Associated Banc-Corp Q4 FY2022 Earnings Call

Good afternoon, everyone, and welcome to Associated Banc-Corp's Fourth Quarter 2022 Earnings Conference Call. My name is Dough and I will be your operator today. At this time, all participants are in a listen-only mode. We will be conducting a question-and-answer session at the end of this conference. Copies of the slides referenced during today's call are available on the company's website at investor.associatedbanc.com. As a reminder, this conference call is being recorded. During the course of the discussion today, management may make statements that constitute projections, expectations, beliefs, or similar forward-looking statements. Associated's actual results could differ materially from the results anticipated or projected in any such forward-looking statements. Additional detailed information concerning the important risk factors that could cause Associated's actual results to differ materially from the information discussed today is readily available on the SEC website in the Risk Factors section of Associated's most recent Form 10-K and subsequent SEC filings. These factors are incorporated herein by reference. For a reconciliation of the non-GAAP financial measures to the GAAP financial measures mentioned in this conference call, please refer to Pages 24 and 25 of the slide presentation and to Page 10 of the press release financial tables. Following today's presentation, instructions will be given for the question-and-answer session. At this time, I would like to turn the conference over to Andy Harmening, President and CEO for opening remarks. Please go ahead, sir.

Well, thank you, Dough, and good afternoon, everyone, and welcome to our year-end earnings call. I'm Andy Harmening, and I'm joined here today by Derek Meyer, our Chief Financial Officer; and Pat Ahern, our Chief Credit Officer. I'd like to start things off by sharing a few highlights from the quarter and then reflecting on 2022 as a whole. From there, Derek will walk through the update on margins, income statement trends, and capital, and then Pat will provide an update on credit. So, no matter how you slice it, 2022 was a significant year in Associated's 162-year history. It was driven by a relentless focus on customers and on our colleagues. We executed against our strategic plan with several milestones achieved in 2022. We staffed and ramped up new commercial and consumer verticals that have since met or exceeded their initial targets, giving us a little more flexibility to drive loan and deposit growth for the bank. We attracted top talent from several major competitors within our footprint and added 20 net new commercial relationship managers during the year, giving us momentum as an employer of choice. We launched the most significant digital platform upgrade in our company's history with our new Associated Bank digital platform, and then within 90 days, we followed that up with a new account opening platform. This gives us a much improved digital experience for our customers and the ability to make future enhancements more frequently. Leveraging these digital enhancements, we officially launched new mass affluent and digital sales strategies, giving us the ability to attract and deepen quality customer relationships. All of these efforts have enabled us to drive positive operating leverage, improve our returns, and serve our customers more efficiently and effectively. While we've grown a lot in many ways in 2022, it's important to reiterate that we've done so in a controlled fashion. We remain firmly committed to maintaining our discipline around credit quality and expense management. These foundational strengths have been developed over the course of a decade and will continue to serve as our foundation as we look to deliver enhanced value for all of our stakeholders. These results also set the stage for 2023. In January, we continue to be impressed by the strength and resilience of our Midwest markets in the face of macro uncertainty. Unemployment rates remain stable, with Wisconsin and Minnesota continuing to come in below the national average. Our consumers remain resilient with increased debit and credit card spending levels in December of '22 versus December of '21. Our business customers continue to pursue growth and expansion opportunities where it makes sense, but the uncertain macro environment is front and center in all conversations. Taken together with the rising rate environment, these trends have enabled us to enjoy another strong quarter here in Q4 and have given us momentum heading into the new year. We continue to monitor significant macroeconomic and geopolitical question marks that remain, but we believe we've put ourselves in a good position to build on our momentum and drive value for our stakeholders without stretching to take additional risks. Our fourth quarter results reflected continued loan and deposit growth, further margin expansion, and benign credit impacts. We once again saw strong loan growth across all major segments. But as we anticipated, the pace of growth slowed somewhat versus the prior quarter in most key categories. Based on a combination of our customer activity in our markets, the execution of our strategic plan, and the rising rate environment, our net interest income increased 9% quarter-over-quarter and 55% versus the same quarter in the prior year. With expenses held flat for the quarter, we once again drove positive operating leverage, and we pushed our return on common equity north of 16% for the quarter. On the credit side, we're continuing to monitor our portfolios closely, but fourth quarter trends remain benign. During the quarter, we saw just 2 basis points of net charge-offs. We did add provision again this quarter, but this was largely a function of our loan growth. Looking at 2022 as a whole, our fourth-quarter results were a fitting exclamation point on what has turned out to be the most profitable fiscal year in Associated Bank's history. Through a combination of strength in our markets, execution of our growth initiatives, and help from rising rates, we drove a 41% increase in pre-tax pre-provision income, posted double-digit operating leverage, and added nearly $4.6 billion in high-quality loan balances. Despite a $121 million provision-driven headwind versus the prior year, we were still able to drive a 6% increase in our net income available to common equity year-over-year. While we're proud of these accomplishments, our focus is on building off this momentum in 2023. With that, I'd like to provide a little more color around our loan trends. Once again, we reported growth in nearly every major loan vertical for the third consecutive quarter. Our construction portfolio led the way, with the bulk of balanced growth driven by funding of prior commitments and a slowdown in pay-off activity rather than new production. We did see broad high-quality loan growth in several other businesses, but in most cases, the pace of growth slowed versus the prior quarter as expected. This annual view of our loan trend shows a clear picture of the broad-based growth and optionality provided by our various lending initiatives. As discussed in the past, this dynamic reflects the strength of our markets and franchise, but it also highlights the diversified nature of our initiatives. This gives us additional levers to pull to drive balanced, durable growth across the portfolio over time in different economic environments without feeling like we need to stretch in one particular area. Our initiatives have helped generate strong revenues for our company in 2022. Coupled with our diligent management of expenses, we've continued to deliver significant operating leverage and pre-tax pre-provision income growth. For the full year of 2022, our pre-tax pre-provision income grew by 41%. We remain committed to delivering positive operating leverage in 2023. Before we move to Q&A, I want to reiterate a couple of points from our discussion this afternoon. First, we remain confident in our ability to drive quality balanced loan growth throughout the year, but not at the pace we saw in 2022. With that in mind, we expect total end-of-period loan growth between 7% and 9% in 2023. We continue to work on dampening our asset sensitivity, but we expect to continue to benefit from the rising rate environment in the near term. Based on our current forecasts for balance sheet growth, deposit betas, and Fed action, we expect to deliver net interest income growth of between 15% and 17% in 2023. Lastly, we continue to invest strategically in people and technology and expect non-interest expense to grow by 4% to 6% in 2023. As always, we remain disciplined on expenses as we work to continue delivering positive operating leverage in future quarters.

