Good morning, and welcome to the Alerus Financial Corporation Second Quarter 2020 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. Please note, this event is being recorded. This call may include forward-looking statements. The company's actual results may differ materially from those indicated in any forward-looking statements. Important factors that could cause actual results to differ materially from those indicated in the forward-looking statements are listed in the earnings release and the company's SEC filings. I would now like to turn the conference over to Alerus Financial Corporation Chairman, President and CEO, Randy Newman. Please go ahead.

Thank you, and good morning, everyone. This is our fourth earnings call since our IPO in September 2019. This morning, we intend to discuss our second quarter 2020 financial results and the current impact of the COVID-19 pandemic. I might also mention that we've updated our investor presentation for our second quarter performance, and you can access that on our website. Today, I'm joined by our Chief Financial Officer, Katie Lorenson; and our Chief Risk Officer, Karin Taylor. As always, we appreciate your interest in our company. In today's call, I will first highlight our record-setting earnings for the quarter and other key points before turning it over to Katie and Karin. After that, we would welcome your questions. Our financial performance in the second quarter mirrors what other banks with diversified business models are reporting. Significant balance sheet growth as a result of almost $360 million of PPP loans, weaker net interest margins, and record mortgage revenue growth. All of this resulted in Alerus reporting a record quarter with net income of $11.5 million. Although the pandemic has been incredibly disruptive, we are blessed with very talented, loyal, and committed professional employees, who are driven to providing exceptional client service. Despite the challenges of moving to a remote work environment and the impact of COVID on personal lives, our employees worked above and beyond to deliver record-setting mortgage production of $431 million to over 2,200 clients. Additionally, our banking division made 1,600 PPP loans providing over $360 million of funding, which also included loans to 370 new banking clients. We also introduced the first of several virtual webinars in the second quarter to provide guidance and help clients with their financial issues in a number of different areas. At our last earnings call, I recall our past experience in dealing with disasters. These learned experiences have enabled us to move quickly and adapt to changing work conditions, proactively respond to increased client requests and inquiries, and never lose sight of managing our company for the long term. Despite volatile and uncertain economic conditions, our company accomplished record-setting production in earnings. Our leadership team is steady and disciplined in our approach. Now more than ever, I am proud to state that our company's focus remains the same. Number one, ensure the safety and well-being of our employees; serve and meet the financial needs of our clients during these unusual economic times; and third, maintain a fortress balance sheet of strong reserve coverage of our credit portfolio, strong core operating earnings from our diversified business model, and maintain robust capital levels. The investments that we have made in technology and people, together with our focus on the One Alerus organic growth strategy, have served our company well during the current pandemic. During these challenging times, they have enabled us to meet and exceed the needs of our clients made more difficult with changing work conditions and record client production. We have seen significant increases in the use of technology that provides digital delivery and client interactions with our trained professionals. In my 40-year career with Alerus and as far back as my record shows, Alerus has performed at an average of 120 ROA, a 12% ROE, and has increased the cash dividend at an average of nearly 9% per year. We continue to believe that our high-value professional services business model in our 60-40 fee income to traditional bank margin income diversification will allow us to outperform our peers and justifies a premium market valuation. We did not anticipate this quarter at our last earnings call, but we are very, very pleased with our financial results. They are an indication of the strength, resiliency, and the consistency of the Alerus business model and leadership team. And while we are optimistic about our ability to meet the challenges of the future, we do anticipate a slower and uncertain economic recovery. Despite these concerns, we believe we are well prepared for these challenges and that Alerus is well-positioned to meet these challenges and needs of our clients, while performing better than our peers. That concludes my initial remarks. And now I'd like to turn it over to Katie Lorenson, our CFO; and Karin Taylor, our Chief Risk Officer, to more specifically discuss our financial performance, our credit quality and more of our company's response to the challenges of COVID-19. We look forward to your questions at the end of their initial discussions. Katie?

