First Business Financial Services, Inc. Q2 FY2025 Earnings Call

Good afternoon. Welcome to the First Business Bank Earnings Conference Call for the Second Quarter of 2025. Please note that this event is being recorded. I will now turn the conference over to First Business Financial Services Inc. CEO, Corey Chambas. Please proceed.

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, followed by a Q&A session. I'd like to direct you to our second 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 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. As you know, we work to achieve a 5-year strategic plan that is built to drive double-digit growth on an annual basis. Results for our second quarter and first half of 2025 show that strategic plan at work. During the quarter, our team again produced double-digit core deposit growth that outpaced our robust expansion of loans. We also maintained a strong net interest margin and saw a decline in net charge-offs. Private Wealth assets expanded significantly and fees grew. Operating revenue was solid even with some expected variability in our fee income sources, showing the value of our revenue diversification strategy. This drove pretax pre-provision adjusted earnings up 13% over last year's second quarter and EPS up 10%. ROA matched the linked quarter and year ago quarters, showing great consistency. Most importantly, tangible book value growth is a significant driver of stock valuation gains, and we grew tangible book value per share an impressive 14% from a year ago. Before I hand it over to Dave, I want to acknowledge our recent announcement of my planned retirement and Dave's succession to CEO effective next May 2026. You are all very familiar with Dave, and we're grateful for his outstanding leadership and his commitment to the future of First Business Bank.

Thank you, Corey. Balance sheet growth was a clear highlight again this quarter. You can see the quarterly highlights on Slide 3 of the earnings call slides. We continue to see exceptional growth with core deposits increasing $70 million or 11% annualized from the first quarter and up 10% from last year's second quarter. Another indicator of our great success in core deposit gathering is service charges on deposits, which grew 16% from last year's second quarter. I'll note that our growth trajectory has been outstanding, but as a business-only bank with larger average client balances, normal daily balance fluctuations can make a significant difference to period-end growth rates. We prioritize developing long-term relationships, and that requires a long sales cycle. So we tend to evaluate our success over a rolling 4-quarter view rather than period-to-period. Loan balances grew about $267 million over the same period last year. That's up about 9%. You can see our quarterly deposit and loan growth trends on Slide 4. We continue to see solid demand for our conventional and niche C&I products. Total C&I balances expanded $30 million or 10% annualized. This included growth within asset-based lending, up $13 million, Floorplan financing, up $10 million, and equipment finance up $7 million. Activity levels in our asset-based lending group continue to exceed what we've seen in the last 2 years. We attribute this to current market dynamics and our new leader in asset-based lending, who is off to a great start. We are positioned to capture growth opportunities in this space. Our Floorplan financing team also continues to see nice demand and extremely high client satisfaction results, which has led to a significant number of referrals. On revenue, I'll cover a few areas quickly. Private Wealth is a true highlight for us. The consistency of its revenue generation, relationship development, and capital efficiency are extremely valuable to our company. Private Wealth assets under management grew an incredible 36% annualized during the quarter and were up 15% from a year ago. Approximately 63% of our growth in assets under management during the past 12 months was from transfers from our new and existing clients. Obviously, there's a market component to this business that can drive variability. But as a revenue annuity stream, it is exceptional and growing. We also saw a decrease in SBA loan sale premiums and fee income. Like several of our fee income items, individual contribution levels can vary quarter-to-quarter. This quarter, the timing of closings and loans fully funding was a factor. Additionally, we've closed a higher proportion of SBA construction loans, which has lengthened our overall timeline between loan closing and loan sales. Pricing is extremely competitive right now, but we have a very strong team in place, and we continue to win deals. On to asset quality. We are very pleased with our low level of net charge-offs during the quarter, particularly the fact that they came from the transportation and logistics segment of our small ticket equipment finance portfolio, which was anticipated and is running off. The $4.6 million increase in NPAs was due to a single credit in the transportation and logistics sector of the conventional C&I portfolio. In total, our exposure to this industry at June 30 was $75 million, $44 million in the conventional portfolio and $31 million in the small ticket equipment finance portfolio. It is important to note that our exposure to this industry in the conventional portfolio is well collateralized. As a reminder, we are no longer lending to the transportation and logistics industry in our small ticket equipment finance business. This gives us confidence that our overall loss risk is relatively low. We continue to be pleased that our overall portfolio is performing as expected, and we have no areas of particular concern. Now I'll hand it off to Brian.