Thanks, Andy. Slide 10 highlights our yield trends and the asset-sensitive nature of our balance sheet. On the asset side, average earning asset yields continue to expand meaningfully in the fourth quarter. Over the course of the year, earning asset yields increased by 187 basis points, or roughly 52% of the increase we've seen in the Fed funds target rate over the same period, reflecting our core asset sensitivity. On the liability side, 2022 interest-bearing liability costs have now increased 131 basis points or roughly 37% of the move in Fed funds target. While the pace of liability costs started to increase in the back half of the year, this increase has largely tracked with our expectations, and we continue to monitor these costs closely. Despite the rising liability costs in the fourth quarter, we continue to see significant quarter-over-quarter expansion in our net interest margin. We view this as a reflection of our recent loan growth coupled with our structural assets sensitivity. Here in Q4, our net interest margin expanded by 18 basis points versus the prior quarter. This expansion equated to a $25 million lift in our net interest income versus Q3, and in a full year basis, our NII grew by 32% or $231 million as compared to 2021. Several factors have enabled us to continue benefiting from the current rate environment. As we've discussed, these factors include our natural assets sensitivity, reduced reliance on wholesale network funding versus the prior rate cycle, and our ability to manage interest-bearing deposit betas. While we do expect the betas to continue to increase into 2023, these broader dynamics have us poised to continue benefiting in the near term. That said, the lack of clarity around the macroeconomic forecast carries significant uncertainty for the industry into 2023. As a result, we continued to take meaningful actions to manage this uncertainty and reduce our interest rate risk. Over the back half of 2022, we executed over $2 billion in interest rate swaps. We did not intend to call the peak on the interest rate environment in 2023, but we will continue to take reasonable steps over time to dampen our asset sensitivity and manage our downside rate risk. While the macroeconomic outlook remains uncertain, our current expectations are for short-term interest rates to rise by 25 basis points following each of the FOMC meetings in February and March, with a rate cut in October. Based on these assumptions in the balance sheet dynamics I just discussed, we expect net interest income to grow between 15% and 17% in 2023. Non-interest income continues to see pressure from the market-driven headwinds we've discussed throughout the year and the customer-friendly fee adjustments we implemented in Q3 of 2022. In the fourth quarter, modest increases in wealth management fees on both income stabilization and mortgage banking were more than offset by reductions in service charges, other fee-based revenue, and capital markets. Also contributing to the quarter-over-quarter decrease was a $6 million investment securities gain recognized in Q3. As a reminder, we expected to see deposit account fee income moderate beginning the third quarter of 2022 based on implementation of the overdraft and NSF changes we announced earlier in the year. These changes were both proactive and pro-customer in nature. When coupled with our relationship-focused deposit initiatives, they give us additional confidence in our ability to strengthen our low-cost deposit base and enhance our broader profitability profile in 2023.

