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Alerus Financial Corp. (NASDAQ:ALRS)
Q3 2019 Earnings Call
Oct 25, 2019, 9:30 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning everyone and welcome to the Alerus Financial Corporation earnings conference call. [Operator instructions] Please note today's 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 in the company's SEC filings.

At this time, I'd like to turn the conference call over to Alerus Financial Corporation chairman, president, and CEO, Randy Newman. Sir, please go ahead.

Randy Newman -- Chairman, President, and Chief Executive Officer

All right. Thank you, Jamie. Good morning, everyone and thank you all for joining us on our call today. Let me first note the significance of today, due to the fact that this is our first earnings call with analysts and investors.

There are several company initiatives that I would like to mention today. But first, let me begin with our third-quarter 2019 financial performance. Financial results were as expected for the third-quarter 2019. We were pleased to report year-to-date net income for the first nine months of 2019, up $21 million to $21.9 million or 10.4%, compared to 2018.

Year-to-date ROA was 1.34% and return on tangible capital equity was 19.24%. Dividends per share equaled 0.42 or $0.42 cents per share, an increase of 7.7% or $0.03 per share over the $0.39 per share reported in 2018, and diluted CPS was a $1.49 per share, which was an increase of 8.8% over the $1.37 share reported year-to-date 2018. The company accomplished two significant milestones this past quarter both of which are key in positioning the company for long-term success. First, after several years of planning, we completed our initial public offering and began trading on NASDAQ in mid-September.

The initial public offering was one of the most important decisions the company has ever made. The IPO raised $62.8 million, increasing our capital, strengthening our balance sheet, and positioning our company, and excellent financial condition to pursue our strategic plan for the future. Also in September, we launched our new digital experience for consumer clients to access their entire financial picture through a holistic dashboard. MY ALERUS was a significant project for our company and successful conversion for us.

With MY ALERUS, we are providing holistic financial wellness tools paired with a seamless account opening to help improve our clients' financial lives. Organic growth and client success continues to be one of our top objectives. Our strong core operating earnings have allowed us to achieve better than average financial results while still meeting the needs of our clients. We expect guidance and improving their personal finances by investing in client application technologies with a digital delivery and access to their complete financial information.

These long-term strategic technology investments, combined with our trained team of advisors, allows us to add valuable holistic advice to help them organize, manage, and improve their personal financial situation. In addition, I would like to give an update on several highlights related to our ability to grow and outperform our peers. For several years, Alerus had been building a foundation for growth in the high performance. For example, our professional high-value business model is diversified and offers organic growth opportunities with both current and new clients, and allows us to achieve annuitized revenue, is less capital intensive, and allows us to operate with less balance sheet risk.

Although we just launched MY ALERUS in September, we are seeing early success. The investments we have made in conjunction with sales training, salesforce, and our collaborative Alerus culture, are resonating and resulting in new business. Just as an example, we have had a couple of great wins in the Twin Cities with clients moving their business, including over $20 million of deposits to Alerus. We operate in four metropolitan statistical areas: the Grand Forks, North Dakota and East Grand Forks, Minnesota MSA; the Fargo, West Fargo-Moorhead MSA; the Phoenix-Scottsdale-Mesa MSA; and the Minneapolis-St.

Paul MSA. The Phoenix and Twin Cities MSAs are the 11th and 16th largest MSA, respectfully in the United States. In addition to our growth opportunities in these markets, Alerus has formalized our niche national market strategy and named a national market president who is focused on our over 360,000 participants in our Alerus retirement and benefits division. And as mentioned before, we successfully completed the rollout of MY ALERUS to clients in our local markets.

We believe our investments in talent and technology will organically grow revenue and we are focused on managing expenses. These investments also position us to scale through strategic and synergistic acquisitions in the fee income business lines of our company. We believe the synergistic revenue acquisitions will continue to improve our financial performance and ratios, and highlight the quality of our earnings, which are less capital intensive, and with less balance sheet risk. Let me now turn it over to Katie Lorenson, our CFO to discuss the financials in more detail.