Thank you, Randy. Good morning, everyone. Thank you for joining our call today. As Randy noted, the second quarter produced an incredible $11.5 million of net income and year-to-date total asset growth of 22%. We are very pleased to see our investments in our One Alerus culture, our talent, and our technology translate into results. Although uncertainty remains, it is clear the franchise value of our company is strong and resilient to incredible challenges. This morning, I'll briefly walk through some of the highlights for the quarter, and then I'll turn it over to Karin, who will give an update on credit-related matters as well as provisioning. During the second quarter, we saw truly tremendous changes to our balance sheet. First, our loan balances increased over $300 million or 18%. The increase included, of course, the PPP loans, which equated to approximately 20% of our total loans. We experienced increases in our C&I portfolio outside of both PPP loans due to extraordinarily low levels of utilization in our lines of credit. We also experienced, of course, a headwind in the residential portfolio due to the level of refinancing and lower-line utilization in our HELOCs. On the funding side, we continue to see incredible inflows from many different sources. We had some really nice commercial new business generation. Our synergistic deposits continued to build, and we also saw cash reserves continue to build within our client base. We estimate approximately $200 million of the proceeds from the PPP loans came in and are still sitting in our deposit base. This dynamic has weighed heavily on our net interest margin, which moved down 21 basis points in the linked quarter. The highlight of the quarter outside of the level of PPP loans was certainly the record volume of mortgage origination. This was made possible through those previously mentioned investments in technology and talent. The transition to mandatory was timely as margins have exceeded expectations and a healthy pipeline heading into the third quarter put the unrealized gain on mandatory at $5 million for the year. Based on record months of applications, we expect the volume to remain above prior year production. However, it is important to note as the forward commitment declines, unrealized gains will likely decrease from the Q2 level. Moving on to the retirement benefits and payroll division. We did see a revenue decline on a linked-quarter and year-over-year basis. The decline was primarily related to the impact of the decline in the average daily balance of assets and the final adjustment to eliminate revenue sharing and replace those fees with transparent explicit fees in our clients' plans. To be specific, in the second quarter, we finalized the fee schedule changes and made an accrual adjustment to exit its fee income line item. This adjustment caused a $1.2 million decrease on a linked-quarter basis, with the remainder of the difference due to asset-based fees. Although average daily balances did drag during the quarter, the market did rebound and inflows topped outflows, pushing the total assets in the division past the $30 billion mark at the end of the quarter. The on-balance sheet contribution of this division continues to gain significance with over $450 million of deposits sourced at market rates with little overhead costs. While retirement and wealth management growth can certainly be challenging in times like this, our One Alerus approach and our business model provide opportunities to engage with our massive client base and provide advice to those looking for help navigating these uncertain times. In the second quarter, we launched an initiative focused on connecting our sales force of advisors and guides with individual participants in this virtual environment. In the first couple of weeks, the results have already generated a couple dozen opportunities and over $1 million in new wealth management assets. From an expense standpoint, the increase in the quarter was driven entirely by mortgage incentive compensation. Other noteworthy items included the increase in our provision for unfunded commitments, a direct correlation to our decline in line utilization, which accounts for over $800,000 of the increase in the linked quarter expenses. In addition, we had another $300,000 of write-downs on our mortgage servicing assets. Despite these increases in non-operational expenses, our efficiency ratio was improving, and we continue to focus on managing expenses and operational efficiency with urgency. Nearly all expense categories were down, and expenses on a linked quarter, absent these items, would have tracked down about 2%, despite nearly $0.5 million of COVID-related expenses in the quarter. Expense management is top of mind for our leadership team as we continue to manage the company during this challenging environment. We are proud of our record performance achieved during this quarter, but we also recognize the economic uncertainty and headwinds that lie ahead. Karin, I'll turn it over to you.