Thanks, Derek. I'd like to start by providing an update on our allowance. We've utilized the Moody's November 2022 baseline forecasts for CECL forward-looking assumptions. Moody's baseline forecast remains fairly consistent with recent trends and assumes continued Fed rate action, minimal GDP growth, and modest employment deceleration in 2023. On a dollar basis, our allowance for credit losses settled at $351 million at year end. This figure represents another increase in the prior quarter, but that build was once again largely driven by significant growth in our loan portfolios. In alignment with this dynamic, our reserves to loan ratio increased just two basis points from 1.2% to 1.22% during the quarter. Our quarterly credit trends remained largely benign during the fourth quarter. Non-performing assets, non-accrual loans, and net charge-offs all decreased from the prior quarter and the same time period last year. The slight increase in delinquencies as compared to recent periods largely reflects the normalization of our maturing auto book. Following a $17 million provision built in Q3, we added another $20 million of provision in the fourth quarter. As mentioned, this provision bill was largely a function of loan growth and not a reflection of larger credit quality concerns within the portfolio. With 2022 representing one of the strongest loan growth years in our history, I'd like to reiterate that this growth has not come from an expansion of our credit box or overextending ourselves in one particular area. The recent growth in our loan portfolios has been driven by investments in our core business, growth of core relationships, and expanding our engagement with familiar customer segments. Our strong credit foundation in place at Associated today was built over the course of a decade. We have an experienced team that continues to work hard to bolster this foundation with a disciplined underwriting culture, improved risk controls, and a proactive approach to portfolio management. With that, I will now hand it back to Andy to share some closing thoughts.

Thank you, Pat. Before we move to Q&A, I want to reiterate a couple points from our discussion this afternoon. First, we remain confident in our ability to drive quality balanced loan growth throughout the year, but not at the pace we saw in 2022. With that in mind, we expect total end-of-period loan growth between 7% and 9% in 2023. We continue to work on dampening our asset sensitivity, but we expect to continue to benefit from the rising rate environment in the near term. Based on our current forecasts for balance sheet growth, deposit betas, and Fed action, we expect to deliver net interest income growth of between 15% and 17% in 2023. Lastly, we continue to invest strategically in people and technology and expect non-interest expense to grow by 4% to 6% in 2023. As always, we remain disciplined on expenses as we work to continue delivering positive operating leverage in future quarters. With that, let's open it up for questions.

Thank you. Ladies and gentlemen, at this time, we will be conducting a question-and-answer session. Our first question comes from the line of Jared Shaw from Wells Fargo. Please proceed with your question.

Everybody, good evening.

Hey, Jared.

Maybe starting on loan growth. You had great growth in construction this year. What does the visibility look like into the pipeline heading into '23? And are there any areas you're focusing on or shying away from as we go forward?

