Good afternoon, and welcome to the Alerus Financial Corporation Earnings Conference Call. Please note, this 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 and the company's SEC filings. I would now like to turn the conference over to Alerus Financial Corporation President and CEO, Katie Lorenson. Please go ahead.

All right. Thank you, Angela. I appreciate it. Greetings all, and welcome to the Q1 2024 Alerus Earnings Call. We appreciate you all taking the time to join us today. Joining me here today in Minneapolis is Alerus' CFO, Al Villalon; our Chief Operating and Risk Officer, Karin Taylor; our Chief Banking and Revenue Officer, Jim Collins; and making his debut earnings call with us today is our Chief Retirement Services Officer, Forrest Wilson. I am incredibly proud to be surrounded by these talented professionals here in this room, and as well as widely and deeply across the Alerus franchise. Earnings for the first quarter of 2024 matched expectations as our team members delivered again in executing our organic growth of One Alerus strategy. Client wins came across all parts of the business and most notably resulted in strong deposit and wealth management growth and inflows. We saw new client wins in C&I, which came with lending opportunities and full treasury management relationships. Our One Alerus business model and holistic approach to serving clients continue to differentiate our company with an impressive quarter of net inflows in wealth management and strong production driven by business owner liquidity events as well as robust rollover business sourced from our retirement division. The synergies between private banking, wealth, mortgage, and commercial banking continue to emerge even faster than expected. The results of these efforts by our team members and support services were evident, with deposit balances increasing over 6% in the quarter and commercial loans growing over 2% during the quarter. Highlights for the quarter included an improving core net interest margin as we saw the benefits from the balance sheet repositioning as well as the impact of organic growth. Fee income, which accounts for over 50% of total revenues, delivered ongoing positive momentum showing growth across each of the fee-based businesses. Alerus remains in a uniquely strong position to grow with a highly diversified loan portfolio and robust liquidity. Loan balances grew for the ninth consecutive quarter, while deposit balances increased for the fourth consecutive quarter, displaying our proven ability to grow and attract new clients. While deposit growth for the industry remains very challenged, we continue to see strong client flows from within our banking markets as well as nationally through synergies with our retirement and benefits businesses. We remain consistently disciplined in our risk management and infrastructure investments while selectively taking market share and supporting our clients and our communities. Our commitment to our shareholders and our fortress balance sheet is unwavering with an allowance to total loans of 1.31% and a CET1 capital ratio at 11.85%. With our quarterly dividend 5.6% higher than the same period in the prior year, we maintained our history as a dividend aristocrat, and we continued our streak of 40 years of paying a dividend and consistently increasing our dividend. Asset quality remains strong with less than 1 basis point of net charge-offs and consistently low levels of nonperforming loans. We remain confident in our strategic initiatives, including our focus on building efficiencies, and we will continue to get better at managing expenses, proceeding on our path to returning the company to top shareholder returns and earnings per share growth. And with that, I will turn it over to CFO, Al Villalon.