Thank you, Katie, and good morning, everyone. First, I'll provide a brief update on our banking markets. We continue to effectively serve our clients in all markets, virtually, digitally via the drive-thru, and in-person as conditions allow. The North Dakota market was never subject to a stay-at-home order. There were restrictions in place for certain businesses, and those were lifted at the end of April. By and large, Grand Forks and Fargo are widely open for business and have been for some time. The Twin Cities market was subject to a stay-at-home order until mid-May. Minnesota then implemented a 4-phase stay safe plan to reopen businesses, and the market continues to make measured progress in reopening. The situation in Arizona has been more serious with the resurgence in cases. We continue to focus on serving clients via technology and the drive-through in that market. Employees across our company worked with urgency during the second quarter to deliver relief to our clients. As Katie mentioned, loans increased by $313 million during the first half of the year, fueled by the addition of $360 million in PPP loans. This was offset by decreases in consumer loans and commercial line usage since the end of the year. The utilization rate on commercial lines decreased to approximately 23% at the end of the second quarter, down from 38% at the end of the first quarter and compared to a 14-quarter average utilization level of 37%. This was primarily the result of increased liquidity of borrowers due in part to various relief programs, including the PPP. Through June 30, we've granted close to 1,600 PPP loans, again, totaling $360 million. Approximately 370 of those loans were made to clients new to Alerus. These relationships have helped build our pipeline for business development, particularly in Arizona, where the market is further from reopening. We have continued to see requests for repayment relief through the second quarter. As of June 30, we had granted 515 deferrals, totaling approximately $148 million in balances, and that was in the form of either a full P&I payment deferral or interest-only arrangement. This represents about 9% of unguaranteed loan balances. Just over half of that relief in dollars was granted to commercial real estate borrowers. Initial deferral periods did not exceed 90 days. As of July 22, 46% of those loan balances granted to deferral had finished the deferral period and resumed normal payments. To date, requests for a second deferral period have been limited, with commercial loan balances granted the second deferral totaling about $3 million. Moving on to asset quality. Net charge-offs for the quarter were $3.3 million, primarily a result of two large commercial charge-offs. Both had been identified as problem credits or on non-accrual and had reserves allocated. The impact of the pandemic did not cause the weakness in these credits, but it did accelerate deterioration in both, one of which was hospitality related. Nonperforming assets to total assets decreased during the quarter from 29 basis points at March 31 to 19 basis points at June 30. The decrease is primarily due to the aforementioned charged-off loans and was partially offset by one relationship that was placed on non-accrual during the quarter. That classification was not a result of stress due to economic conditions related to COVID-19. I'll turn now to the provision for loan losses. There remains a high level of uncertainty regarding the duration of the health crisis, the possibility of surges in cases over a second wave of the virus, and the potential for dialing back the pace of reopening businesses in our market. In the face of this uncertainty, we continue to build our reserves, moving our ratio of allowance to total unguaranteed loan balances to 1.62% compared to 1.54% at the end of March. Our allowance to nonperforming loans also increased to over 500% at the end of June. As I mentioned, the two large loans charged-off during the quarter were fully reserved. The provision this quarter was due to continued economic uncertainty. Increased allocations were made to all segments for current economic conditions as well as to potentially higher risk portions of the portfolio, including small business credits, loans with a payment deferral in place, and criticized loans. These additions dictated a provision of $3.5 million for the quarter and allowed us to maintain our level of unallocated reserve at approximately $1.8 million. We expect to allocate this amount as initial payment relief periods continue to end and we have clear insight as to the impact of the current environment on specific credit. This concludes our prepared comments. We'll now open the meeting up for questions.

We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Jeff Rulis of D.A. Davidson. Please go ahead.

Thanks, good morning.

Good morning, Jeff.

Maybe just a follow-up for Karin. The deferral, that sounds fairly positive on those that are presumed payment, I guess, do you have a figure of current deferrals as a percent of loans? If you're at 9%, it sounds like – is that number in half at this point?

Yes, it's pretty close to half of that, yes.

Okay.

4.7%, I believe.

