Old Second Bancorp Inc (OSBC) 2020 Q4 法說會逐字稿

Good morning, everyone, and thank you for joining us for today's Old Second Bancorp, Inc.'s Fourth Quarter 2020 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 like -- would ask you to refer to the company's SEC filings for a full discussion for the company's risk factors.

On the call today, we will be discussing certain non-GAAP financial measures. These non-GAAP financial measures are described and reconciled with their GAAP counterparts in our earnings release, which is available on our website at oldsecond.com under the Investor Relations tab.

I will now turn the conference over to Mr. Jim Eccher. Please go ahead.

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 details. I will then conclude with some summary comments and thoughts about the future before we open it up to questions.

Net income, $8 million or $0.27 per diluted share in the fourth quarter. Earnings in the quarter were negatively impacted by $1.3 million in MSR valuation mark-to-market losses despite continuing strength in mortgage banking overall. Fee income declined from last quarter based on some moderation in mortgage banking revenues relative to recent record results, seasonal reductions in mortgages originated and the aforementioned mark-to-market losses on MSRs due to movements in interest rates. Approximately $63 million of PPP loans were forgiven by the SBA during the quarter, which resulted in an increase in our net interest margin over the prior quarter from full recognition of net deferred fees on those loans upon payoff.

Our loan-to-deposit ratio is a fraction over 80% at year-end, relatively stable with last quarter and a significant increase from 90.8% a year ago. Expense discipline continues to be strong with a slight increase noted in noninterest expense for the current quarter compared to the prior year like quarter due to the higher salaries and employee benefit costs and FDIC insurance expense due to assessment credits received in the fourth quarter of 2019.

Asset quality trends at this point remain remarkably stable, and the bulk of our lending team continues to be focused on the second round of PPP loan origination and staying in close contact with our customers. Nonperforming and classified assets experienced slight increases only, and we remain confident in the strength of our portfolios. Details are available in the earnings release tables on these changes.

Loans under modification stand at approximately 1.4% of the loan book today, and we are working closely with our borrowers to understand each and every situation. Of the original $231.3 million of loans, which were on a COVID-19 related deferral, $198.6 million or 86% have either returned to payment status or paid off as of year-end 2020. As of year-end, 51 loans totaling $32.7 million in balances are currently in 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 portfolio, current modification breakdowns and reserve levels. Exclusive of PPP loans, the reserve currently stands at 1.73% of total loans. During the fourth quarter, $1 million of reserves for unfunded commitments was reclassified in the allowance for credit losses on our loans.

Our outlook remains cautious given the uncertainties, but optimistic that the underlying economy will continue to improve. We believe that we are more than adequately reserved under base case scenarios and have continued to overweight more pessimistic scenarios given the high degree of uncertainty. Overall fundamentals and earnings trends were relatively stable and consistent with prior quarters, with mortgage banking results continuing to reflect the positive impact of the low rate environment.

Loan growth trends exclusive of the payoff and forgiveness of PPP loans during the quarter was very strong, and we are cautiously deploying liquidity into short-dated assets. Profitability remains strong, and we are extremely pleased with this level of performance.

Old Second continues to be focused on the steps and protocols necessary to protect our employees, customers and communities during this pandemic. For our customers, our locations remain open and available, albeit with safety precautions. We are continuing to work with those that have been directly impacted, and we are offering the ability to defer payments as appropriate.

A vast majority of our staff, excluding retail, continues to work remotely without issue. Old Second is proud to serve our communities, and I couldn't be more grateful of the efforts of our employees in 2020.

We are fortunate that our core lending strengths have steered us clear of many of the most impacted industries. We realize the potential exists for many industries to still be significantly impacted in the short to intermediate term from the implications of high unemployment and the potential for fading consumer and commercial demand. We are closely monitoring trends in both retail and office commercial real estate, both for our customers and in our operating footprint.

Our overall outlook remains cautious at this point, though we are seeking new lending relationships. We do believe we will have losses at some point, but we believe our portfolio is well diversified and will hold up much better than most. Importantly, we believe our capital and liquidity position are as strong as they have been.

In regards to the fourth quarter, specifically, total loans increased $4.5 million from last quarter in spite of the $62.6 million of PPP loans forgiven. We did not see a significant line of credit drawdowns at Old Second in the fourth quarter. Thus far in 2020, line drawdowns have continued to remain muted. Loan growth trends in 2021 should improve from a year ago, though the path of the overall economy and pandemic progression could impact that estimation.