Katie Lorenson -- Chief Financial Officer

Thank you, Randy and good morning, everyone. Yesterday afternoon, we announced net income of $7.1 million or $0.48 per diluted share for the third quarter of 2019, compared to net income of $8.3 million or $0.57 per share -- per diluted share in the second quarter of 2019. During the third quarter, net interest income increased $390,000 on a linked-quarter basis, as an interest recovery of approximately $400,000 was received. And proceeds from the IPO were used to payout our short-term borrowings, decreasing our interest expense by approximately $200,000.

The reported net interest margin was 3.69%, excluding loans held for sale in the interest recovery, the margin was stable quarter over quarter at 362. Loan yields again, excluding loans held for sale and interest recovery, decreased from 499 to 496 driven by the impact of the Fed's rate cuts on our variable loan portfolio. The cost of funds decreased during the third quarter to 1.39% from 1.41% in the second quarter. We have a strong and growing core deposit franchise, comprised of nearly 30% of non-interest bearing accounts.

In addition, our growth in our synergistic deposits is well-timed and a rate down environment, as these funds have 100% data and reprice every quarter. We also we're very disciplined and continue to be disciplined in the public funds arena, and did not and have not bid up on any long-term money or [Inaudible]. Overall, margins are challenging the forecast, says, perceptions about short and long term interest rates are changing so quickly. We, like most financial institutions, do expect compression in our margins.

But that level of compression will be highly dependent on our mix of assets, as we continue to deploy proceeds from the [Inaudible]. In summary, we are focused on attracting and retaining clients, and growing our net interest income dollars for the long-term. But we will continue to do this while adhering to our disciplined credit culture. A segment to asset quality.

Asset quality continued to improve during the third quarter. We had a net recovery quarter, bringing our year-to-date charge offs to average loan to 27 basis points. The provision for loan loss, decreased nearly 300,000 in the third quarter, compared to the second quarter of 2019, and our allowance for loan losses was one -- 1.36% of total loans and 446% of non-performing at the end of the quarter. Transitioning to the fee income divisions of the company.

We continue to believe our diversified business model is of high value, especially in this continued low rate environment with revenue growth very difficult to attain and spread income. We are pleased to report our non-interest income is about $8 million or 10.5% in the first nine months of 2019, compared to the same period in 2018. The primary driver of the increase is related to our mortgage division, as most of you know, less than two years ago, we hired a new leader and in a very short time, we've invested in technology talent to move to a digital and mandatory delivery. Revenue has increased due to higher profitability and an increase in originations which are up, $75 million more than the first nine months of 2018.

The current rate environment has led to increased refi activity putting the year-to-date mix of 23% refi, compared to 16% a year ago. And we've had five straight months of application volume over $100 million. September broke the streak at $94 million but October pipelines look strong. Over the past several years, the company has historically retained about 20% of origination volume on the balance sheet.

The objective was to build net interest income and reduce asset sensitivity. Given the low rate environment and higher just -- higher margins on loans sold, the level of retained loans has decreased to $57 million in 2019 or approximately 8% of originations. This has positively impacted mortgage revenue but reduces loan growth year over year. Lastly, we continue to focus on efficiency within the mortgage division.

Our digital application tool has reached 65% utilization rate in just a few months. Our most recent digital marketing campaign resulted in 103 loans and over $800,000 of revenue, and we're up just one FTE despite a 12% increase in origination. Other non-interest income is up nearly $2 million in 2019, compared to 2018. This is due again to the sale of our Duluth branch in the second quarter and a $500,000 gain in the third quarter related to a parcel of land.