Thanks, Katie. I'll start my commentary on Page 11 of our investor deck that is posted in the Investor Relations part of our website. Let's start on our key revenue drivers. On a reported basis, net interest income increased 3.1% on a linked quarter basis. The increase was driven primarily by organic loan growth, strong deposit growth, and an arbitrage opportunity using the Bank Term Funding Program. Net interest income represented 46.7% of revenues. Switching to fee income. Noninterest income decreased 0.4% on a linked-quarter basis, primarily driven by client swap income of approximately $1.3 million that was recognized in the prior quarter and other noninterest income. Despite not having any swap income in the current quarter, we did see fee income increase across all of our fee-side income segments. I will go into detail about each of our income segments in later slides. Turning to Page 12. Net interest income increased to $22.2 million in the first quarter. The BTFP arbitrage was accretive to net interest income by $349,000. We can pay back the BTFP any time, or its due date in 2025, with no penalty. Adjusted core net interest margin, which excludes the impact of the BTFP arbitrage was 2.44%, an increase of 7 basis points from the prior quarter. During the quarter, higher loan balances and rates along with lower volumes helped drive margin expansion. We expect our reported net interest margin to continue to improve in 2024. After 2024, or when we repay BTFP, our reported net interest margin will revert to the core margin we show, primarily due to reduction in average earning assets. Should the Fed remain on pause, we continue to expect our net interest margin to improve. While the Fed outlook is uncertain, our ALM modeling shows that with a static balance sheet and at current spreads, our net interest margin will exceed 3% for the full year in 2026. Should the Fed cut interest rates sooner, we expect to get to 3% net interest margin sooner depending on the timing and magnitude of rate cuts, especially as our net interest margin returns to being liability-sensitive, with $400 million of swaps maturing in July of this year and another $200 million of swaps in January of 2025. Let's turn to Page 13 to talk about our earning assets. Total loans grew 1.4% from the prior quarter, driven by organic growth in C&I and commercial real estate. Our investment portfolio declined 2.2% as we continue to remix low-yielding securities into higher-yielding loans. For 2024, we continue to expect to see modest loan growth. While 7% to 8% of loans are expected to contractually payoff during the remainder of the year, we do expect loan production to offset this runoff and expect our earning assets to continue to grow. Turning to Page 14. On a period ending basis, our deposits increased 6.1% from the prior quarter. The momentum and deposit growth we saw in the prior quarter continued into this quarter. While overall deposits grew, noninterest-bearing deposits balances decreased 4.9% and now represent 21% of total deposits. Overall synergistic deposits, so those sourced from our retirement and wealth businesses, increased 3.7% from the prior quarter. Given the strong deposit growth, we saw our loan-to-deposit ratio decreased to 85.2%. For the second and third quarters of 2024, we do expect a seasonal outflow of approximately $200 million, mainly from our public funds. While these outflows will pressure deposit balances in upcoming quarters, we do expect deposit levels at the end of the year to rebound to the end of the year higher than where we ended in 2023. Turning to Page 14. I'll now talk about our banking segment, which also includes our mortgage business. Our focus is on the fee income components now since I've already covered net interest income. Overall noninterest income for banking was down $627,000 or 15% from the prior quarter. Most of the decline was attributed to $1.3 million decline in swap income that was recognized in the prior quarter. This swap income does not relate to our balance sheet swaps. Rather, these swaps are done at the client level when a banking relationship would like to lock in a fixed rate by swapping out a floating-rate loan. This type of swap income tends to be lumpy and unpredictable. For the second quarter, we do expect the overall level of noninterest income to increase from the first quarter level as we expect mortgage income to improve with a typical seasonal pickup in the second and third quarters. The current level of other noninterest income of $1.5 million is a better run rate on a go-forward basis, and we expect that level to be stable as we do not expect any client swap income in the upcoming quarter at this moment. On Page 16, I'll provide some highlights on our retirement business. Total noninterest income increased 2.2% from the prior quarter. In the quarter, assets under management increased 4.9%, mainly due to improved equity in bond markets. Participants within retirement grew 1.5% during the quarter. As we did in our 10-K, we broke out the noninterest expense that is allocated to the retirement segment. The table on the top left does not include any credit for our synergistic deposits since those earning assets of are those deposits are within the banking segment. These synergistic deposits are highly valuable when compared to borrowing at FHLB, which are currently in the low 5% range. While almost 53% of retirement synergistic deposits are indexed, 16% are noninterest-bearing and 31% consist of HSA deposits, which only carry a cost of funds around 10 to 15 basis points. For the second quarter, we expect fee income from the retirement business to be stable at $15.7 million despite the recent downturn in the markets. Turning to Page 17, you can see highlights for our wealth management business. On a linked quarter basis, net revenues increased 9.3%, while end-of-quarter assets under management increased 5.5% due to improved equity and bond markets. Over 85% of revenues in this segment are asset-based fees. Similar to the prior slide, we show on the top left the noninterest expenses allocated to the wealth segment, but we have also excluded any credit for our synergistic deposits. As you can see here, 88.6% of our synergistic deposits in wealth are indexed while the remainder are noninterest-bearing. For the second quarter, excluding any market impact, we expect fee income from the wealth business to be stable given recent market volatility. Page 18 provides an overview of our noninterest expense. During the quarter, noninterest expense increased 0.9%, mainly due to higher seasonal compensation and benefits. As we continue to deal with inflationary pressures, we continue to expect expenses to grow for 2024, to grow low single digits when compared to 2023 on a reported basis. Turning to Page 19. Credit continues to remain very strong. We had net charge-offs to total loans of 1 basis point in the quarter. A nonperforming assets percentage was 17 basis points compared to 22 basis points in the prior quarter. And our allowance for credit losses on loans to total loans was 1.31% or 498% over nonperforming loans. I will discuss our capital liquidity on Page 20. Our common equity Tier 1 capital to risk-weighted assets is 11.9%, which is almost 200 basis points above the 9.9% stress minimum required by the largest financial institution subjected to the Dodd-Frank stress test. On the bottom right, you'll see a breakdown in the sources of over $2 billion of potential liquidity. Overall, we continue to remain well positioned from both liquidity and a capital standpoint for future growth or weather any economic uncertainty. While we did not repurchase any shares in the quarter, we have an active 10b5-1 share repurchase plan out there that is very disciplined in our share repurchase approach. The recent sharp run-up in our share price ended up being above the repurchase levels we set in our 10b5-1 plan. Our 10b5-1 plan currently remains in place today. So to summarize on Page 21, the momentum we had in the fourth quarter of 2023 continued into 2024. We continue to see organic loan growth and strong deposit growth. Our net interest margin continued to improve in the quarter. Even if the Fed remains on pause, we continue to see a path of the margin to improve to over 3%. Our fee businesses, which are non-spread-based represented over 53% of revenue in the quarter and continue to be a differentiator for us. Our capital levels remain strong and we remain committed to returning capital prudently.