Thanks, Dave. The second quarter margin of 3.67% reflects our continued strong balance sheet management. You can see a breakdown of this on Slide 6 of our earnings supplement. Our margin includes fees in lieu of interest, which refers to the recurring variable amount of interest income we earn from items like prepayment fees and asset-based loan fees. These declined by $379,000 from Q1. This contributed 18 basis points to reported margin in Q2 compared to 23 basis points in Q1 and 27 basis points in Q4 of '24. Excluding these and other variable items, our adjusted net interest margin rose 1 basis point to 3.47% for the quarter compared to both linked and prior year quarters. We're very pleased with our ability to maintain a strong and stable margin in this environment. In the last month of the quarter, we added multiple meaningful new deposit relationships, which enabled us to let some wholesale funding mature without the need to replace it. A few additional notes on fee income. In the other line, we saw a decrease of $369,000 in SBIC fee income in Q2. We expect this fee income should improve in the second half of the year as existing funds mature, though variability is always expected. We also expect to invest in additional SBIC funds going forward as a long-term revenue catalyst and effective use of capital. The same is true for BOLI, which has favorable taxable equivalent yields and tax implications. One administrative item as a reminder, last quarter, we reclassified certain types of C&I loan fees from noninterest income to fees and of interest in our net interest income line. For the second quarter, this reclassification was approximately $567,000, and it was $500,000 in Q1. This affects year-over-year comparisons for net interest income and fee income but has no impact on total revenue. Quarterly variability in specific line items reinforces the value of the fee income diversification we've worked hard to produce. We continue to expect total fee income to grow at our long-term target rate of 10% annually going forward. Our expenses were well contained in Q2. I'll reiterate that when we think about expenses, our primary objective is achieving annual positive operating leverage. That is, annual expense growth at some level below our targeted level of 10% annual revenue growth. On taxes, our year-to-date effective tax rate of 15.8% is right around the lower end of our expected range of 16% to 18%. We continue to believe this range is appropriate. Finally, our strong earnings are generating more than enough capital to facilitate our expected organic growth, and we continue to feel good about our capital levels. And now I'll hand it back over to Corey.

Thank you, Brian. We're very pleased to report this strong quarter, but I hope we've continued to make it clear that we take a longer view. So it's helpful to draw your attention to our year-to-date performance, which is outstanding. Compared to the same period of 2024 and the first 6 months of 2025, we've delivered 10% growth in operating revenue, 18% growth in pretax pre-provision earnings, 17% growth in net income, and 14% growth in tangible book value. We're very optimistic about 2025 and beyond, and we believe our focus on strategic initiatives will continue to serve us well into the future. I want to thank you for taking time to join us today. We're happy to take your questions now.

Your first question comes from Jeffrey Rulis from D.A. Davidson.

I wanted to check in on the loan growth side. It sounds like there are some constructive comments and optimism. I appreciate, Corey, that you are looking at it from a longer-term perspective. However, as we look at the year, is achieving 10% growth going to be a stretch? Or are there some seasonal factors or tailwinds that might strengthen in the second half?

Yes. I would say we're not far away, Jeff. We're running in the 8s. So we do some larger deals, and it can move around quarter-to-quarter. So we're still feeling like that's well in sight, not really a seasonal thing, Dave?

Right. I'd just add, as of the last 4 quarters, we've been at about 8.9%. Again, that's a deal or 2 away from 10%. And we've had pretty broad-based growth. In our conventional markets, we've seen growth, particularly in our Southeast, which is our Milwaukee market and Northeast market. And then we've seen some nice growth in some of our specialty areas. So there's nothing we are seeing in our pipelines right now that would have us back off of that.

Okay. I may not have expressed that clearly. You have achieved decent growth despite the macro disruptions so far this year. Are you seeing signs of increased confidence from your business borrowers now that the tariff issues are less of a concern? Is there a sense that the second half of the year might look better, or will it remain consistent?

I think it's a pretty steady state, Jeff. The disruptions and on-again, off-again things that have gone on have caused folks to be concerned, cautious maybe a little bit. And I think things have calmed some and the economies continue to move forward in a strong way. So I think some of that uncertainty hesitation is dying down a bit. So our borrowers are really not showing us any indication that they're going to do anything different than business as usual.

Got you. And my other question, just wanted to hop on the funding side and more deposits. Last few times, we've chatted deposit competition has heated up, and we've seen a little pickup in the deposit costs. Does that give you any pause or any threat to that kind of terminal net interest margin in the 3.60% to 3.65%? Do you feel like that's shaking out where deposit pricing is becoming more challenging and that's a threat to that level? Or I guess, expectations about deposit costs and margins combined?

Yes. The cost of deposits has been a challenge recently, but we have consistently paid competitive rates to build relationships in the market. We are currently observing that higher rates are persisting for a longer period. While we will continue to pay these rates, we do not believe they will negatively impact our outlook on net interest margin for the long-term target of 3.60% to 3.65%.

Your next question comes from the line of Daniel Tamayo from Raymond James.

