Orrstown Financial Services Inc Q3 FY2025 Earnings Call

Good morning. My name is Tiffany, and I will be your conference operator today. I would like to welcome everyone to the Orrstown Financial Services, Inc. Third Quarter 2025 Earnings Conference Call. I will now turn the call over to Tom Quinn, President and Chief Executive Officer of Orrstown Financial Services, Inc. and Orrstown Bank, who will begin the conference. Mr. Quinn, please go ahead.

Thank you, Tiffany, and good morning. I'd like to thank everyone for participating in Orrstown's Third Quarter 2025 Earnings Conference Call, both by telephone and through the webcast. If you have not read the earnings release we issued yesterday afternoon, you may access it along with the financial tables and schedules by going to our website, www.orrstown.com. Once there, you can click on the Investor Relations link and then on the Events and Presentation link. Also, before we start, I would like to mention that today's presentation may contain forward-looking information. Cautionary statements about the information are included in the earnings release, the investor presentation and our SEC filings. The presentation also includes non-GAAP financial measures as identified in the earnings release and the investor presentation. The appropriate reconciliations to GAAP are included in the appendices. Joining me today on the call are Orrstown Bank's Senior Executive Vice President and Chief Operating Officer, Adam Metz; as well as Executive Vice President and Chief Financial Officer, Neil Kalani; our Chief Revenue Officer, Zach Khuri; Chief Risk Officer, Bob Coradi; and our Chief Credit Officer, Dave Chajkowski will also participate on the call. Our financial highlights for the quarter are summarized on Slide 3 of the deck, we delivered another quarter of excellent results. Loan growth was strong. In the third quarter, we achieved 4.9% annualized loan growth after taking some steps early in the year to align the acquired portfolio with our risk profile. We have seen good growth in the last 2 quarters. Net interest margin was 4.11% for the third quarter of '25 compared to 4.07% for the second quarter of '25. We believe that we are pricing loans prudently and managing funding costs well, which is evidenced by the stable margin. Fee income remained a core strength of the organization during the third quarter. Fee income as a percentage of operating revenue was 20.8%. The second consecutive quarter that this ratio was nearly 21%. Expenses continue to decline. Noninterest expense declined by $1.3 million compared to the prior quarter. Our efficiency ratio decreased from 60.3% to 56.4% quarter-to-quarter. All this translated into our strongest quarter of earnings on record with diluted EPS of $1.13. Our return on assets of 1.60% and a return on equity nearly 16%. We believe that our successful execution of last year's merger with Codorus Valley is evident in our financial performance. At this time, I would like to turn the call over to Adam Metz for a discussion on our balance sheet. Adam?

Thank you, Tom. Good morning, everyone. We have previously discussed the steps that we've taken to proactively protect the bank's risk profile and position the bank to be successful in all economic scenarios. These steps seem particularly relevant given the credit concerns disclosed by other institutions last week. As a reminder, these steps included managing our CRE portfolio to reduce concentration, stress testing the C&I portfolio for the potential impact of tariffs, reviewing our TM platform for clients sending foreign wires and proactively discussing strategies with them. And reevaluating lending relationships above $2 million, adjusting risk ratings as deemed appropriate and presenting some of them with exit plans. Our relationship banking model requires our sales teams to keep in close touch with our clients. We have regular conversations with our clients on a variety of topics recently, including tariffs, the government shutdown, the Pennsylvania budget impasse and general economic conditions, helping them navigate the evolving landscape and plan accordingly. After the first quarter, we indicated these steps had resulted in higher-than-expected reductions in loan balances, but expressed optimism that steps had taken to protect credit quality and lay a solid foundation for future growth. We believe that this solid foundation was reflected in our third quarter results. As Tom said, in the third quarter, we achieved 4.9% annualized loan growth. We continue to lean into our relationship banking model where high engagement and local decision-making differentiate us in the market and allow us to meet client needs with speed and care. Importantly, credit quality remains sound. Net charge-offs were again nominal in the quarter. Classified loans decreased by $1.7 million to $64.1 million at quarter end. Although nonaccrual loans increased by $3.8 million to $26.2 million at quarter end. Most of this increase was primarily related to one relationship within the commercial construction and development portfolio. We are mindful of some economic uncertainty and its potential impact on the overall business environment. We remain focused on credit quality and plan to continue to grow prudently. And we, along with an independent third party, regularly evaluate our portfolio for new risk considerations. We view our capital position as an organizational strength which provides us with significant strategic flexibility for the future. We are well capitalized by all measures. Neil Kalani, our CFO, will now discuss our third quarter results in more detail. Neil?