Yes. That's a really good question. I'll just speak to the CRE construction; that’s a point in time rather than a trend in my mind. We saw the growth because of the funding up of some of the construction loans, and then a brief hesitation on some folks to refinance in the permanent market as opposed to new production that we put out there. We see very little new production, particularly in the industrial side of the equation. The pipelines are significantly down in commercial real estate. So I think you'll see that category moderate as we go throughout the year. We expect to have very balanced growth between consumer and commercial, and that's purposeful. As you know, we have several levers right now. So we can start to maximize higher performing portfolios that are more holistic as opposed to single deals, businesses that will deemphasize third-party origination already have; we did that in December. And that pipeline is, frankly, flowing through in December and diminishing as we go into January. So we expect C&I to continue to be solid, really within our footprint and with holistic relationships. We've already seen the evidence of that as we brought on RMs throughout the year. That's why we feel like bringing those RMs on during the year has a full-year effect in 2023 and even stronger focus on ancillary business, including deposits and treasury management.

Okay. And then as we look at margin and spread income, I guess where could we see margin sort of peaking with some of the changes you took? And just to confirm as the net interest income growth target is 7% to 9%, is that full year '23 over full year '22? Or is that from annualized fourth-quarter levels?

Jared, this is Derek. Those are full year numbers. And our guidance on net interest income is based on the yield curve assumptions we made and the loan growth that we outlined in terms of expectation. We're not giving guidance on where we're calling the peak on rates; we sort of talked about that. I talked about that in the script. When we saw, as we went into this year and looked at all the plans, the rate moves, even while we were planning in December and even in the first weeks of January, I think it's pretty dangerous to try and call that. What we're really anchored on are the fundamentals that are going to drive durable margin. We came into this very asset-sensitive. We are going to remain asset sensitive, but we're taking some of that asset sensitivity down, which we talked a little bit about with our hedging. We're also putting a stake in the ground with the outperformance on deposit growth.

To get to the net interest income guide, I guess that implies a pretty significant step down in margin as we go through the year; is that the right way to be looking at that, even though you're still asset sensitive and we're still expecting a little bit of rate moves up earlier on?

Yes, I think year-over-year, on a full year basis, it's a step up. I think when you look at sequential quarter, you're still trying to—everybody's trying to figure out where is your peak quarter, and we're not making that call.

Okay. And then on capital, should we expect that you could be more active in capital management to potentially get to the lower end of that range? Or is that just a function of the natural movement of the balance sheet, and we shouldn't really be expecting a buyback or any significant change to capital return strategies?

Yes. We're not looking to change our capital return strategies. It's still dividends and organic growth.

Thanks, Jared.

Our next question comes from the line of Scott Siefers with Piper Sandler. Please proceed with your question.

Good afternoon, guys, thanks for taking the question. I wanted to also ask about sort of net interest income and trajectory there. So I guess, just looking at guidance, it suggests that the quarterly average of net interest income for the full year '23 will be about $10 million a quarter less than what we did in the fourth quarter. Now, granted, the fourth quarter was just an extraordinarily strong number. But maybe do you have, Derek, a sense for how net interest income in dollar terms would trajectory throughout the year? In other words, would we stay high for say, the first half of the year as long as the Fed is still raising rates and we get that benefit? And then does it taper off? Or was there anything in the fourth quarter that would have kind of elevated it? And then we maybe step down but have a steadier dollar average throughout the year?

Yes, I don't – again, I don't think I'm going to be that specific. I think we recognize that deposit betas are catching up. When exactly they – which quarter they catch up and you see some of that quarterly compression, I don't – again, I don't think we have that called. So I think we're more comfortable giving the full year guidance.

Okay. All right, perfect. And then just given some of the hedging actions that you've taken, or took in the second half of the year, do you have a sense where what might represent a floor for the margin once it does begin to taper off by any chance?

No, we don't. I think you can back into some scenarios, using our asset sensitivity that we have there. If you do some little bit of cowboy math, that a 25 basis point shock might impact you by $7.5 million to $7 million on a full year basis. We've been managing that down to a combination of the swaps and the evolution of the portfolio. Because as far as I'd go with that the biggest consideration is how do you continue the hedging strategy with the shape of the yield curve and so, if your natural balance sheet isn't offering you protection or is with some of the growth we've got in the auto book, you might start thinking about swaps or floors. But we're not at that point yet. We're still monitoring each quarter and we'd like the progress we're making. We want to stay asset sensitive.