Okay. So high, $70 million or so. That – and I just wanted to clarify the total deferrals that was all done on 90-day? Were there some 100 – 180-day-type deferrals?

We did not do any 180-day deferrals. No.

Okay. Great. And then, yes, just towards the margin, Katie, if you could outline the impacts on PPP, sort of the excess liquidity headwind, what – in terms of what that did on margin? And then just any color on your ability to deploy or to deploy excess liquidity and kind of the margin outlook from here?

From a PPP standpoint, all else being equal, ex PPP, really, just on the couple of basis points impact for this quarter, excess margin was certainly the weight of it – if you just take out the excess cash that has been sitting on the balance sheet, probably about $100 million of average balance, that probably jumps the NIM up to the 330. So outlook for Q3, we believe Q2 is certainly the low point, looking to continue to put this cash to work. In the investment portfolio, I'm expecting some outflows. So we think some recovery in the NIM going forward as well as continued rate reductions on our money market accounts, which we expect to decrease into the 30 to 40 basis point range for the third quarter.

And my last one, just on the expense side, kind of a cost-conscious approach. And I think – and it's more bigger picture maybe for Randy or Katie on the – kind of how you manage expenses. You've certainly done a lot of heavy lifting on investment into the platform. And I guess from here, it's more of watching costs. But as we move – accelerate more towards sort of a digital experience, I guess, your thoughts on kind of the expense run rate and how you manage kind of investments that you think are good for this climate versus kind of reminding costs and keeping those flat. Just an update on that?

Good question. I think what we're seeing in the second quarter is reflective of the urgency and the efforts in regards to a focus on managing expenses. And really, the bulk of the big investments in terms of technology are in those numbers, the future outlook and the need for any additions there in terms of serving our clients digitally. It's not really on the forefront. Those are in the run rate. We've made those investments already. So from an operational expense standpoint, it was really nice quarter in that regard. And very – the company all throughout is extremely diligent and focused on building efficiencies, whether it's through robotics and automation as well as just capacity within our workforce. So outlook, I think ex the mortgage incentives, we can continue to grow revenue in this company without adding any incremental expense.

Okay, thank you.

The next question comes from William Wallace of Raymond James. Please go ahead.

Actually, a great follow-up to that last question to your last comment was, what was the increase in the comp line from variable comp on the mortgage business?

Good question. It was $3 million for the quarter.

That's the increase of $3 million or the total was $3 million?

That was the increase of $3 million. We went from $2.3 million to $5.3 million.

Okay. And then in your prepared remarks, I apologize, you gave a lot of information, so I just couldn't write it down fast enough. You – I believe you said on the mortgage business that you expect mortgage volume will be – will continue to be elevated year-over-year, but then you said something about the gain that I missed that. Could you kind of restate that and then quantify – help us quantify what your thoughts might be?

Absolutely. So we do anticipate really nice volume moving into the third quarter based on where pipelines are today in our application volume, et cetera. We expect the margins to hold where they are. But as Q4 seasonality comes in, in that forward pipeline decline, which is just natural and a typical year, so you know that this is a typical year, we would expect to see the value of that unrealized gain decrease in the third quarter. And so you can think about it a little bit as just a little bit of an offset to the revenue total.

Okay. Okay. So that variable comp, the $3 million increase, that might not be the – what you see on the volumes today that you might have production in line with the second quarters or down slightly. Is that a fair characterization?

From the comp side, there is a lag. So I would actually expect to see the mortgage comp in the third quarter not go down and potentially increase upwards to even $1 million, but then falling off back to kind of Q1 levels into the fourth quarter.

Okay. Great. And then if you – maybe on the – then as a follow-up on the NIM commentary. If you were to keep liquidity where it is, what do you think the opportunity is on NIM to kind of help us think about what you can do with NIM and then maybe getting back at 15 to 20 basis points as you deploy liquidity? That makes sense?