Wealth management revenue has increased from prior year by approximately 4%, as assets under management have increased nearly $215 million -- $250 million or 14%. The increase was driven by strong sales growth in all markets, totaling $185 million for the first nine months of the year. Market gains for the year nearly $200 million and net growth is highest at $31 million in our blueprint product, a key synergy with our retirement plan clients, and continued opportunity for growth. Our managed account offering was rolled out to alert plan participants in the third quarter and grew to over $4 million quickly.

The digital advice solution is built within MY ALERUS and will be offered to external pilot clients in the fourth quarter. We continue to focus on growing our assets by increasing our capture rate of rollovers and terminated participants. And we have also invested in talent, adding and promoting seven producers, who continued to integrate into the Alerus model and build a robust pipeline. Last but not least, the recap of our retirement division.

Total assets under administration have increased 10% to $30.7 billion from the low point and $27.8 billion at the end of '18. Revenue for the division is down approximately, 1.5% at $46 million for the year through September as outflows have outpaced implode by approximately $500 million, and new revenue per plan is typically lower than a lost or terminated plan. However, transaction and related fees continue to increase, and the number of plans and participants continue to trend positive. Retirement plans are up 122 to 6,860 and participants have increased over 10,000 to nearly 366,000 clients.

Notably, money market deposits sourced from this division exceeded $85 million at the end of September. Moving to expenses, which totaled $106 million through the first nine months, and have increased $5.7 million and 5.7%. This increase is primarily related to personnel clubs, which include an increase in variable compensation and in mortgage department. In addition, we are a self-insured organization and health costs have continued to be a challenge through 2019.

We will be spending time focusing on our options in 2020. Technology expenses continue to increase in the third quarter, as we see quarters with a full run rate of the related investments. However, most other expense quarter -- categories are down as leadership teams place emphasis on managing expenses and building scale throughout our business. Efficiency and operating leverage are a key focus for all leadership and teams in the company.

We continue to manage FTEs and process improvement. As an example, our operations team has saved over 240 hours per month through processing [Inaudible]. We believe that they are just getting started. Loan balance has decreased $27 million or $1.6 million in the third quarter.

The decrease was primarily in the commercial loan portfolio. Factors contributing to the decrease included reduction in commercial line utilization from 41% at the end of the second quarter to 33% and the lowest we've seen in the trailing 10 quarters. We also successfully exited nearly $7 million of criticized credit during the quarter, bringing our total exit by our special credit services up to over $20 million in 2019. We continue to see significant competition for loans in all of our markets and we have chosen not to pursue certain deals with undesirable structures and pricing.

That said, we closed or expect to close nearly $80 million of construction loans by the end of the year. Fundings on these loans will be limited in 2019. However, we see the benefit of these balances into 2020. Lastly, on the funding side, deposit growth was very strong for the third quarter, increasing nearly $80 million.

The growth was comprised of core growth with existing clients, as well as, a nice new business wins, and $43 million of the increase was in -- was from our deposits sourced from our wealth and retirement division. In addition, our health savings accounts increased at a 12% annualized rates in the third quarter, and public funds continued to trend down with a $10 million dollar decrease. I will now turn it back to Randy Newman for closing comments.

Randy Newman -- Chairman, President, and Chief Executive Officer

Thank you, Katie and our personal thanks to all of you on this call for listening to our first earnings call, and for your continued interest in Alerus. I might also note that Karin Taylor, our chief risk officer is also with us this morning and available for questions. And at this time, that completes our prepared remarks. And we'll turn it back to our operator and we welcome your questions.

Thanks, again.

Questions & Answers:

Operator

[Operator instructions] First question today comes from Jeff Rollins from D.A. Davidson. Please go ahead with your question.

Jeff Rollins -- D.A. Davidson -- Analyst

Thanks. Good morning.

Katie Lorenson -- Chief Financial Officer

Good morning, Jeff.

Jeff Rollins -- D.A. Davidson -- Analyst

A couple of questions on the margin. How much did the interest recoveries add in basis points this quarter around, I guess, around 9 basis points, is that it?