The next question comes from Brendan Nosal with Hovde Group.

Maybe just to start off here on the BTFP trade. At this point, is the intention to keep it on for the full 12 months, and then is it safe to assume that this is match funded for 12 months?

That is correct, Brendan. That's a safe assumption. The only time we probably repay the BTFP is if we see that arbitrage opportunity not be worth our time.

Yes. Yes, that makes sense. And then I guess following up on that, in terms of the margin more specifically, I appreciate the longer-term guide for the 3% and to see the continued core margin expansion this quarter. Can you just give us a finer point on the NIM outlook for the rest of this year, kind of assuming that the Fed doesn't do a whole lot here?

Currently, we are somewhat asset sensitive due to our swap position. If the Federal Reserve stays on pause, we will still experience ongoing improvement in our net interest margin, and our liability sensitivity will increase as our swaps mature in July and January next year. The most uncertain factor for us right now is the deposit environment. We anticipate a gradual improvement throughout the year. Even if the Fed remains inactive until 2026, you could see our net interest margin, which is currently 2.44% on a core basis, gradually reaching an average of 3% by 2026. This is how I would approach the outlook.

Yes, yes. Okay. And then one more follow-up. Can you just remind us how much of a drag on the margin in each of those 2 swaps that are rolling off later this year or early next year?

The current drag can be understood through our Asset-Liability Management modeling. Presently, in a down 100 basis point scenario, our net interest income is likely to decrease by about 1%. In contrast, when we disclosed this in 2022, without the swaps, our net interest income in a down 100 scenario would have increased by approximately 6% or more. This shift indicates that we have moved from being liability sensitive to asset sensitive. Eventually, in the down 100 scenario, our net interest income is expected to be up by around 6%.

The next question comes from Jeff Rulis with D.A Davidson.

Just a follow up on the BTFP. Is the timing of that in the quarter indicative of a full quarter's impact on both net interest income and margin in Q1?

No. Jeff, I think there's a little bit more we could pick up there because we picked that up late January.

Okay. Could that be then now a little more accretive to NII and a little more dilutive to margin?

Correct. That's the way to think about it, Jeff. When we take the dilutive margin, it is often dilutive to reported net margin, not core margin.

To that point, as long as that is out there, we can track reported and adjusted figures and assume that the gap closes once retired. Is that the way to think about those two items?

Correct. That's the way to think about it because there's a denominator effect on our average earning assets. So we have approximately around $300 million to $350 million range of average earning assets that's impacting that. So then if you take that off the denominator, that's going to have a great impact.

I wanted to discuss retirement and benefits while Forrest is on the line. I’m looking for any changes to the strategy. A significant reason for bringing Forrest on board was related to mergers and acquisitions or other strategic matters. Is there anything else to add while we have Forrest here?