Yes. So even with the changes, again, the money market accounts have that automatic reset. So even all things being equal, we see a few basis points pickup in that regard. Even if the balance sheet stays static in terms of cash.

Okay. Great. That's very helpful. Thank you. And then you talked about the opportunity or – and looking at the expenses and opportunities to be more efficient. I'm curious, if the experience of your customer is a little bit different than what we're hearing from a lot of the other banks around the country, given that your markets North Dakota never really shut down, or do you think there's an opportunity on the branch side for consolidation? Or is the customer activity not really changed that much? I guess, that's probably broken into the difference between North Dakota versus the Twin Cities, but I'd like to know, just big picture, if you think there's opportunity on the branch side? And how you're trying to figure out that opportunity?

Yes. It's a great question. I can tell you, I've been amazed at how busy our North Dakota locations are to the point of waiting lines in the drive-through before we opened our lobbies. That sometimes exceeded half an hour or so. The activity there, especially on the commercial side of use of our branches really has not slowed. As a reminder, we are not a branch-heavy company. We have just 15 locations across our entire footprint of North Dakota, Minnesota, Arizona. That being said, we are closely monitoring all of the trends and uses as well as our digital engagement. We actually, as a company, were at capacity when it came to our facilities. This certainly gives us more capacity in our current locations, but we are exploring opportunities. We have made a decision, as of today, to not reopen at least one location, but we'll continue to evaluate all locations and all of our office space across the company.

Okay. And then last question is just on the retirement and benefit services business. Just talk about continued headwinds or tailwinds there and expectations maybe in the back half of the year?

As I look at the second quarter and where the assets have rebounded, I do believe this to be a low point for the quarter. And so I think we track back up to the $14 million in terms of revenue for the third quarter. The headwind for us in this business will be related to ESOP transactions, which of course will be – are on a pause. Businesses aren't moving forward at all at this time as well as the new business generation, but it's a long sales cycle. So I believe that to be more of a 2021 headwind.

Okay. So do you think that that just results hopefully in maybe slightly slower growth in 2021? Or do you think that you could see some fallout as there's potential pressures in the small business community?

We've evaluated our book of business within our retirement division, much like we did with our credit division, and we really have much like our loan portfolio extraordinarily diverse. We're not seeing pressure on levels of contributions or planned terminations or anything in that nature. So I don't believe it's a 2020 issue. We have seen a slow in attrition, which we think potentially offsets some of that headwind to new business generation.

Okay, thanks. I will set back. Let somebody ask question.

[Operator Instructions] The next question comes from Bob Shone of Piper Sandler. Please go ahead.

Good morning. This is Bob on for Nate.

Good morning.

My question revolves around provisioning going forward. And if you guys could maybe provide any color around, if we're going to see consistent provisioning to the level of 2Q 2020? Or how high the reserve might go? Thanks.

Sure. Obviously, that's a tough question, given the uncertainty. And of course, the payment relief has potentially masked some of those traditional flags that we look at. I would just say that we remain very cautious and that given the uncertainty, we expect that we'll continue to remain at an elevated provision level next quarter as well.

Okay. And then looking at the line utilization, you guys mentioned that it's below the three-year average. Have you seen a bounce back in that utilization so far in the third quarter?

We have not. It's remained very low.

Okay. And then kind of related to that, given the strong core deposit growth, do you anticipate as PPP funds are being used and with tax season being pushed back, that there will be some anticipated runoff in 3Q?

Yes. I think we expected to see that in Q2 also. So it's a little bit of a mystery, but we would – we are expecting that there will be outflows in the third quarter.

Okay. And then last one for me. Just kind of a modeling question. For the PPP income, I think you guys said it was around $2 million this quarter. Is – was there any accelerated fee income in that number? Or was it just the 1% interest plus the standard kind of 24-month amortization of the fee?

Good question. No, it actually was – it's a little bit shy of where it should have been. Probably $200,000 short of where it should have been because the average balance has changed a little bit. So no, the system actually calculates the income incorrectly. So we did make a manual adjustment. So we were not overstated in the quarter.