Katie Lorenson -- Chief Financial Officer

No. It should be around 7 basis points.

Jeff Rollins -- D.A. Davidson -- Analyst

Seven? OK. And were --

Katie Lorenson -- Chief Financial Officer

Yup.

Jeff Rollins -- D.A. Davidson -- Analyst

Sorry?

Katie Lorenson -- Chief Financial Officer

No, go ahead, Jeff.

Jeff Rollins -- D.A. Davidson -- Analyst

Now, were there interest recoveries last quarter?

Katie Lorenson -- Chief Financial Officer

Nothing of any significance, no.

Jeff Rollins -- D.A. Davidson -- Analyst

OK. So, sequential margin, I suppose in the flattish range. I guess, Katie or Randy, kind of outlook on margin going forward. You've alluded to some -- expecting some compression but kind of, as we, if you could kind of frame up the asset sensitivity and in your assumptions behind kind of broad compression.

That'll be helpful. Thanks.

Katie Lorenson -- Chief Financial Officer

Sure. Yeah. So again, with loan growth fairly flat for the quarter, predicted to be fairly flat for the outlook of the quarter I should say in Q4. So, we will be continuing to put proceeds into the investment portfolio.

We expect overall on the margin to see compression into the mid-350s, mid to upper 350s for the fourth quarter.

Jeff Rollins -- D.A. Davidson -- Analyst

I'm sorry what was that last bit? The -- that was margin?

Katie Lorenson -- Chief Financial Officer

That was margin yes.

Jeff Rollins -- D.A. Davidson -- Analyst

Three -- the 350s?

Katie Lorenson -- Chief Financial Officer

Yes, mid- to upper 350s.

Jeff Rollins -- D.A. Davidson -- Analyst

OK. Great. And the -- I guess, the provision, you know, you had some reserve build, you had net runoff, just a small increase in NPAs. Just trying to think about the mentality of building those in a quarter that didn't have a ton of growth.

If you could maybe speak to that?

Katie Lorenson -- Chief Financial Officer

Yes, absolutely. We -- no, we feel very strongly in building balance sheet strength. That being said, we did back off from where we had been forecasting because the loan growth coming in less than expected. Outlook for fourth quarter would -- with the flat would be -- and we do anticipate higher level of charge-offs in the fourth quarter, bringing our annualized charge-off rate closer to the mid-30s for the year.

So you know, we think provision expenses probably in the 1 3 to 1 5 range for the fourth quarter.

Jeff Rollins -- D.A. Davidson -- Analyst

Great. Here's the last question, would be in that C&I book kind of running out some criticized loans. Is there -- is there more woodshop in there? And I guess, there's always credit pruning going on, but is there identified credits that we could see some more come out of that C&I book or things you're working on?

Karin Taylor -- Chief Risk Officer

Right, Jeff. This is Karin Taylor speaking. We do have some additional credits in our special credit services division that are slated to exit, although at a much lesser rate than we experienced in 2019. We would expect, you know, there may be some yes this year, but more likely some into 2020, and that would be at less than half the rate we experienced in 2019.

Jeff Rollins -- D.A. Davidson -- Analyst

Great, thanks. I'll get back.

Operator

Our next question comes from Nathan Race from Piper Jaffray. Please go ahead with your question.

Nathan Race -- Piper Jaffray -- Analyst

Hi, everyone. Good morning.

Katie Lorenson -- Chief Financial Officer

Good morning, Nate.

Nathan Race -- Piper Jaffray -- Analyst

Katie, perhaps to start on expenses for the fourth quarter, assuming we get lower production on the residential side of things. Could you kind of just help us with the run rate expectations for 4Q, and perhaps, start-ins into 2020 as well?

Katie Lorenson -- Chief Financial Officer

Right. Yes. Yeah. We do expect to see some downward trends in the fourth quarter.