Thank you, Adam. Good morning, everyone. The third quarter was another successful quarter for us. We recorded $21.9 million of net income or $1.13 million in earnings per diluted share. This equates to a return on average assets of 1.6%, a return on average equity of 15.7% and a return on average tangible common equity around 20%. All of these metrics place us near the top of our peer group and were achieved through multiple avenues. Looking at Slide 4, the margin increased by 4 basis points to 4.11% in the third quarter. Loan pricing on new originations and increased purchase accounting accretion drove loan yields higher, while the acceleration of $300,000 of debt issuance costs associated with the subordinated debt redemption increased the cost of funds a bit. On September 30, the company redeemed $32.5 million of subordinated net notes, which were at a rate of 7.72% for most of the second quarter. This action will reduce interest expense going forward while the company maintains its flexibility from a capital perspective. The other notable results from this quarter is the increase in loan interest to $66.0 million from $63.2 million in the second quarter. We placed a significant focus on generating the necessary growth to offset the impact of the reduction in purchase accounting accretion on loans over time and maintaining a margin near its current levels. Being asset sensitive as rates come down, I do expect margins to contract as competition remains heavy on both loan and deposit pricing, and that will certainly factor into our ability to maintain or increase the margin. Fee income is discussed on Slide 5. We saw an increase in noninterest income to $13.4 million in the third quarter from $12.9 million for the second quarter. This represents almost 21% of revenues. Swap fees were substantial at $800,000, service charges increased by $400,000 due to higher volumes and credit card incentives earned. Wealth Management continues to perform extremely well, and we're starting to see mortgage volumes increase. I would expect the normalized quarterly run rate to be in the $12.5 million to $13 million range going forward. The team continues to succeed in generating additional avenues in fee income, but it's going to fluctuate from quarter to quarter. On Slide 6, you can see that the noninterest expenses have declined by $1.3 million from the prior quarter. The key highlight here is that we no longer have merger-related expenses; the efficiency ratio decreased again to 56% with the continued goal of getting below 55%. The numbers still include the impact of additional third-party consulting services that are expected to continue but will decline over the next several periods. Considering the decline in expenses while continuing to invest in the bank's future, I would expect a quarterly run rate around $36 million going forward, plus some standard inflationary impact next year. Our credit quality is discussed on Slide 7. Once again, we recorded a small provision with a small amount of net charge-offs, our allowance coverage ratio was 1.21% at September 30, which we continue to believe adequately addresses the risk of loss in the loan portfolio. As Tom always says, and Adam just reiterated, we lead with risk. Therefore, we are cognizant of general industry concerns about credit, and our proactive approach helps us properly assess our portfolio, identify risks and take any steps necessary to mitigate them. Slide 8 covers the positive trends in our key metrics for the past year. The growth in the earnings metrics noted in those charts speaks for itself. In addition, TCE has grown to 8.8%, and our tangible book value per share has returned to premerger levels with a strong buildup expected from here. Our loan portfolio is discussed on Slide 9. Both Tom and Adam covered our growth for the quarter, but we're now close to $4 billion in loans with an average yield of 6.58%. We had $224 million of loan production during the third quarter and continue to have a solid pipeline. Payoffs continue to have some impact on the loan growth during the third quarter. On Slide 10, deposits increased by $17 million. We tapped into some brokered options for the first time in a while as the team works on building long-term core deposits. The cost of deposits declined again by a couple of basis points in the third quarter. We adjusted deposit pricing downward later in the third quarter, and that impact is expected to be reflected in the fourth quarter. As I've discussed in the past, we held deposit rates higher than previously anticipated. We determined now is the appropriate time to start adjusting them to be more in line with market rates. The 88% loan-to-deposit ratio provides us with sufficient liquidity to fund our loan pipeline without placing a heavy reliance on alternative funding sources. Slide 11 highlights the performance of the investment portfolio. We continue to take strategic actions with the portfolio to ensure it performs well in the current environment. The yield of 4.67% remains at the top of peer levels. Net unrealized losses decreased by $9 million as market rates declined, and the duration declined slightly from the prior quarter to $4.4 million. Our regulatory capital ratios are addressed on Slide 12, and the total risk-based capital ratio did decline during the quarter as a result of the redemption of subordinated debt. But despite that, we feel good about our current capital position as well as our ability to grow capital rapidly in the future. I'd like to now turn the call back over to Adam Metz for his closing remarks. Adam?

Thank you, Neil. The numbers speak for themselves. We are proud of our quarterly results. As Tom said, we believe that our successful execution of last year's merger is evident in our financial performance. We are optimistic about the future, both in the short and long term. We would now like to open the call to questions. Before we get started, the operator will briefly review the instructions with you.

Your first question comes from the line of Tim Switzer with KBW.

I have a follow-up on your commentary regarding the net interest margin. I understand the asset sensitivity here and with the Fed rate cuts, we might expect to see some near-term pressure. How should we think about the trajectory of the downward movement, assuming we get maybe one or two more rate cuts over the next few months? Is there a good rule of thumb that you have for how many basis points of the net interest margin each 25 basis point cut affects?

It's going to vary a bit, but the guidance I've provided is in the 4.0% to 4.15% range. The accretion fluctuates, which will have an impact. A couple of 225 basis point cuts won't significantly affect us. The main factor will be competitive pricing; if we consistently price loans appropriately and continue to lower deposit costs, we should be able to maintain our position through the next couple of cuts. However, the market conditions and the need to generate new loans will determine where that pricing settles. The competitive landscape and our efforts to grow the balance sheet will influence the final margin. With the recent sub debt reduction and adjustments to deposits, we will keep evaluating. My hope is to stay around this range, possibly up to 5 basis points lower, with any accretion having a positive or negative impact based on timing.