I appreciate the information on the increase in NPAs related to the specific transportation commercial and industrial loan. Just to clarify, was that the entire amount of the increase in NPAs? I’m not sure if you mentioned the amount of that loan, but I know you provided the categories where the increases occurred, particularly in the commercial and industrial and small ticket segments. Can you tell me the amount of the specific loan that led to the increase in NPAs?

About $6 million. So net increase was something almost $6 million.

Got it. And where does that loan stand now in relation to reserves compared to the total loan?

We conducted an impairment analysis and specifically set aside reserves for it. At this point, we believe it is fully collateralized.

Okay. I have a follow-up question, unrelated to the previous topic, regarding the SBA loan sale gains you mentioned in your prepared remarks. Given the rising competition in this area, do you have any specific guidance on where you expect that line to land? I understand it can be volatile quarterly, but perhaps you could share your expectations for the annual performance?

So yes, I mean, as we've talked over the past few quarters, it does bounce around a little bit. I think Q1 was a little higher than we were expecting originally. Q2 is down, and we expect it to kind of bounce back closer to Q1, I think, for the remainder of the year.

Your next question comes from the line of Damon DelMonte from KBW.

Just to circle back on the transportation portfolio. I guess how are you feeling about the remainder of the portfolio? Are there any other early signs or building signs of more degradation in that portfolio?

We are looking at two areas here. One is our equipment finance transportation loans, which are continuing to decrease. We stopped lending in that area in May 2023, so the remaining loans are becoming more seasoned. We believe that the number of nonperforming loans from this group will continue to decline. On the conventional side, the situation appears stable. The key difference is that the conventional loans typically have much stronger collateral coverage.

That's helpful. And then with regards to kind of the outlook here for expenses, Brian, do you think you kind of just show modest growth off of like this quarter's level? Or kind of how do you feel like the back half of the year is shaping up?

Yes, I would say typical modest growth. We're going to continue to hire where we need to. We'll have the seasonal offset of social security expenses going down. We're at a point now with some of our technology spend that's being capitalized and more of just a lower run rate there. So I feel good about our ability to drive positive operating leverage on an annual basis here still in '25.

Okay. Great. And then I guess just lastly on the provision outlook. Absent any other loans moving into nonperforming that, we just kind of think about it just from enough to support growth and kind of keep the reserve level flat with modest charge-offs. Is that a fair way to characterize it and look at it?

Yes, it's a fair way to characterize it. I would say the last 3 quarters have been in that $2.5 million to $2.7 million, and that run rate seems realistic or reasonable for what we're seeing for growth. Charge-offs were down a little bit this quarter. So that was a good indicator on a go-forward basis. And the thing we can't control really is some of the inputs into the CECL model relative to the economic forecast going forward. So that's always a bit of a wildcard for all the banks, as you well know.

Your next question comes from the line of Nathan Race from Piper Sandler.

Curious just as you're thinking about opportunities to grow core deposits, I know that pipeline isn't as visible in terms of maybe what you have coming on, on the commercial side of things, but just curious, kind of how you guys see core deposit growth trending, excluding brokered and CDs in the back half of this year? And just maybe any targets over the next year or so in terms of where you'd like to see wholesale funding get down to? I know wholesale funding is a part of the model in terms of how you match fund some of your commercial real estate growth, but would appreciate any thoughts along those lines.

I'll start with the latter part of your question, Nate. Our strategic plan aims for around 75% in-market deposits and 25% wholesale funding, with a possible variation of about 5%. This adjustment is influenced by our match funding needs and the borrowing preferences for term financing. If borrowers opt for swaps, our funding requirements decrease; if they prefer fixed rates, we need a bit more. Our target range works effectively for our neutral balance sheet, which we prioritize strategically. That's the range we strive for in terms of deposits. Regarding pipelines and future growth, Dave, would you like to address that?

Sure. Regarding pipelines and growth in the latter half of the year, I don't anticipate any changes from the first half. We aim to maintain our approach. Our treasury management team is actively making outbound calls. We monitor our service charges on deposits, which have increased by 16% over the past year, indicating consistent outreach and the addition of new accounts. We expect to continue this trend, though deposits may fluctuate, leading to higher growth in some quarters compared to others. Overall, we believe we can keep pace with our loan growth.

Yes. So yes, big picture, Nate, I'd say net-net, if we're going to grow our loans 10%, we've got to grow our deposits 10%. Quarter-to-quarter, that 10% might be a little more wholesale one quarter, a little more in market one quarter, but that will equalize out. And again, why we kind of look at a rolling 4-quarter basis on that as well.

Okay. Great. That's really helpful. And Brian, you mentioned you guys are going to obviously remain competitive, driving core deposit growth going forward. But just curious what you're seeing from a competitive perspective these days among some of both the larger and smaller institutions that you compete with? Are you seeing any more rational pricing these days? Or any notable changes from a competitive perspective within the last 90 days or so?