Again, variability will depend on the mortgage book. Pipelines look strong for October in particular, and you know, the rest is variable as we look out much further than that. Refi businesses is a bigger piece of portfolio so the fallout rates is a little bit higher. So that will add -- that will add variability to the expense line.

But as we look to Q4 now, we look to see about $1 million decline quarter -- on a linked-quarter basis.

Nathan Race -- Piper Jaffray -- Analyst

That's helpful. And then, maybe changing gears, I'm thinking about income trends in the quarter. Retirement and benefits services fees were down sequentially, and they tend to pick up a little bit in the fourth quarter. Does that kind of -- how you expect that line to kind of traject to 4Q?

Katie Lorenson -- Chief Financial Officer

Yeah, we do. Our -- little bit of volatility in the third quarter was right -- relating to a revenue-sharing component, which is one of the few components of revenue remaining that's recorded on a cash basis, and that does have some timing volatilities. So, it was $600,000 in the first quarter and $900,000 in the second quarter, and then, dropped to $300,000 in the third quarter. We expect that to turn to -- to return to kind of a normalized run rate level in the fourth quarter.

And we're doing a lot of work to smooth that out and understand the timing a little bit better, and [Inaudible] for what we know is coming. In addition, there are -- there's typically -- from our ESOP business, they typically have a strong fourth quarter. They, of course, have annuitized revenue but also some transaction fees, and we do expect a stronger for -- a strong fourth quarter from them. So, from a revenue standpoint, you know, we believe that the fourth quarter will show better than the third quarter at 15.3, hopefully, closer to the 15.5 to 15 7, 8, 9 range.

Nathan Race -- Piper Jaffray -- Analyst

OK. That's very helpful. And then, just quickly on the tax rate, kind of between 24% and 25%, so a good number to use going forward?

Katie Lorenson -- Chief Financial Officer

Yeah. The -- you know, I think, that based on what we can see where our accruals were at, and I think, we're -- I think, we are pretty conservative, as we looked through the tax rate. So, going forward, I think, we'll be in the 23% to 24% range.

Nathan Race -- Piper Jaffray -- Analyst

OK, great. I appreciate the color. Thank you.

Katie Lorenson -- Chief Financial Officer

Thanks, Nate.

Operator

[Operator instructions] Our next question comes from Daniel Cardenas from Raymond James. Please go ahead with your question.

Daniel Cardenas -- Raymond James -- Analyst

Good morning, guys.

Katie Lorenson -- Chief Financial Officer

Good morning, Dan.

Randy Newman -- Chairman, President, and Chief Executive Officer

Hi, Dan.

Daniel Cardenas -- Raymond James -- Analyst

Just a quick question under assets, under administration. I mean, big drop on a sequential-quarter basis. Maybe a little bit of color of inflows versus outflows, and expectations for any potential rebound here in Q4 under the -- for AUAs.

Unknown speaker

That's year-to-date.

Katie Lorenson -- Chief Financial Officer

So, just real quickly, Dan. Can you -- can you repeat that one more time?

Randy Newman -- Chairman, President, and Chief Executive Officer

Your question is on the outflow, Dan? Is that right?

Daniel Cardenas -- Raymond James -- Analyst

Yeah. Just kind of looking to see. So, you know, we saw about a $150 million decline under your AUA. So, just kind of wanted to see what was driving that.

And then maybe, get some color as to what the inflows look like during the quarter.

Katie Lorenson -- Chief Financial Officer

Sure. Sure. So, overall assets within the whole retirement division because, as you know, there's AUA and AUM. We're pretty -- we're actually pretty consistent with levels reported in the third quarter.

So that being said, the terminated business for the year is up $500 million, compared to -- or the outflows I should say, compared to the inflows that that trend has been pretty consistent over the period. Then, you know, that's what leads to -- typically our revenue on a plan that is terminated or a loss plan is higher than a plan that comes in based either on the size of the plan and or just the overall fees. And so, that -- that's part of what drove the decline in the linked-quarter.

