First Business Financial Services, Inc. Q1 FY2025 Earnings Call

Good afternoon. Welcome to the First Business Financial Services First Quarter 2025 Earnings Conference Call. At this time, all lines are in listen-only mode. Following the presentation, we will conduct a question-and-answer session. After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded Friday, April 15, 2025. I would now like to turn the conference over to First Business Financial Services, Inc. CEO, Corey Chambas. Please go ahead.

Good afternoon, everyone, and thank you for joining us. We appreciate your time and your interest in First Business Bank. Joining me today is our President and Chief Operating Officer, Dave Seiler, and our CFO, Brian Spielmann. Today, we'll discuss our financial performance along with some operational highlights followed by a Q&A session. I'd like to direct you to our first quarter earnings release and supplemental earnings call slides, which are available through our website at ir.firstbusiness.bank. We encourage you to review these along with our other investor materials. Before we begin, please note 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 most recent annual report on Form 10-K and as may be supplemented from time to time in the company's other filings with the SEC, all of which are expressly incorporated herein by reference. There, you can also find information related to any non-GAAP financial measures we discuss on today's call, including reconciliations of such measures. We are pleased to report another outstanding quarter. Our model is built to produce 10% annual growth, and the first quarter is one more example of our strategic plan at work. Our team has a clear directive to drive relationship-based deposit growth. And this quarter, we produced double-digit core deposit growth that outpaced our robust expansion of loans. We also maintained a strong net interest margin and stable asset quality. All the elements required to consistently grow shareholder returns showed strength during the quarter. Loans grew across our markets and portfolios. Private wealth management assets and fees grew. Operating revenue showed continued strength, and operating expenses were contained and in line with growth in our workforce. Non-performing assets declined. These successes drove pre-tax pre-provision adjusted earnings up 23% over last year's first quarter and earnings per share of $1.32, up 27% from a year ago. Most importantly, tangible book value per share grew 14%. Dave will walk through some of the business activity that drove strong first quarter results.

Thanks, Corey. It's worth repeating that our balance sheet growth was very strong this quarter and that's by design. You can see the quarterly highlights on Slide 3 of the earnings call supplemental slides. Loan balances grew about $275 million over the same period last year. That's up almost 10%, which is our long-term organic growth goal. Total deposits grew $488 million or 18% from last year's first quarter. That includes our continued use of wholesale deposits to execute our match funding strategy, maintain adequate liquidity and support our loan growth goals. We saw exceptional growth in the first quarter with core deposits growing $66 million or over 11%. You can see our quarterly deposit and loan growth trends on Slide 4. On the lending side, we continued to deliver on our growth targets in the first quarter. C&I led the growth with balances expanding $77 million, or 27% annualized. A few successes in particular merit attention. SBA lending sustained its momentum under the recently expanded team. We expect this trajectory will be variable, but with strong loan sale premiums for the past two quarters, we expect SBA to be a meaningful driver of revenue in 2025. Additionally, activity levels in our asset-based lending group are exceeding what we've seen in the last one-and-a-half to two years. We attribute this to market dynamics and with our new ABL leader now in place alongside our exceptional team, we're positioned to capture growth opportunities in this space. Our floor plan financing team also continues to show nice demand, extremely high client satisfaction results and is off to a great start in 2025. This is a good time to highlight two of our lending businesses in light of the current uncertainty around the economic outlook. Our asset-based lending and accounts receivable financing businesses are typically countercyclical. Yields on these loans typically carry a significant premium over conventional C&I yields, and they are generally 100% secured. We would expect growth in these portfolios in a softening economy. Moving briefly to revenue, our first quarter revenue grew by nearly 13% compared to the first quarter of 2024. This sustained strength reflects the diversified nature of our revenue streams and supports our continued goal of achieving 10% or greater annual revenue growth over the long term. The diversification we've built into our revenue profile provides a buffer against reliance on any one source. You can see our revenue growth trajectory on Slide 7 of the earnings deck. On to asset quality. We continue to be pleased with how our portfolio is performing and have no areas of particular concern. NPAs declined by $4.3 million from the linked quarter due to net charge-offs against specific reserves on credits in the transportation sector of the equipment finance portfolio and the SBA portfolio. While these net charge-offs reduced the overall allowance for credit losses, this was partially offset by increased general reserves due to loan growth and modest deterioration in the economic outlook in our model forecast. Together, these factors drove the increase in the allowance coverage of NPLs compared to December 31. We are always looking closely at migration in the portfolio. Our weighted average risk rating has barely moved. We continue to wait out the bankruptcy proceeding process and related litigation for the $6.2 million ABL credit mentioned in previous quarters. We expect full repayment on this credit, but unfortunately, it continues to inflate our otherwise healthy level of NPAs. Lastly, I want to comment on the current environment and what we're hearing from our clients. We are in very healthy markets and our clients are generally healthy and thriving. We do have ongoing dialogue with clients and there is a rising level of uncertainty related to changes in US trade policy along with the potential for any unfavorable changes to lead the economy into recession. Although we are built to grow at a double-digit pace in most conditions, our growth will be impacted if conditions weaken. We can't put a number on that today, but we would expect to continue outperforming our peers as we have done in recent periods of economic weakness. Now, I'll hand it off to Brian.