It's as competitive as ever. While it's frustrating, we feel good about our position because we can pay what we need to, and we’re still able to price our assets appropriately, particularly in some niche commercial and industrial lending areas, which allows us to maintain a margin of 3.60% to 3.65% going forward. However, the competition remains as intense as it has been.

Yes. And I'll just tack on to that. As Brian said, the C&I growth is faster than the CRE growth over the last couple of years. That continues to be our strategy, and that plays well with the need to be able to have a bit higher yield, which we do on the C&I book overall to 200 basis points or so higher than the CRE book. And it's a good thing that we've been growing that and continue to expect to do that because deposits are just more expensive for everyone. And if you're a growth-oriented company like we are, we've got to bring in new deposit relationships. If you're a bank that's just kind of stagnant and not really growing, you don't really have to do that. But fortunately, our model is such that we're able to do it and maintain the margin.

Right. Appreciate that. Maybe one last one. Brian, can you just update us in terms of kind of the margin sensitivity to short-term rates in terms of maybe what we could expect from a margin impact if we do get a Fed cut at some point in the back half of this year?

Yes, I'm happy to provide that update. Currently, we are slightly asset sensitive as of Q2, mainly due to some short-term cash on our balance sheet. We intend to utilize those assets in the second half of the year. Our models indicate some minor downward sensitivity regarding the upper range of interest rates, but it’s very small and pertains to immediate shocks as well. We are confident in our ability to manage deposit betas when rates start to decrease, allowing us to maintain our target range of 3.60% to 3.65%, which is slightly above our current performance. We have accounted for a small amount of compression in that expectation.

Okay. But it sounds like once that cash is redeployed, the beta should be pretty well matched on both sides of the balance sheet?

Your next question comes from the line of Brian Martin from Janney.

I am not sure who mentioned it, but I recall you discussing some wholesale funds maturing this quarter. I am curious about any implications this might have for near-term margins, especially since I'm unclear on when it happened during the quarter. I'm just trying to grasp any potential impact it may be causing later in the quarter.

Yes. Good question. So basically, it was a function, and this is what we always do. We tend to have some shorter-term wholesale funding. We're rolling 1-week advances as we're looking to place funds out on a curve for our match funding or we're waiting for core deposits to come in. And that was the case this quarter where we had roughly $100 million of short-term advances floating, rolling every week, and that was then swapped out with the $100 million plus of core deposits. The weighted average rate of those is pretty consistent given some of the duration we had in the CDs. So really, what we're seeing is a push on net interest margin given that mix change given the size of it. So we feel good about our ability to, again, maintain that margin target.

I'm curious about the mix of loans this quarter compared to traditional loans. Specifically, how the specialty trends were and what your outlook is for the next 12 to 18 months. Last quarter, it was around the low 20s percentage-wise, so I'm interested in what the mix was this quarter and your thoughts on that moving forward.

Yes. We'd like to see that mix move up a little bit. On some of the niche lending areas, we've seen really good activity in ABL, as Dave mentioned. And so we expect that to continue. And we would look for our floor plan business to continue to grow. That's been a really steady and growing business for us. Those would probably be the 2 areas that we'd be looking for the most growth in the near term.

Got you. And as far as just longer term, like longer-term target on the percentage of where you think that kind of shakes out or where you'd like to see that? If it's in the low 20s today, is that trending toward a 30% type of level? Is that too aggressive in terms of where you want to get to over time?

I think it’s a bit uncertain how long "over time" really is, but I do believe that it could eventually reach around 30%. The challenge is that we are essentially trying to catch up with a runner who already has a head start because our standard commercial and standard CRE business continues to grow. This means we need to achieve even more to increase the other percentage. I recall it has been as high as 26%, but we've encountered some softness in a couple of areas recently, especially with ABL, which is now beginning to recover. I believe we can close that gap again, and I would expect that it could get closer to 25% in the next year or so, and potentially increase a bit more. During our last strategic plan, we progressed from 16% to 25% over five years, averaging a couple of percentage points each year. If we succeed in growing those business lines as we aim to, we could see increases of 1% to 2% annually.

Got you. And those business lines, whether this quarter or just year-to-date, have they been pretty stable. I mean, I guess they're just keeping pace. They have not really outgrown in the first half of this year relative to the other portfolios?

Yes, I think that's a fair characterization. I'd say Floorplans have outgrown, but the others are likely pretty consistent and more in line.

Yes. Okay. And then just one last question for me. When the Q is released, are there any notable changes in the trends regarding criticized loans or classified loans, aside from the one credit you mentioned?

There's nothing material to note there that we're aware of. And like I said in the Q, you'll see those trends are pretty consistent.

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

Thank you for joining us today. 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 day.

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