Okay, thanks. I will step back.

Katie, it's Randy. To Bob's question on the deposits, would you happen to know the breakout of the deposit increase? Some of that came from the synergistic side or the synergistic deposits from the benefit side, which should remain with us. The deposits that may have come from the PPP funding, of course, that will probably run off. But would you happen to know what that split is?

Yes. $90 million, excuse me, of the increase was related to the synergistic deposits of the retirement and wealth management.

Okay, thanks.

And we have a follow-up from Jeff Rulis of D.A. Davidson. Please go ahead.

Yes, thanks. I just wanted to clarify the retirement and benefits number, that was a recovery to $14 million in the third quarter or something north of that?

Yes, we believe so.

Okay. And I guess anyone – guess is to how you climb back to – I think you just mentioned transaction volume is light. So maybe it's inhibited getting back to kind of your ceiling levels. But any thoughts on further growth as we continue to sort of reopen? Or if we do, there's some upside to that number?

There certainly is a big focus for our sales. Our advisers in that front is – the client expansion, either at the participant level and engaging participants individually and in terms of IRA rollovers, wealth management opportunities. But then also expanding into health savings and payroll are real interests for companies today.

Okay. Kind of a cross-sell. Got you. And then, just one last one. Could you touch on sort of organic loan growth or net or just expectations for the – maybe through the balance of the year as I think PPP sort of stunts some of that, whether it's line utilization or other, any thoughts on kind of net of PPP moves, if forgiveness comes in that, just isolate that, but just kind of the portfolio as you see it kind of the balance of the year? Thanks.

Sure. Our pipelines were fairly strong earlier in the year. We did have some nice growth initially. And then obviously, with the onset of COVID-19, everything just kind of stopped there. Some of our borrowers just paused, waiting to see what the impact was. We are feeling pretty good about our pipelines now early in the third quarter. People are getting back to business, picking up some initiatives that they had. But we're cautious in our outlook, simply because we feel there are some headwinds. Obviously, there's going to be competition for the best credits out there. And we're being prudent in our underwriting as well. And so while we think there's opportunity, I think that growth will likely be muted for the rest of the year.

Jeff, it's Randy. I might say to it. A significant strength of Alerus is our business model. And if the economy does slow and traditional banking organizations may find it difficult to find good loans or increase loan volumes, our sales staff or business development staff does not sit idle. We have other things. I mean we report these as separate divisions, but inside the company, we really operate as one combined sales force. So our people do not sit idle, and they're able to go out and really sell the other areas of our company to remain active and thus continue to bring in revenue into our company.

Got it. Yes. I guess the other piece of that is your own appetite for risk and you got to kind of manage that. But it sounds as if you're – the markets you're in, you're still looking for incremental business where it – I think where it makes sense. So I appreciate the color. Thank you.

Okay. Then at this time, this concludes our question-and-answer session. I will now turn the call over to Randy Newman for concluding remarks.

All right. Thank you. First, let me extend our appreciation to everyone who joined our call this morning. Thank you for listening and asking questions. The first half of 2020 has brought about a tremendous impact to the lives of our clients and employees as well as our business. We acknowledge the economic and uncertainty that lies ahead and are preparing for this challenge by maintaining a fortress balance sheet, strengthening our coverage for loan loss reserves, and preserving robust capital levels. The backbone of our company is serving in the best interest of our clients. We continue to focus on this commitment by engaging our team and meeting the holistic financial needs of our clients. Our business may be interrupted, but it is not disrupted. We are a very resilient company. We have a strong balance sheet, a strong leadership team, and a business model that is envied by many traditional banks. We believe the diversification of our business model and geographic markets will allow us to perform better than our peers, especially in the current environment. We're very proud of our financial performance this past quarter and our team's ability to perform well through this period of economic uncertainty. Thank you again for joining today’s call.

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.