, I'd like to turn the call back over to Jim.

Thanks, Brad. In closing, we are increasingly optimistic about the remainder of the year, confident in our balance sheet and ready for the challenges ahead. Prolonged low rates is certainly not the best environment for a deposit base like Old Second, but we are extremely profitable given our focus on expense discipline. We expect to remain so. We believe our credit and underwriting has remained disciplined, and our funding and capital position is strong. Today, we have the balance sheet and liquidity to take advantage as things improve.

We are extremely active in the effort to bring additional salespeople to our team and are making substantial progress on the planning to ensure a smooth transition for West Suburban customers and employees. We are excited about the opportunities that exists for Old Second for 2022 and beyond.

That concludes our prepared comments this morning. So I will turn it over -- back over to you, Kate, to open it up for questions.

(Operator Instructions) Our first question today is coming from David Long at Raymond James.

On the West Suburban transaction, I think you've got the proper approvals. Is that still expected to close maybe early December? And then if that's the case, and then also as a follow-up to that, I wanted to just hear about any progress you've made in preparing for the integration and when the branch integration and system conversion may happen?

So David, we have all regulatory approvals in hand. We are basically just need to have shareholder meetings on both sides, which we're targeting for the end of November, anticipating in early December close. So yes, we are knee deep in working through integration plans and targeting mid- to late April for system conversions.

Got it. Okay. And Brad, you've got 17% of your earning assets in cash. You're talking about -- you've been put yielding or using some of that in some short duration yields. What securities are you willing to add at this point on the yield and the duration side?

So we've been targeting a little under a 2-year duration. The purchases in the last 6 months have been primarily concentrated in variable government-guaranteed student loan paper, some AAA-rated CMOs and CLOs basically.

Got it. Okay. And what would it take to get you to extend that duration?

Higher rates.

Easy enough. And then finally, on the liability side, the balance sheet, any noncore funding that you think you can shore up? I think you've got some senior debt that becomes callable here soon. Just curious if there's any opportunities to make the liability side even more efficient than it is now?

There are some opportunities. The senior debt issue is in the $40 million range, and it goes variable at the end of the year. The rate will be -- the variable term will be a substantial improvement in the cost of that. It's likely that we'll evaluate the potential for replacing that in the first quarter of next year, but nothing is definitive at this point. I think there's a lot of things you can do from the capital management perspective, especially with the fundamental balance sheet change we've got coming at us. We'll continue to look for opportunities there and believe that the projections as we've laid them out in the proxy statements still appear reasonable.

Our next question today is coming from Nathan Race at Piper Sandler.

I appreciate the constructive outlook for loan growth ex PPP in the fourth quarter, and congrats on some of the hires that you guys have had recently along those lines. Just curious as you kind of look out to 2022, obviously, the Law of large numbers is working against you in terms of percent of loan growth. But when you kind of look at the team you have in place now and just the opportunity to continue to hire across the Chicago land area, what are kind of a good kind of range of expectations in terms of organic growth in 2022?

Go ahead, Brad.

I think that the trend that we have right now on the hiring front and what we expect in terms of prepayments, we're getting increasingly optimistic that by the end of next year, we may very well double our loan origination capability, which is a very exciting thing for us. Obviously, that doesn't come cheaply, and we're investing a lot in salespeople. But we have a lot of reasons to be excited in terms of the level of talent and conversations that we've been able to have over the last several months. So we're getting increasingly optimistic on what we're capable of doing from an asset generation standpoint, while still staying in our credit box.

I would just add, the third quarter, while it was flat, was relatively active in new fundings and production what's been a little frustrating as our early paydowns basically are running at a 2x level from where they were last year and our line utilization is down about 8%. So we factored both of those factors. And if we have returned to a more normalized run rate and then see any kind of increase in line utilization, coupled with the talent and the pipelines that are building should mean a very strong year, next year.

Okay. Great. And then just in terms of kind of providing for that growth expectation into next year, obviously you have the CECL Day 2 double count in the fourth quarter as the acquisition closes. So how should we kind of think about excess reserves that exist today in terms of thinking about just the trajectory of credit cost and provisioning in 2022 as well?

I think independent of any merger considerations, which those calculations aren't fully done yet, though our estimates is detailed in the proxy statement appear reasonable. I think that as I said, we're probably more conservative than maybe others in terms of what our estimates are for economic activity. And I would expect just on a stand-alone core basis, that Old Second's reserve will continue to trend down. So -- while if we do achieve loan growth next year on a scale that which we are hopeful for, there will be some level of provisioning, I would expect it to be pretty muted by continuing economic improvement.

(Operator Instructions) Our next question today is coming from Chris McGratty at KBW.

I want to start just on NII. A couple of housekeeping items before the main question. Could you quantify the level of PPP income in the quarter and also the size of that prepay that you cite in the release?

So the prepay was a few hundred thousand dollars. And calling it large probably wasn't the best word choice. That kind of stuff happens quite frequently, especially here lately over the last 9 months or so. In terms of PPP income, we've only got about $30 million of the portfolio left. It looks like...

It was $200,000 or $300,000, Brad, it wasn't that much?