Yes. Well, thanks, Jeff. Forrest Wilson here, and glad to be here. But yes. I mean really quick observations would be that this is a very solid business. It's not broken. There is an opportunity for improvement, which I can address in just a second. But I've been very impressed with the team, a lot of tenured folks that are smart, experienced, dedicated, but there is a lot of opportunity here as well. Organic growth and I think we can see some nice pickup here over time. It's going to have to be paced out, if you will, but there's an opportunity for more partnerships like one we have with MassMutual, that market, which we have a nice foothold in. As you just kind of alluded to, Jeff, there's definitely some opportunities for acquisitions as the space continues to consolidate. I think we have to be really thoughtful with this. It's something that I have some experience with throughout the years. And as excited as we can get about acquisitions, and I do believe we'll likely do one, two, three, a few of them over time, we need to be very thoughtful as they can push you in the wrong direction as well. In line with that, Katie and I looked at one already that was going to look good at first, but when we dug in, it really wasn't going to be accretive to driving shareholder value, and we stepped out of that. But the kind of the third and final thing that I'm seeing is that there's an opportunity for efficiencies gained just through structure, which we're working on. There's a lot of process improvement that can be done. And then although we have a good technology platform, AI is coming in quick to this business, and there's a lot of opportunity there to leverage that. We're looking at that as well. So hopefully, that kind of gives you a little bit to answer your question, Jeff.

Yes, I appreciate that overview. My last question is about the loan growth outlook. It's been quite strong so far this year, but I noticed you've tempered that expectation. Could you clarify whether this is due to a conservative approach for the remainder of the year or if there were any payoffs or other factors affecting that growth outlook after a robust first quarter?

Jeff, this is Jim Collins. I'll take that one. I think it's a little conservative, but I think we've been a little conservative because rates are staying higher. We did a lot of some growth in investor CRE and multi-housing in both of our largest markets. And we really need to make sure those stabilize and we don't go into those markets and put too many on the books right now until we see how those markets are going to develop. That was a lot of the growth we had at the back end of last year, which floated into the first quarter. We've had some solid C&I growth, a lot of new relationships, full, treasury management, loans, deposit relationships flowing in the first quarter. I'm bullish on that, but those relationships take a little while to develop. So we're just kind of harnessing that loan growth. I expect we'll definitely hit the budget maybe exceed it, but we don't want to throw out some numbers that we can't achieve.

The next question is from David Feaster with Raymond James.

Maybe just following up on some of this commentary around the balance sheet managing. You guys have been very active, right? We've got the balance sheet restructuring, put on the swaps and liability sensitivity is going to resume in the back half of the year, like you alluded to, Al. I know you talked about NIM expansion exclusive of cuts and getting back to plus 3%. But I'm curious, how do you think about managing the balance sheet at this point? And anything that you're considering or looking at and whether the prospects of a higher-for-longer environment impacts that at all? It doesn't sound like you're looking to put more swaps on. But I'm just kind of curious how you think about managing the balance sheet.

Thanks for the question, David. Regarding the balance sheet, let's start with the investment side. I believe we’re in a good position since our investment portfolio is within our targeted range of 15% to 20% of total assets. Although yields in the investment portfolio have decreased slightly, this is mainly due to a significant portion of our municipal bonds yielding low and being held to maturity, which we don't plan to sell. On the loan side, there’s currently not much of a market for selling some of our loans. Therefore, our focus will be on remixing the balance sheet, especially as Jim and his team establish more commercial relationships and bring in higher-yielding loans. We're open to opportunities to offload, particularly in multifamily, but that would require significant rate changes. Regarding swaps, I think we might engage in some swaps to manage our interest rate risk from an asset-liability management perspective. I mentioned earlier that in a downside scenario, our net interest income could improve in the high single digits, and we want to mitigate any potential tail risks. Therefore, we might implement some swaps with tight collars to manage that risk.

Okay. Following up on that, do you have any details regarding the repricing of your fixed loans or fixed-rate earning assets that are set to mature in the next 12 months and the expected increase from those? Additionally, how do you plan to address the public fund outflows that you anticipate in this quarter and the next?