Thanks, Dave. I'll cover first quarter financials in a little more detail. As a reminder, when looking at our first quarter results in comparison to the linked quarter, our fourth quarter had some unusual items, which boosted earnings by about $0.28. Our ability to produce a net interest margin that is strong and stable compared to peers contributed to our solid performance. First quarter margin of 3.69% reflects our continued strong balance sheet management. You can see a breakdown of this on Slide 5 of our earnings supplement. Our margin includes fees earned in lieu of interest, which declined by $307,000 from the linked quarter. Compared to the first quarter of 2024, fees in lieu of interest grew by $1.2 million. Fees in lieu of interest refers to the significant and recurring, but variable amount of interest income we earn from items like prepayment fees and asset-based loan fees. Recent levels were elevated and contributed 23 basis points to reported margin for the first quarter and 27 basis points in the fourth quarter, compared to 10 basis points in the first quarter of 2024. Excluding these fees, our adjusted NIM was 3.46% for the quarter compared to 3.48% in the linked quarter and 3.43% for the prior-year quarter. Margin remains strong and consistent due to pricing discipline and continued execution of our long-standing match-funding philosophy. Dave covered fee income and the strength we continue to see there. Just a few additional notes. Ongoing variability in swap fees and returns on SBIC funds are expected. Our swap fee income will continue to vary quarterly based on CRE activity, the rate environment and client preference. We saw a decrease of $475,000 there in the first quarter. SBIC fee income is driven by interest income in the portfolio and unrealized and realized gains. We saw an uptick of $318,000 in Q1 and expect realized gains should show strength throughout 2025 as the existing funds mature, though timing may contribute to ongoing variability. One administrative item is that we reclassified certain types of C&I loan fees from non-interest income to fees in lieu of interest in our net interest income line. For the first quarter, this reclassification was approximately $500,000. The reclassification does not change our outlook or target range of 3.60% to 3.65% for net interest margin, but we'd expect to land on the higher end of that range, all else equal. Quarterly variability reinforces the importance of our fee income diversification we've worked hard to grow. We continue to expect overall annual fee income to grow in our long-term target range of 10% going forward. Our expenses were well-contained this quarter and showed expected workforce related and seasonal growth. Total expenses were up $1.6 million compared to the fourth quarter. $1.2 million of that growth came from compensation expense due to larger workforce, merit increases and higher seasonal payroll taxes. When we think about expenses, our primary objective is achieving annual positive operating leverage, expense growth at some level below our targeted level of 10% revenue growth. We will continue to manage expenses towards this goal in the event that economic conditions impact revenue growth. Next, taxes. The first quarter returned to a more normalized effective tax rate of 17%, in line with our target range of 16% to 18% for 2025. Recall that in the fourth quarter, we saw a significant change in estimated state taxes, which brought our effective tax rate down to 5.8%. Finally, we continue to feel good about our capital levels and our strong earnings are generating more than enough capital to facilitate our expected organic growth. And now, I'll hand it back over to Corey.

Thanks, Brian. I'd like to draw your attention to our Slide 11 in our earnings deck. This shows our five-year strategic plan and our progress toward achieving our long-term goals. You'll see that above all, our goal is to deliver shareholder returns that exceed our peers. We expect we can do this in any environment. The metrics we track to achieve this are laid out on this slide. Today, we continue to do what we've always done and that's focused on controlling the controllable. This is the value of a well-thought-out strategic plan that is understood by all employees. It guides us in both stable and volatile times. We continue to be optimistic about 2025 and believe focus on our strategic initiatives will serve us well in the future. I want to thank you for taking time to join us today. We're happy to take your questions now.