Yes. Okay. Perfect. Thank you guys very much. Really appreciate it again.

Thanks, Scott.

Our next question comes from the line of Daniel Tamayo with Raymond James. Please proceed with your question.

Good afternoon, guys. Thanks for taking my questions.

Sure.

Maybe another stab at the net interest income from a different point of view. But just looking at the balance sheet, would you say you're at the point with excess liquidity now where you expect that the balance sheet growth to more or less match loan growth at this point?

Yes. So the way I'd characterize it, we have bottomed out on securities as a percent of fixed assets. So there is a component of our funding plan and deposit growth that includes supporting investments and securities. So it probably gets you closer to what you're talking about.

Yes, that makes sense. Okay, and then I appreciate your comment on expecting positive operating leverage in 2023. Is there any kind of environment from a rate perspective that would restrict that the ability to achieve that or do you feel pretty comfortable with that guidance?

Yes. Look, that the rate question, the yield question, the impact in the market is being asked on almost every call, and there are obvious reasons. And that's because there's a lot of contradictory information out there to understand what the future might be. With regards to what we see in our portfolio, the tailwind that we have from the growth that we've already experienced in '22 heading into '23, the initiatives that we have show that we're able to find a bit more on the deposit side a little bit ahead of what the marketplace is. Our ability to shift expenses from a low return area to a higher return area all those things at this stage give us confidence in what our forecasts are.

Appreciate all that color Andy. Just lastly, on the expense guide. It came in below actually where I was looking for it. And I'm just curious in terms of the pace of expense growth through the year, if there's anything that we need to keep in mind or if it's just you're considering rather steady growth through the year. Thanks.

Are you disappointed that's not higher, Daniel? Sorry, rhetorical. The reason that we feel confident in this space is because we've taken an approach, frankly since I've been here, which is we're looking very strongly at the expenses that we have and say, are we spending in the right place? Let's start with that. And then we cut expenses in those areas going into the year. We've targeted in the first year of taking out roughly $10 million. We have a similar approach going into the year regarding what do we do in our physical branches, what are we doing in third-party origination, which typically has less margin and return on it, we took action with our staffing, and as we brought that lever down. It's not just a function of investing in new areas; it's also simultaneously taking the expense off the table in areas that cannot yield as much for us in the long term.

Okay, great. Appreciate all that. That's all for me. Thanks for taking my questions.

Thank you.

Our next question comes from the line of Terry McEvoy with Stephens. Please proceed with your question.

Hi, thanks. Good afternoon. In prior presentations, you provided the 2023 loan growth outlook by those three categories: commercial down to auto finance. So I guess my question is kind of in an ideal world, what bucket would you like to grow and how would you like that mix of growth to be in 2023, and is auto finance kind of the filler so to speak, because to allow you to hit that target, given just some of the lower returns that we hear in the marketplace?

Yes, that's a great call out Terry. We have a lot of levers. We want to see where the year is going, as opposed to saying in the middle of the year that we're going to go hard in this asset class, only to find out that maybe that is not the area offering the best returns. We're looking very closely at our mortgage business. Now our mortgage business in production is off 80% so far versus the prior January. So how do I want to forecast that out in a year when we’re seeing pay downs at historic lows and we're still seeing that grow? We're trying to pull these levers through, but what we know is we have the ability to manage what our loan growth number is, because we've taken action with quality people in quality segments. Then we're going to look at what the returns are in those areas. So the idea is that we can drive higher yielding assets over time. For 2023, what I would like to do is drive balanced growth. We are not the auto lending company; we are a company that can choose between consumer and commercial and try to balance the growth while maximizing the areas on margin. So that's a little bit of why we haven't broken that out going into the year.

Appreciate that and then just as a follow-up, I mean, what do you say to investors who are concerned with what they might feel is late cycle loan growth and how those loans may perform in a downturn? When I look at page 4, that right-hand category, there has been significant growth for a bank your size in commercial and CRE and construction and even auto finance or especially auto finance. What's your response?