Yes, it wasn't significant.

Okay. And so you kind of put in the loan growth and the securities caution together. How do we think about just the trajectory of NII from here on an organic basis?

As we said last quarter and we saw this quarter, we would expect to grow NII from these levels in all linked quarter periods.

Okay. And then if I could, the -- 2 more questions. A little bit of color on those nonaccrual that you talked about would be great. And then once the deal closes and given the valuation, how are you thinking about resuming the buyback?

Sure. As far as the uptick in nonaccruals, Chris, really 2 credits. One is a large big box retailer. It's been on our watch list for a long time and classified last year actually, lost a major tenant, single-tenant property. We had put an allocation on it a couple of quarters ago. So not a surprise by us. They are actively negotiating a new lease with another tenant. So we don't see any further charges there. The other one is a couple of million dollar crane operator that was hit extremely hard by the pandemic. We are very well secured on that and don't see any further losses. Absent that, overall classifieds were down about 7% for the quarter.

Okay. And then on the buyback, any thoughts there?

No imminent plans, I would say that just from a kind of theoretical standpoint. I would view a buyback at these valuations to be an extremely good use of capital.

Our next question today is coming from Brian Martin at Janney Montgomery Scott.

Can you give a little bit of color just on the hiring you've done, Jim? And just, I mean, to Brad's comment about potentially, I guess, doubling your capability, just kind of -- does that assume that you're going to pick up more talent here? Is that kind of baked in with what you have? And just -- so those couple of questions and just kind of the hiring outlook, given some of the disruption in the market, you just kind of update us on that, how that's progressing?

Sure, Brian. Yes. So we added a new commercial real estate team earlier in the quarter. Very optimistic that, that team is going to hit the ground running and even produce yet this fourth quarter, and then a senior leasing executive that's been in the business north of 25 years joined us a couple of weeks ago. We continue to have very constructive dialogue with a number of additional lenders in the Chicago market. Optimistic that we will be successful in landing a number of them over the next couple of quarters. So we feel real good about that.

Okay. And how about -- I mean, just as far as maybe -- I don't know for you or Brad, Jim. Just kind of the expense outlook. I mean, I guess the hires you've got are currently in the run rate, just the -- how do we think about that with in conjunction with some optimistic thoughts on hiring additional folks here.

Yes. So good question. I mean, these folks are certainly going to cost us. It's going to be an investment. But we have also recently seen a few retirements along with a departure or 2. So as of now, we're probably net-net equal. We certainly look to see further investments over the coming quarters that will probably tick up our run rate on overhead.

I think that we're all under some fairly significant wage pressure across the franchise. There's no secret in terms of what's going on out there in the quest to maintain a workforce wage inflation is significant in the Chicago marketplace. So I don't know that we'll be as successful as holding the cost down as we were in 2021, but it is our effort to find efficiencies where we can. We would expect to see increases in benefit costs and overall salary levels commensurate with the level of inflation that we're seeing in the Chicago marketplace. But we'll do our best to lock down efficiencies where we can. We've done some of that on the IT side. There are a number of investments that we've made in the last 2 years that won't be there in 2022. So we got a good handle on it. But certainly, it's not going to be as easy in 2022 as it was in '21.

Got you. That makes sense. And just your comment, Brad, about kind of doubling the origination capability, I guess that's kind of just driven off of the people you already have got hired. So you're expecting...

No, that is not the case. We have not made that kind of expansion yet. What I would tell you is, is that every hire that we're looking at in the various stages of getting there is evaluated based on what the earn-back is just as we look at an M&A transaction. And we don't expect anybody not to pay for themselves in relatively short order in terms of the salespeople we're looking at. So I think that it's quite possible that over the next 6 to 9 months that we will have achieved the ability to double our loan origination capability.

Okay. That's helpful. And then just last one for me. Just on your -- with West Suburban coming on, just kind of your mix of what you're doing on the liquidity front, kind of what are the securities to asset levels? Or I guess, how are you thinking about that the combined balance sheet as you look with the combination on that front?

I'd point you to the proxy statement on that. The information that's in there is pretty detailed and we do have some discussions on what the pro forma balance sheet looks like. I would just say this is that we are going to run with substantial excess liquidity. I also don't believe that the risk versus return in terms of plowing that excess liquidity at a point in time into a securities portfolio is a good idea at all. I've spoken quite plainly about that in the past. I see no reason to do it. We will be patient. We've got growth out there in the overall economy, and we also have a great deal of inflation. Neither one of those things is consistent with rates staying where they are. And if it takes 1 to 2 years to get there, I got to tell you that doesn't bother me. I would rather wait than announce some sort of portfolio restructuring because you plowed into 30-year mortgages, they did something stupid like that.

We have no further questions in the queue at this time. Mr. Eccher, do you have any closing comments you'd like to finish with?

Okay. Thanks, Kate. Okay. Thanks, everyone, for joining us this morning, and we will look forward to speaking with you again next quarter. Have a good day.

Thank you, ladies and gentlemen. This does conclude today's event. You may disconnect at this time, and have a wonderful day. Thank you for your participation.