Thank you. Ladies and gentlemen, we will now begin the question-and-answer session. Your first question comes from Daniel Tamayo from Raymond James. Please go ahead.

Thanks. Good afternoon, guys.

Hey, Danny.

Hey, Daniel.

Could you provide information on the new loan yields for the first quarter and the roll-off yields, as well as any comments on whether you've observed any tightening of spreads?

All right. Yes. I would say new loan yields are pretty consistent with the prior quarter. We're seeing for the very competitive credits, those spreads are narrowing a little bit, but not much change. So, I would say nothing really to note there in the first quarter.

Okay. Do you have a rough number for the loan yields?

No. We don't. We typically will see pricing in the 2.25% to 2.75% range depending on the type of credit and the type of product it is. So, over SOFR, sorry.

On the bank side.

On the bank side. And then, obviously, the specialty finance or initial commercial lending area with ABL and ARF and other areas, we get wider spreads there. And so, that's where that mix comes into play in the margin.

And Danny, for a while, we provided a breakdown of new loans for the quarter. We thought that would be helpful, but we realized it got skewed based on where the loans originated in that quarter. As Brian mentioned, if we had a lot of asset-based or factoring deals in that quarter, it would significantly impact the figures, making it more confusing than informative. Therefore, we decided to stop generating that specific information on a quarterly basis.

Understood...

I would say that the situation is quite stable on both the loan and deposit sides at the moment. We've finally reached an equilibrium state on both sides of the balance sheet.

Agreed.

That's kind of where I was going with this. The core margin has been fairly stable, showing a slight decline over the past few quarters, but it remains relatively steady as you mentioned. There are about 5 basis points of additional fees in lieu of interest included now. I appreciate your guidance suggesting an upper range of 3.60% to 3.65%. So, what you're indicating is that you're not observing any changes in loan yields, which remained relatively stable this quarter. You wouldn't anticipate those to decline at all from current levels, assuming we do not see any rate cuts, and probably the same applies to funding costs. Is that correct?

Yeah. That's spot on, Danny.

Okay. And then, you talked about it a little bit in your prepared comments, about the tariffs and maybe creating some uncertainty and probably hard to quantify at this point, but just curious, as you look through your borrower base, where it might be most exposed to these tariffs, where you're watching most closely, as we go through these next few months, and who knows what's going to actually come out of Washington, but at least to give you a starting point.

Dave, why don't you start with that?

Sure. To start, we have been actively communicating with our clients over the past two months to understand their thoughts and potential impacts. Currently, we are not receiving much feedback from them. While they do have concerns and uncertainty, I don't think they have been greatly affected so far. Our attention is primarily on clients with international connections and contractors, and up to this point, we haven't observed a significant impact.

Jim, anything different to add there?

No, there has been a lot of discussion and uncertainty, but it hasn't affected us yet. The somewhat positive aspect is that we don't have many clients engaged in international business. We have often attempted to promote international products since they are beneficial for banks, such as letters of credit for managing foreign currency risk. However, we currently see limited use of these products among our clients, which is likely a good thing at this moment.

Got it. Okay. I appreciate all that information. Just one last small question. I apologize if you've already addressed this in your comments. I know you touched on it briefly in the release. Regarding the increase in net charge-offs due to the pull-forward of equipment finance losses, is it correct to consider this as a one-quarter phenomenon?

Yeah. Let's have Brad Quade, our Chief Credit Officer, handle that one.

Hey, Danny. Good. Yeah. That is a one-quarter anomaly that we're going to see at that level. While we do expect some continued credit costs in the equipment and the equipment finance portfolio in Q2 and beyond, we look at that size of the charge-offs there as being unique and kind of accelerating at quarters worth of charge-offs.

Okay. All right. Great. I'm glad to see the Packers finally decided to take a receiver last night in the draft.

Yeah. I'm excited...

Our next question comes from Jeff Rulis from D.A. Davidson. Please go ahead.

Thanks. Good afternoon. Maybe a quick follow-on in the same vein. Expectation on the provision, assuming loan growth is where it's at, a step down, there's some correlation, I guess, I'm asking on the provision to the increased charge-offs. Is that correct?