Overall, we remain cautious but surprisingly encouraged about our results in a number of areas, and I'll turn it over to Brad to provide more color.

Thank you, Jim. Good morning, everybody. Net interest income increased $1.4 million relative to last quarter and $700,000 relative to the fourth quarter of 2019. The margin was favorably impacted by the net loan fee income recorded due to the $62.6 million of forgiven PPP loans in the fourth quarter. This net fee income offset the further expansion of excess liquidity on the balance sheet and the impact of lower-yielding loans still outstanding.

We continue to have strong deposit inflows and substantial excess liquidity for the entirety of the quarter. We have begun to cautiously deploy some of that excess liquidity, including the purchase of approximately $50 million of securities during the quarter. We've also made other short duration investments.

The strategy to deploy a portion of the excess liquidity will continue in the short term, while we remain cautious on both duration and credit. Our margin performance, exclusive of the liquidity and PPP factors remained relatively stable this quarter. I still am not assuming at this point anyway that the deposit inflows will reverse quickly. If the outflow or bounce back is relatively quick, our margin outlook would improve substantially. If economic conditions improve and loan growth returns, our margin outlook would improve substantially. I do not currently expect either of those conditions to occur in the short term.

Fee income trends declined in the fourth quarter of 2020 compared to last quarter due to the seasonal slowdown in mortgage originations as well as a higher mark-to-market loss on MSRs. Net gains on the sale of mortgage loans were still approximately 200% over net gains from the fourth quarter of 2019.

Overall, the quarter was still very strong in this respect. Service charges on deposits were slightly higher in the fourth quarter of 2020 compared to last quarter, with 28% less in the fourth quarter of 2019. In addition, a BOLI death benefit of approximately $900,000 was received in the fourth quarter of 2019 and which was not repeated thankfully in this quarter.

No provision for loan losses was recorded this quarter following the approximate $10.4 million of provision expense recorded earlier in the year. The economic outlook for us assumes a slight improvement to the prolonged recessionary environment with an unemployment rate remaining at approximately 7% through September 30 this year and elevated over the remaining life of the loans.

As Jim mentioned, Old Second has minimal exposure to the hardest hit industry and a very strong credit culture overall. We spend a lot of time looking at things and it's extremely interesting to us that exclusive of a couple of credits that are just ridiculously obviously due to COVID, and shut down our credit overall, including trends in classifieds and non-accruals, and basically everything has improved markedly this year, certainly not something we expected.

Still, our consumer lending exposure is -- remains relatively modest. We're not seeing any weakening there at all. Reserves across the commercial book are up, obviously, a great deal in excess of 50% this year. I think at this point, we are extremely pleased with both how credit has performed in 2020 and also what the trends for 2021 look like, we couldn't be more surprised.

Our efforts in the coming quarters will be focused on continuing to help our customers funding quality loan growth where we can, remaining short in duration and extremely cautious on credit, but we are open for business.

I currently expect a stable margin, maybe modest contraction, and that assumes the liquidity remains robust and credit risk spreads remain unreasonably tight. Our capital and liquidity levels are obviously extremely high at this point. We continue to be interested in repurchasing stock. And we're on the lookout for M&A opportunities as they present themselves. Expenses for us, though modestly higher in the fourth quarter due to some basically one-off items, we expect to remain relatively well controlled for the remainder of 2021. And if we see things continuing to remain relatively difficult from an economic environment, the likelihood of some expense initiatives in the second half of the year goes up.

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

Okay. Thanks, Brad. In closing, we remain encouraged with these trends, confident in our balance sheet and ready for the challenges ahead. We have taken the steps to position ourselves well for a slowdown in recession. As Brad mentioned, we believe our credit underwriting has remained disciplined, and our funding and capital position is strong. We remain optimistic that opportunities will be available to improve our franchise. The focus continues to be on timing, and making sure that we have the balance sheet, liquidity and access to capital that we need in order to take advantage.

That concludes our prepared comments this morning. So I will turn it over to the moderator to open it up for questions.

(Operator Instructions) Our first question is coming from Chris McGratty of Keefe, Bruyette, & Woods.

Hey, Brad, just want to start on capital. I appreciate the -- you're looking for inorganic growth. But with your stock at tangible, isn't the play to get really aggressive with the buyback, given where your capital levels are?