I would say if you look at 12 months, you probably started too late. We've worked on fundamentally changing the balance sheet to derisk it over that timeframe. Specifically, I could call out, for instance, our residential real estate portfolio; we're oversized in residential real estate, but we're oversized in a portfolio that is prime and super prime, in a market that doesn't have large fluctuations up and down. Inherently, our balance sheet is less risky, in our opinion, going into that, and that has seen some growth. When we look at auto and calling that out specifically, it is the oldest new business I've ever experienced. Not only do they have decades of experience, we also brought in historical data to understand how the portfolio operates, so we know that. 97% of that book is prime and super prime. By taking a scorecard approach, which considers many factors, it's 99% of our portfolio. We know that because we can check that against historical data. We did not expand our credit box anywhere; in fact, we've tightened it as we've seen the world change. We tightened that on commercial real estate underwriting and commercial underwriting. We've added balances in areas that we know well.

I would agree with everything you said. We did not change our credit box relative to the growth you've seen. We're continuing to look at, as Andy said, what's going on in the marketplace, whether that's interest rate adjustments, sizing, or underwriting to an exit. The growth you're seeing again reflects the core client that we’ve been focusing on. We didn’t stretch to add in a new vertical; we didn’t stretch to add in some new geography. We feel we're comfortable with the core focus we had, coupled with the adjustments we're making to reflect what's going on in the economy.

Great. Thanks for taking my questions.

Good question. Thank you.

Our next question comes from the line of Jon Arfstrom with RBC Capital Markets. Please proceed with your question.

Hey, thanks. Good afternoon, guys.

Hello. Good afternoon, Jon.

Just a quick follow-up on that for you, Pat. On Slide 17, you mentioned some normalization driving the delinquencies up. I know these are small numbers, but what do you expect that to look like in a couple of quarters just so we're not surprised by that?

I think it's going to revert back to kind of pre-pandemic numbers. How long that takes, a year ago we thought maybe we'd be there by now, but it's not. The portfolio continues to outperform. We're seeing the indirect auto book is a little over a year now, so we're reaching some normalization. But really, the rest of the consumer delinquencies we saw this quarter are really small and we haven't really seen significant trends. When we get back to say 2018, 2019 numbers is still to be determined.

That helps. I was just going to ask about the delinquencies as well. Non-financial question for you, Andy. The brand campaign you talked about, what is the message on that and what do you think needs to refresh your emphasize in terms of messaging?

I hate to spoil it for you, Jon. I'm going to email those commercials to you as we're launching. What I'll say is we brought in a new chief marketing and product officer, and his expertise is in customer research. When you launch something about the brand, you first want to know what you're about, but you also want to know what your customers are about. We're going to combine what the messaging is that's true to us and what we do, but it's also going to be what's in it for me. We think about marrying a marketing message; we must think about our product execution. There will be significance in the products we launch in the second, third, and fourth quarters that should align with that brand message. We want our digital platform to be relevant, particularly to those switching banks, typically people that are 40 years old and under. This is the sweet spot of what we're doing in digital. It's right in the focus of ease of use and satisfaction we're seeing from our digital account opening. It's been a lot of work leading up to this moment. I'm taking a note to myself to email you, Jon, all the commercials.

I'm sure I'll see them. Okay, and then just a couple more cleanups, just back on Terry's question on Slide 5. On auto, I understand what you're saying there, but do you expect auto to grow very materially from here, and have you achieved what you wanted to get in terms of some of the portfolio diversification?

I would say that we have the option to grow it. I would say that we have to look at our mortgage portfolio as a natural hedge to a decreasing mortgage emphasis, which we're seeing its importance. We believe that auto will have growth in 2023. The exact number on that will depend upon what our overall position is, what the other categories do, what mortgage specifically does, and what we can find in liquidity. It's a little bit too early to pinpoint that. That's why we haven’t broken that out for the year. We really want a balanced growth between commercial and consumer.

All right, I'll just leave it at that. Thanks, guys. I appreciate it.

Thank you.

There are no further questions. Thank you. I'd like to hand the call back to management for closing remarks.

I really appreciate the interest you've had in Associated Bank. We will be on the road, telling our story of what's happening with the company, and look forward to speaking with many of you later this quarter at various locations. In the meantime, if you have questions, contact our leadership team or me. Again, thank you for your interest in Associated Bank.

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