Yes, in the current quarter, there's correlation with the increased provision due to the pull-forward on the charge-offs. So, I think all else equal, we have a growth factor in provision. And then, we'll continue to work through the equipment finance portfolio with some additional net new along with the charge-offs in the quarter. And then, again, the CECL model factors, the quantitative piece, right, will kind of present itself as it will with the rest of the industry. So, yeah.

But most of what we pulled forward because, essentially, I think you could think of it as two quarters' worth of charge-offs from that equivalent finance portfolio, which is where there was a transportation noise. But because of all that was done on timing, those were essentially reserved for already. So, I don't think it had the same impact on the provision for the quarter. It just pulled those charge-offs out of the specific reserves that were already in place for them.

Got it. So, it came out of the reserve, but the impact on the provision line is less significant, and that's largely due to future growth and some adjustments, I suppose. So, is it reasonable to assume that the provision level will be similar to what you've seen in the previous quarters?

Yes.

Okay. So, jumping ship a little bit, your cash and securities balances as a percent of earning assets is kind of a two-year high. I guess, is that an intentional strategy, somewhat temporary? Just trying to check in on those levels relative to overall earning assets.

Yeah. I'll say intentional, but temporary. Intentional in the fact that we're looking to the balance sheet for 10% of total assets for liquidity at quarter-end, and you try to land the plan as best you can around that. And we had some nice core deposit inflows near really the last business day of the quarter, which then left us with some additional deposits there and inflated the balance sheet. We've already put that to work though.

Got it. Okay. Appreciate it. And then, you mentioned the fee income expectations overall. I just want to clarify in that loan fee income line, the reclass, is that permanent that the run rate on loan fees remains kind of at this run rate, safe to say?

Yes. I would say in the quarter, right, we had around $7.5 million. So, you add that reclass back, we're closer to $8 million. That's with some of those components that we talk about, right? SBA was stronger, but private wealth, SBIC fund investments, different areas that we still think we can grow fee income.

Swaps.

Swap fee income that comes and goes as client preferences in the rate environment. So, we believe we can make up that reclass throughout the course of the year in fee income based on the various engines and cylinders we have in that fee income growth.

Okay. I may follow up with you on that. But thanks. I'll step back.

Thank you.

Your next question comes from Damon DelMonte from KBW. Please go ahead.

Hey, good afternoon, guys. Hope you're all doing well today. Quick question, just to kind of follow up on that, the last comment on the loan income reclassification. So, I think, Brian, you said that was about a 5 basis points impact to the margin. Is that correct?

Yeah. About.

Okay. So, I think total fees in lieu of interest was around 23 basis points this quarter. And I think, historically, it's been a little bit lower, maybe like 15 basis points. So, should we kind of model 20 basis points now if you look at the pickup from the other 5 basis points on the reclass?

Yeah. I think that's fair. On average, right, it's been around 15 basis points to 20 basis points. And so, similar to our margin comments around that 3.60% to 3.65%, all else equally, we'd probably be on the higher end of that range, right? So, the 15 basis points to 20 basis points would probably be on the higher end. It's probably a fair assumption.

Okay. Got it. That makes sense. And then, with regards to opportunity to reprice fixed rate loans or CDs that are coming due, can you just talk a little bit about what the schedule for those look like?

Our CD portfolio may be smaller, but we still see opportunities there. In our earnings release, we highlighted that over $100 million is maturing at a rate above 4%, while over $100 million is being renewed or newly issued at rates below 4%. There are still advantages to be gained, although the portfolio isn't large. Regarding loans, considering the timing of when those loans were originated, there remain opportunities not just in the loan segment but also in our bond portfolio, although those opportunities are decreasing as we progress through the current interest rate cycle.

Got it. Okay. That's probably all that I had. Everything else had already been asked. So, thank you very much.

Thanks, Damon.

Your next question comes from Nathan Race from Piper Sandler. Please go ahead.

Hey, guys. Good afternoon. Thanks for taking the questions. Bigger picture, on the SBA front, obviously, there's been a lot of headlines recently in terms of some changes in terms of underwriting and kind of just how that may impact deal volumes and so forth. So, just curious how you guys are kind of thinking about any ramifications, some of the changes in the SBA arena may impact your revenue line going forward.