A powerful argument can certainly be made for that. It's not something we'd be shy about.

And in terms of that direction, I mean, would you entertain kind of an accelerated buyback given where the levels are?

Yes. I mean that certainly comes with certain expenses associated with it. It's more complicated execution. It's something that we've looked at over the last 6 months or so. I think that there's still a lot of uncertainty out there, Chris. And you can open up a web browser at any given point over the last week and see a number of things that will bother you if you let it. So I would say that it's unlikely that we'll lurch at anything. But given how much capital we've built, the strength of our earnings stream and the underlying trends that we're seeing on credit, the few problems that we have right now are so obvious in terms of their COVID nature and so quantifiable in terms of the potential risk, we don't see a time concerned about.

That being said, there are some obvious structural things in the economy that are changing that we'll have longer-lasting implications. That includes the appetite for office space downtown as well as what brick-and-mortar retail looks like. We're not a huge player in the former and obviously exist somewhat in the latter. But stress in those things will impact us just as it will everyone. So in times like this, I don't feel an overarching desire to lurch at anything. But buyback remains at this point anyway, I do say with confidence, the most attractive thing that I see out there to do with capital.

Great. Thanks for the color. Just in terms of the revenue outlook because margins obviously pretty tough to predict with liquidity. How should we think about net interest income...

I think we lost Chris there. Chris, are you still there?

Yes, I'm here. Am I still there?

Yes, sir. I can hear you. Management team, can you hear us at this time? I'm sorry, they seem to be having some technical issues.

Well, it appears that we might have some technical difficulties. We are not able to hear anything that's coming through the line right now.

Ladies and gentlemen, please stand by while we get our management team back on the line. Mr. McGratty, just one moment, please, we will bring you back in the queue.

Ladies and gentlemen, we apologize for that inconvenience. Chris, you are back on with the presenters for today.

All right. Great. Thanks for the color on the buyback, Brad. I wanted to switch on the outlook for net interest income. I understand the difficulties of margin given liquidity. How should we think about net interest income growth or stability, excluding the PPP in light of what you've talked about? You do have some borrowings on the balance sheet. I'm wondering if those are on the table at all? And just any color on the NII guide will be great.

So I feel pretty good that we can offset the runoff of the PPP loans, but obviously significantly better yield than what the PPP is giving us. And that should be basically a one-to-one wash as the remainder of our PPP loans are forgiven. We will continue to deploy some of the excess liquidity in various short duration low credit risk ways.

In addition, the debt that you speak of on the balance sheet is callable at the very end of the year. So it won't provide any benefit this year, but will provide substantial benefit next year, assuming that the issuance market remains the same, the same level of spreads. Overall, I do believe that we'll grow net interest income quite nicely this year. What the margin is, is almost a separate discussion at this point, given the impact of the liquidity and the sizable cash position that we're holding that basically phases 10 basis points. So really, the reported margin is just a function of that. Net interest income should show growth, it's in line with what we typically have produced. I expect 2021 will be a pretty good year on the revenue growth front.

Okay. What -- Brad, what's left on the PPP, like the fees?

I think we've got about $400,000, $500,000 in the remaining.

Okay, great.

Almost 70% of our PPPs have been forgiven already, so we'll be able to redeploy a lot of that.

Our next question is coming from Bob Shone of Piper Sandler.

It's Bob on for Nate. How are you guys doing?

Good. Bob, how are you?

Good. I just wanted to start on expenses. And maybe we know that we get the 1Q compensation increase that we usually see. But maybe how should we think about the quarterly run rate and overall expense growth for 2021? And then in addition, maybe an update on any willingness to hire additional relationship managers, given kind of the dislocation we've seen in the Chicago market?

So a big part of the underlying expense trend that we've seen, aside from some of the one-timers that we discussed in the fourth quarter, we actually had some people start going to the doctor again in the last part of the year. So claims within basically employee benefits were up rather sizably. I think that a significant portion of the expense growth that we expect in 2021 will be people just actually going to the doctor again is just peer levels of size. Employee benefits were down this year by a rather substantial amount just based on people not leaving the house. I would say this is probably going to be half.

In terms of the expense growth overall, I think somewhere in the 3% to 4% range. And that's going to push you somewhere around $20 million to $21 million per quarter, maybe closer to $21 million in total OpEx, exclusive of mortgage banking activity. That is assuming that mortgage banking activity stayed the same as it is right now, which I don't actually believe will occur. But just to give you an idea of the underlying dynamics.