Yes. Regarding the first part, in terms of what is coming into the book and what is going out, we anticipate a slight increase of a couple of hundred basis points from what is rolling off to what we are bringing back on. That’s the general idea. Additionally, about 7% to 8% of our loan book is expected to roll off this year in gross loans. And then...

On the deposit side, we picked up 12 significant C&I relationships in the first quarter in the Twin Cities. We have public funds that come in for six months, then they gradually drain out, and later return towards the end of the year. The efforts of the C&I teams across all markets will assist in replenishing some of the public fund deposits that are leaving. While we won't be able to replace all of them immediately, these relationships will contribute to deposit growth over time. Therefore, deposit growth will not occur instantaneously. We anticipate good core deposit growth from both existing and new relationships to help mitigate the impact of the public funds leaving, but there will be a gap that we need to address.

And David, this is Al. One more. Just to build on what Jim said there too. While we see seasonal outflows in our public funds in the second and third quarter, we do see that building back up both in the fourth quarter and in the first quarter of the next year. So we're doing a temporary seasonal outflow right now that should pick back up in the back half of this year.

Okay. Regarding the gap in deposit growth, are you planning to use cash to fund that gap, if there is one?

Yes. By cash or if we need to do some short-term borrowings.

Perfect. Touching on the credit front, credit remains strong. You have a solid reputation as a conservative underwriter. Given the current heightened focus on commercial real estate, I'm interested in how you view your portfolio. As you assess things in the market, what are you monitoring closely? What do you observe? Is there anything raising concerns for you at this time? Additionally, from a competitive perspective, do you find the landscape to be more rational now? I'm curious about your observations in that regard.

Sure, David. This is Karin, I'll take that one. We obviously take a look at our refinance risk. We're fortunate in when we started growing our CRE book, rates started to increase. So our refinance risk, we feel is limited and very manageable. We do have some construction deals on the books and like others, we're just watching stabilization period. Our deals are performing well, but we're certainly cognizant that we could see some strongness and stabilization. Generally speaking, the fundamentals in our market for the asset classes we're in are very strong. And so we're not overly concerned, but certainly watching it. In terms of competition, yes, I would say it is more rational. I mean there certainly are players who have concentrations. We've seen growth, but we're not overly concentrated. And those that are have pulled back and aren't lending, not to the same degree they were.

The next question comes from Nathan Race with Piper Sandler.

Just thinking about the wealth management revenue growth outlook going forward. Curious to get an update just in terms of the success you guys are having in terms of transitioning clients from the retirement platform onto the wealth. And what added tailwinds we can expect in terms of organic AUM growth with some of the private bankers that have been added over the last 2 quarters?

Yes, Dave, this is Jim. I'll take that one. So the terminated participant plans, so the plans that are rolling off of our 401(k) group into our wealth, we've implemented some new tactics and some new tracking mechanisms, and that is actually increasing and going extremely well. We anticipate that, that will only increase over time as we learn from how we're building this out a little bit better. So I suspect that, that will continue. We are also a little bit more active in recruiting some additional wealth advisers in that space because we need more capacity. So we're actively recruiting, and I think we're finding some pretty good success in recruiting some of those individuals in that space. So that will help as well. As far as the private banking team, they really launched at the end of last year, early this year. We're having a lot of success with the private banking team and the mortgage department as well as the wealth team. We've also had some pretty good success with commercial businesses that are selling with the wealth group and the private banking group getting in early before that announcement of the business sale and that liquidity event and capturing a significant chunk of that liquidity. We have one specific large event this quarter. That's that example, and we'll probably harness about two-thirds of that liquidity event in our wealth department. So as that continues to build in all markets, really, we're focused on the private banking and the Twin Cities. Now we should be launching Arizona later on second quarter, early third quarter and continued traction, and I only see positives out of that.

Okay. Great. Very helpful. And then just curious to kind of think about the trajectory of deposit costs over the course of the quarter. And if you could give the spot rate on deposit costs at the end of March.

Yes. So Nate, the way I think about it right now is we continue to see migration from noninterest-bearing to interest-bearing. So right now, I mean we continue to see that pressure, which is going to be pushing up our deposit cost slightly. But I'd say that our overall deposit beta has slowed down dramatically. So I'd say right now that we probably see just marginal increases in our overall deposit costs from these levels. But there will still be pressure and the bigger pressure will just continue. The question is now going forward is how much pressure comes in the noninterest-bearing side as people move into interest-bearing.