I don't think we see a significant difference at this point. The main factor driving our volume right now is our sales team. Therefore, I don't have major concerns about changes in volume.

Okay. Got you. And then, obviously, you guys are still kind of sticking to your double-digit or high-single-digit balance sheet growth outlook, but just curious with all the macro volatility of late, have you seen any kind of slowdown in activity levels when it comes to what you're seeing in loan committee or otherwise?

Jim?

We really haven't. There's been a lot of conversation and they're dealing with it on a case-by-case basis, but we haven't seen it pull through on the pipeline yet.

Okay. Great.

The only real-time data we have comes from loan deals that are currently in process at the bank, which have been underway for some time. We attempted to assess whether we had any real-time data, particularly regarding our equipment finance business. Dave, could you elaborate on that?

We've observed an increase in volume and applications for a higher volume, smaller ticket product over the last 30 to 45 days. We're not certain if this surge is due to customers hastening their purchases to avoid tariffs or if it's simply a reflection of normal economic activity. We will only be able to determine that in the future, but for now, it indicates that there hasn't been a real-time slowdown.

Okay. Got you. And then, question for Brad. I'm curious about what you observed regarding criticized classified migration in the quarter and any general thoughts you have on that topic?

Yeah. From a credit standpoint, I mean, nothing exceptional. I'd say the trend lines were benign. We had very little way of change quarter-over-quarter. We continue to work through a couple of the challenged credits that are on there. But the overall portfolio and even those that headed into the quarter with some signs of distress had general stability quarter-over-quarter. So, really too early to pick up any real trend lines of deterioration from broader economic concerns.

Okay. Got it. And then, maybe one last one for Brian. Just curious how you're thinking about remaining deposit cost leverage, just based on kind of where your pricing is today and maybe what you have in CDs rolling off based on kind of where your pricing is today on some of those products as long as that remains on pause.

I would say it's going to be minimal. We've discussed the small CD portfolio and the opportunities it presents. Acquiring new clients can be costly, and we view the brokered CD market as an alternative cost of funds. Fortunately, we've been competing effectively in that space. We believe that asset yields will support a rate of 3.60% to 3.65% in the long term, considering both conventional products and the higher-yielding niche of commercial and industrial sectors. I know that was a long explanation for a brief question. Apologies for that.

No, that helps a lot. Thank you. And just lastly, can you remind us what your loan deposit ratio target is? It decreased nicely in the quarter, but I'm curious where you'd like that to land over time.

Well, I think, we might have said this, Nate, is we don't think about it that much. We don't care about it that much. We just think about our funding and liquidity, et cetera. But we know there are some kind of older school bank investors who look at loan to deposit ratio and think that's an indicator of risk. They could see the Silicon Valley Bank experience and realize maybe that's not the case. But we also, because of those optics, we're trying to get it down a little bit. That's why we favor brokered CDs over home loan bank advances when we want to match fund our balance sheet. So, ideally, if that was 99.99 instead of a 100-some-01, we think it could be better just because it had some screening that people do.

So that's our first test this quarter. We'll see. We're below 100 this quarter. Yeah, we're at 98 maybe this quarter. I think that has been significant—there's a lot of success on the core deposit side, but also just transitioning away from home loan advances to brokered CDs for our match-funding brought us down. We believe there is an opportunity to continue reducing that, given our core deposit objectives and goals. But, as Corey mentioned, we're really focused on achieving that 75% core funded to total bank funding ratio. If it increases slightly, that's great, but we will always maintain some level of wholesale funding to manage interest rate risk.

And as long as that's in that 70% to 80% range of our core funding, that's a good place for us to be to be able to appropriately match fund the fixed rate portion of our loan portfolio that's on balance sheet. So that's a good range for us to be in. But as Brian said, the transition from home loan to brokered, which has been over the last couple of years, in terms of what we've used for that match funding, that's brought that loan to deposit ratio down. So, hopefully, we look more attractive and hit a few more screens, and people come and listen to the story and discover what we're doing here and find it attractive.

Yeah. Agreed. Sounds good. I appreciate all the color. Thanks, guys.

Thanks, Nate.

There are no further questions at this time. I will now turn the call over to CEO, Corey Chambas. Please continue.

Thank you for joining us today, everyone. We appreciate your time and your interest in First Business Bank, and we look forward to sharing our progress again next quarter. Have a great rest of your day and a great weekend. Thanks.

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.