Daniel Cardenas -- Raymond James -- Analyst

OK. Good. And then, maybe just a little bit of color on the expected uptick in charge-offs coming here in 4Q, is that commercial-related or what's really driving your expectations for a little bit higher net charge-off level in the quarter?

Karin Taylor -- Chief Risk Officer

Sure, Dan. This is Karin. It is commercial related, one credit, in particular, that's been in our special credit services area that we intend to clean up in the last quarter of the year.

Daniel Cardenas -- Raymond James -- Analyst

All right. And then, maybe some color on level of classified assets. Where does that number stand at quarter-end?

Karin Taylor -- Chief Risk Officer

Yeah. Our classified assets, we were able to reduce those by about 16%. So, we are down to about $48 million in classified loans.

Daniel Cardenas -- Raymond James -- Analyst

All right. Great. And then, HSA balances, what were those at the end of the quarter?

Katie Lorenson -- Chief Financial Officer

The HSA balances were almost $118 million at the end of the quarter.

Daniel Cardenas -- Raymond James -- Analyst

OK. And so, it just kind of jumping over to loan growth quickly. I mean, it sounds like we're looking for flattish growth here in Q4, as you kind of look at it to 2020. I mean, what's kind of your thoughts for annual loan growth in 2020?

Karin Taylor -- Chief Risk Officer

Yeah. This is Karin again. We -- we're still expecting mid-single-digit growth in 2020. Our pipelines are good.

But as we look out through the quarter, just the timing of closing and funding, they're such that we really don't see the benefit until 2020.

Daniel Cardenas -- Raymond James -- Analyst

OK. And then, last question for me. Just in terms of capital utilization. So, you guys raised some capital here back in September.

Any thoughts on the M&A environment? What's that looking like, specifically, on the retirement and benefits side?

Katie Lorenson -- Chief Financial Officer

Yes, Dan. This is Katie. We were very pleased with the level of engagements that we are seeing in the market as far as the number of calls we are getting, and the number of opportunities that we believe exist. We're continuing to kind of build our target list and our pipeline, but our having active conversations with five to six different companies right now in the fee income side.

Of the varying different stages, and again, just conversations now. But I'm very pleased to see the level of interest and the amount of solicitation that we're getting from companies that are interested in potentially exiting.

Daniel Cardenas -- Raymond James -- Analyst

OK. Good luck on that. And then, maybe just one last question on the margin. If you can remind me what -- how many, how many rate cuts do you have baked into your 4Q assumption and how many, if any, do you have baked into 2020?

Katie Lorenson -- Chief Financial Officer

So, we do not have any baked into our model right now. A 25-basis-point cut is about an $800,000 annual impact on our static balance sheet as of the end of the quarter.

Daniel Cardenas -- Raymond James -- Analyst

So, that would be about what, but seven or eight basis points?

Katie Lorenson -- Chief Financial Officer

Yep. It should be a little bit less than that. It should be about five or 6 basis points.

Daniel Cardenas -- Raymond James -- Analyst

Five or six. Right. That's it for me right now. Step back.

Katie Lorenson -- Chief Financial Officer

Thanks, Dan.

Operator

[Operator instructions] And ladies and gentlemen, at this time, I'm showing no additional questions. I'd like to turn the conference call back over to management for any closing remarks.

Randy Newman -- Chairman, President, and Chief Executive Officer

We don't have any additional closing remarks. So, we appreciate everyone's participation this morning. Thanks, again.

Operator

[Operator signoff]

Duration: 30 minutes

Call participants:

Randy Newman -- Chairman, President, and Chief Executive Officer

Katie Lorenson -- Chief Financial Officer

Jeff Rollins -- D.A. Davidson -- Analyst

Karin Taylor -- Chief Risk Officer

Nathan Race -- Piper Jaffray -- Analyst

Daniel Cardenas -- Raymond James -- Analyst

Unknown speaker

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