That's great color. And then maybe turning to loan growth. Maybe can you talk about some of the drivers of the loan growth, excluding PPP, we saw this quarter. And then maybe how pipelines have trended since last quarter?

Sure, Bob, yes, we're obviously very pleased with the fourth quarter. There was a handful of large relationships that we're successfully able to close. Some of them we thought we're going to close in the third quarter kind of spilled over into fourth quarter. We had further expansion in multifamily, professional services, health care. Health care has an extremely successful year and we have continued expansion in leasing. So unusual for the fourth quarter, but we're very pleased with it. Looking into next year, you had asked about adding to our talent base. We're certainly open-minded about that. And I think we have the capacity to take on another team if one becomes available without really adding to the overall headcount as we do expect a few retirements at some point this year.

Okay. And then maybe if I could sneak one more in. In your prepared remarks, you talked about the reserve and having more weight on pessimistic scenarios, say that there is a little less weight on these pessimistic scenarios. What's a more normalized reserve level for the company under kind of that situation?

That's a question with a lot of variables to it. I would say that if we were purely to equal weight, the base case scenarios that are out of the Moody's and Fed right now, our reserve would probably be about 15% lower today.

Our next question is coming from Evan Lisle of Janney Montgomery Scott.

Yes, it's Evan. I'm on for Brian Martin is morning. Yes. So first, I think I'm going to start with just -- I know you guys gave some color on the criticized and classified levels. Would just -- would you anticipate that those levels, 4Q, maybe they're at a peak with a slightly better macroeconomic outlooks. And just -- I don't know, just some color on your anticipation with that going forward.

Sure. I guess, if you step back and look at your year-over-year, our classifieds were -- classified assets were down about 8.5%. So we're pleased with the overall progression. If macroeconomic factors improve, obviously, we expect to see continued improvement in the loan portfolio. We do anticipate meaningful improvement in some of our deferrals in the next quarter as we're already hearing from borrowers that things are stabilizing, and they expect to come off deferrals within the next quarter, credit is holding in nicely.

Okay. Perfect. Yes. And just kind of on that point, I know last quarter, you guys don't have direct exposure to COVID industries, like you said on the call, but I was just curious, you gave some color on stressed areas. And just if you could give an update on those areas, that would be helpful.

Yes. I mean the most stressed areas now are investor CRE, some multifamily and some retail CRE. Surprisingly, we only help really one investor retail tier in deferral, one office in deferral, which is remarkable. But all signs show that our deferral will continue -- our deferral activity will continue to improve in the next quarter.

Okay. Perfect. And then next, I think you guys have given color on kind of the loan pipeline. And I was just curious your thoughts on that loan production versus payoff and just how you're looking at that moving forward?

Well, first quarter is always a challenging quarter for loan growth. Obviously, very pleased with what we did in the fourth quarter. A lot of that was booked later in the quarter. So got realized some nice benefit as we head into the first quarter. We're seeing some opportunities. Our pipelines are building. I couldn't be more pleased with our health care team and we've got good momentum along various verticals. So I think loan growth in 2021 will be better than 2020.

Okay. Perfect. And then last one for me, just housekeeping. Looking at your core fees, looking at that level in 4Q, is that a good stepping off headed into '21? Are you comfortable with that? Or just how you're looking at core fees going into '21?

I think the core fees is entirely dependent upon what kind of assumptions you place on mortgage. And what happens there. The other things are pretty much at run rate. And we should do reasonably well growing that within any other cash and if commercial loan growth activity comes in and we start seeing some loan origination fees, we can get a nice balance there. But your guess on mortgage is as good as mine.

(Operator Instructions). Our next question is coming from David Long of Raymond James.

Good morning, everyone. I know you mentioned M&A opportunities are always kind of looking there. But we expected M&A activity to be rather light, but it seems like volume is really picking up here, and we even had a deal announced in Chicago here last week. Just curious if you're, one, actively having conversations today; and two, what is the tone from potential partners on pricing? And how has their expectations changed?

We are having conversations, but that has been the case for the bulk of this year, just you try and stay close to people, so you know what everybody is going through. I think that when we see 6 or 7 months with valuations being depressed and albeit universally, so everybody's expectations could come closer together. There's very little dispersion right now, at least in the community bank space in terms of where valuations are. So I think the deals can get done in this environment. I'm optimistic that that's the case. And I think that sellers are more rational today than they have been in probably 2 years.