Yes. I guess as the competitive environment stands today and based on your pricing, I mean, is it fair to expect at least that the magnitude or pace of deposit cost increases slows from here?

Yes, I think that's reasonable. We're observing that certificate deposit rates, particularly from our competitors, have been reduced and we have made similar adjustments. We’ve noticed that rates for terms greater than 12 months have decreased, especially due to the yield curve inversion. Overall, I would say that our deposit rates are currently around 75 to 100 basis points below the Federal funds rate.

Okay. Got it. And then just lastly, I got on late, so I apologize if you already touched on this, but I think you guys had modest loan growth at least near term. You guys have exceeded that based on the similar guidance here for the first quarter. So just curious, is it just elevated payoff expectations potentially that's weighing on that outlook coming into 2Q? Or is there any other thoughts on how we should think about loan growth over the remainder of 2024?

No problem, Nate, I'll turn it off to Jim here in a second. Just so you know that we are expecting about payoff of around the 7% to 8% of total loans for the remainder of the year. And then Jim can comment on the color of what's going on.

Yes. So some of the growth we had in the tail end of last year and this year was really centered around investor CRE. There's a heightened focus on C&I growth in all markets. And that tends to be larger lines of credit, but that aren't funding automatically, and those relationships take a little bit more time versus a transactional CRE deal that funds right away. So that's what's tampering that in our forecast. But we're still very bullish on bringing in new relationships for the rest of the year.

The next question is from Damon DelMonte with KBW.

Just curious on the mortgage banking outlook with rates remaining kind of stubbornly high here. Is there any concern that the typical seasonal increase here in the second and third quarter might not be as favorable as it has been in the past or that you may be expecting?

We're still closely monitoring our performance for the second quarter, but considering the higher rates and slightly lower inventory in our key markets, we anticipate that we may fall a bit short this quarter. We'll have to evaluate the third and fourth quarters as they come. The second and third quarters are crucial for potential growth, and we are maintaining our budgeted projections with confidence that we can reach them. However, the second quarter may be slightly underwhelming due to current rates and demand.

Got it. Okay. That's helpful. And then with regards to the loan growth and the opportunities, how does Arizona factor into your outlook? Is that a meaningful contributor to the overall growth? Or is it still being driven primarily by the Twin Cities?

Currently, growth is being driven more by the Twin Cities than by Arizona. However, we hired a significant number of bankers last year who are working through their learning curves, in addition to our established team in Arizona. The expectations for this year and what is in the pipeline look very promising. Over time, Arizona will contribute more, but I believe this year we will see a noticeable contribution from them compared to previous years.

Okay. Great. And then just last question, all my other ones were asked and answered. With regards to the expected fair value accretion, I think it was a little bit lighter this quarter. Al, what would be a decent level we could incorporate into the margin for that?

I'm sorry, I missed the question there, Damon, one more time?

Fair value accretion expectations, I believe it came in later this quarter than we had seen in the last couple of quarters, but is there kind of a scheduled level that you would expect going forward?

No. I'd say just using this level going forward, I mean that's probably the way to think about it.

This concludes our question-and-answer session. I would like to turn the conference back over to Katie Lorenson for any closing remarks.

All right. Thank you. Thank you to everyone joining our call today. Thank you for the questions. We appreciate it. At the end of 2023, we turned a pivotal quarter in our company's transformation to return to our long history of delivering top shareholder returns. During the first quarter, the momentum grew and has put Alerus on a strong path for 2024 and beyond. We continue to see organic opportunities and improvements in our net interest margin, which will positively impact our earnings going forward. Our highly valuable fee income businesses, driven mostly by stable annuitized recurring revenues with minimal risk and capital allocation continue to bolster our performance and will be a key differentiator as we emerge from this rate and economic cycle to outperforming the industry. Our continued focus on core deposits and serving clients holistically with our talented team members across our unique business lines is growing our franchise and growing our brand. I'm completely confident in our ongoing success and our team's ability to execute on our strategic plans to create value for our clients, our communities and our shareholders. I will end by thanking our talented team members again for your hard work, your dedication and for making Alerus a great company to do business with and a great place to work. Thank you, everyone. Have a great day.

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