And your comments regarding the heavy competition on both loan and deposits. Are you able to provide any commentary around where that's coming from? Is it the larger competitors in your market, others closer to your size, are there any geographies or categories where it's a little bit more competitive?

I think it really depends on the market as we talked about our growth markets leaning towards the Baltimore, Lancaster, Harrisburg markets and those competitors vary in those markets. And so I don't know that we see consistent but on any given relationship or any given opportunity, it does remain competitive.

Tim, to elaborate on my previous point, from a numerical standpoint, as rates decrease, there will be a slight negative effect on our margins. However, the measures we implement moving forward can counteract that impact. We are placing significant emphasis on pricing strategies. We understand that, in isolation, our model will experience margin declines, but we have the ability to take actions that will mitigate this issue.

That makes sense. And on the loan side of competition, do you have a sense for how much of that is being driven by maybe some competitors who had pulled back on CRE or other areas momentarily and now they're kind of reentering or is it just that maybe loan growth demand is a little bit more tepid and so there's just less of the pie?

Yes, I think we see a mix of that, Tim. But I would tell you that we have been able here Q4, to get the price that we sort of set to the markets. In fact, they've done better than that. And I think that's a tribute, as I said in my comments, I think it really is a tribute to our relationship model. We're very high touch, very engaged with our clients and our prospects, and it makes a difference.

Your next question comes from the line of Gregory Zingone with Piper Sandler.

Just to go back to the NIM for a second. Do you have a spot NIM for September?

It's in the low 4s.

Okay. And then pivoting to credit for a minute. Would you be able to provide some color on what those largest credits are in classified today?

Yes. The larger credits include some commercial real estate, an auto dealer, and a variety of other commercial and industrial credits.

Would you be able to pin down a dollar figure in terms of maybe like your top 1 or 2 credits in there?

The top couple of credits total about $20 million in classified.

And you said it's roughly probably 2 or 3 credits that make up that balance.

That's right.

Okay. And then since quarter-end, are there any new updates with any of those balances that you can share with us today?

I would like to mention that we discussed some of the movement into classified loans, and there was an owner-occupied credit we received, which amounted to $1.3 million, and it moved to nonaccrual in the third quarter. Since then, we have received a pay down of just under $900,000 on that. This illustrates that we are quite conservative in our decisions to place credits into nonaccrual. Additionally, it's important to note that approximately 50% of our nonaccrual balances are current with their monthly principal and interest payments.

Okay. Awesome. Last question for me, the early 5% loan guide for next year, do you have a lending focus in mind for how you want the mix to look like?

Yes, as we discussed, we believe we have some capacity in commercial real estate. We took proactive steps to address this before and immediately after the merger. Recently, in the last quarter, we brought on additional talent in the commercial and industrial sector, especially within our middle market group. This presents us with opportunities, and we believe we can offer a unique experience in the middle market space. As I've mentioned, having the right talent is crucial, and I think we have some strong capabilities in that area.

Your next question comes from the line of David Long with Raymond James.

Neil, you mentioned that you might experience some pressure on net interest margin with the rate cut, but you also stated that there are steps you can take to offset this compression. What specific tools do you have to help avoid net interest margin compression if we anticipate rate cuts?

It really comes from a pricing perspective. We made some adjustments to the deposit costs and have intentionally set rates higher as we transitioned out of the system conversion and merger. From a client perspective, it made sense not to lower rates as quickly as others. We have some capacity to decrease rates, and new funding opportunities play a role in that as well. However, the key factor is that it's competitive-driven. On the loan pricing side, we continue to maintain our pricing levels, and we aim to keep them stable. Balancing growth with margin maintenance is essential, and we need to find the right equilibrium. If it is beneficial for us to generate more growth, we may lower our margins somewhat. Ultimately, much of this is influenced by the market and competition.

Sure. Understood. With that outlook of $4 to $4.15 on the net interest margin, what are your expectations regarding the shape of the curve over the next few quarters? Additionally, if we encounter a flatter or inverted curve, how much pressure might that place on the net interest margin compared to your expectations?

My modeling assumes the existing curve will likely flatten out over time. However, we will manage against that as part of our thought process, and we are observing some contraction. If long-term rates increase, that will be beneficial for us. Therefore, if we start to see some steepening of the curve, it will work in our favor.

That concludes the Q&A portion of the presentation. Mr. Quinn, I turn the call back over to you for concluding remarks.

Thank you, operator, and thank you all for participating today. As always, if we can clarify any of the items discussed on the call this morning or in our earnings release, please feel free to give us a call or contact us, and I wish you all a wonderful day. Thank you. Bye now.

This concludes the Orrstown's Financial Services, Inc. third quarter 2025 earnings conference call. You may disconnect your line at this time.