Got it. Okay. And then as you're having these discussions, and what is the key item that you're looking for in a bank that you'd like to partner with? Is it -- I feel like it used to be getting good core deposits, but everyone has liquidity today. So just curious what you're looking to most accomplish with doing a transaction at this point?

I think enhance Chicago distribution as a factor still to make the M&A math work, a base level of profitability is required. It doesn't have to be off the charts good. But between supplementing a Chicago presence, if it comes with a couple of good lenders, that would be a bonus, but that's not always the case. Base level of profitability to make the M&A map work. I think that we wouldn't be shy about a lever at this point, it's something that gives a return to our investors, I think, is prudent given the level of capital that we're having. So maybe more so today than we would have even 1 year ago, I think a simple lever can be attractive.

Our next question is coming from David Konrad of D.A. Davidson.

A couple of questions. One is housekeeping on the PPP. Just wondered on the forgiveness this quarter, what was the dollar amount of the fees that came through NII?

Yes. I think we'll give that number. I think it's about $1.6 million.

Yes, okay. And that will drop to $450,000 or so in the first half of next year with the remaining outstanding?

That's correct.

Okay. And then more of a broader picture, a lot of your peers are putting liquidity into mortgage-backed securities despite compressed spreads and obviously, the convexity risk, but it looks like you guys are doing something a little bit unique in going to the asset-backed market. So just wondering what you're doing there? And then what type of securities and kind of the yield versus maybe the MBS yield, kind of the trade-off there versus the shorter duration?

So the only thing that we've done at this point was we put about $50 million into variable rate belt product. And largely, that was done or in its entirety that was done before the chatter around student loan forgiveness. So basically, it was a dislocation there based on both the variable and the opportunity for some spread tightening based on the political chatter. And where does that fit broadly into what we're doing.

So you talked about relatively short duration based on that factor. And then also there's an implicit 97% government guarantee on those assets as well. So we're staying relatively at least effectively short and then also looking for a very strong and supportive credit. The only other thing we've done is some issues that are likely to be callable also variable based on call trends within similar assets. So basically, effective short duration with a credit guarantee is basically where we've been playing.

Our next question is coming from [Eric Grubelich,] a private investor.

Yes. Jim, I may have missed this at the beginning, but did you mention your potential activity in the second round of the PPP loans and what you might be doing there compared to the first round?

Yes. We have started, [Eric.] I would say, loans in the pipeline now after the first couple of weeks in the program relative to the first round is significantly lower. Right now, for us, we're probably at 20% to 25% of the volume today where we were in the first go round. So it certainly doesn't look like we're going to have anywhere close to the activity we had in the first round.

So impact on margin is not going to be as meaningful as it was in the past.

I would -- if I had to guess, that would be somewhere between 25% and 50%.

Okay. Yes. And then I just had an unrelated question. I think Brad had mentioned -- he had a question from, I think, David Long about M&A. And you used the word distribution in Chicago. And I guess my question for you is, what's important in the distribution? Is it the physical location? Or is it really the bodies, the lenders, the relationship managers, and is it -- how hard or likely is it to try and lift people out you want rather than taking a risk of buying a whole institution, especially if you don't need the liquidity?

It's both. We've had the conversation for upwards of 20 years about how brick-and-mortar distribution is going away. And it tends to coincide with the movement of interest rates, specifically 5- to 10-year interest rates. Every time it falls, everybody assumes that nobody cares about branches anymore. And every time it rises, be announced they're going to build more branches.

The reality is that things don't change that quickly. The bulk of depositors still grew up in a world and normal world where physical presence matters. And to think that people come out of this situation once the pandemics subsides and don't want to return to some level of normalcy in running errands and logging into the branch and saying hi to Suzi teller, it is naive. So similar to what -- how I answered the stock buyback question is we tend not to lurch in any one direction with which way the wind is blowing.

The reality is for at least probably the next 10 years is physical distribution still is going to matter at some level. To the degree it was 10 years ago, absolutely not. But it's also not obsolete at this point either, given the fact that the bulk of depositors are baby boomers more later. So we still place a value on that. There is still value on that. And we will evaluate it based on that fundamental assumption.

At this time, I'd like to turn the floor back over to management for closing comments.

That concludes our presentation for today. Thank you for joining us, and we look forward to talking to you again next quarter.