Earnings Call Transcript - ORRF Q2 2025

Operator, Operator

Good morning. My name is Kate, and I will be your conference operator today. I would like to welcome everyone to the Orrstown Financial Services, Inc. Second Quarter 2025 Earnings Conference Call. After the speakers' remarks, there will be a question-and-answer session. 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.

Thomas Quinn, President and CEO

Thank you, Kate, and good morning. I'd like to thank everyone for participating in Orrstown's Second 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 may click on the Investor Relations link and then on the Events and Presentations link. Also, before we start, I would like to mention that today's presentation may contain forward-looking information. Cautionary statements about this 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 investor presentation. The appropriate reconciliations to GAAP are included in the appendices. Joining me on the call this morning are Orrstown Bank Senior Executive Vice President and Chief Operating Officer, Adam Metz; as well as our Executive Vice President and Chief Financial Officer, Neil Kalani; our 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. Despite some lingering merger-related expenses, GAAP earnings were strong and core earnings continued to increase. Excluding certain merger-related charges, return on average assets was 1.51%, and return on average equity was 15.12% for the second quarter of '25 compared to 1.45 and 14.97%, respectively, for the first quarter of 2025. We expect stronger net income going forward as loan growth accelerates. Net interest margin also increased. NIM was 4.07% in the second quarter of 2025 compared to 4% in the first quarter of '25, with the possibility of further upside. We believe that we are pricing loans prudently and managing funding costs well, which is evidenced by the improving margin. Fee income remained a core strength of the organization during the second quarter. Fee income as a percentage of operating revenue was 21% during the quarter, an improvement from prior periods. Noninterest income increased $1.3 million quarter-to-quarter. The team has been doing an excellent job of generating fee income from various sources, led by our wealth management fees remaining the largest component of our fee income. Now at $3 billion in assets under management, there is significant opportunity to build this business. While expenses remain slightly more elevated than we would like, they are coming down. Over time and our core operating expenses are in line with expectations. The team remains focused on establishing a foundation to support future growth. Excluding the impact of merger-related expenses, the efficiency ratio was 58.7% for the second quarter compared to 60.5% for the first quarter of 2025. We do not anticipate any meaningful merger-related expenses going forward. We do expect expenses to continue to decline throughout the year, which will further boost our already strong earnings stream. We believe that we have consistently demonstrated the ability to maintain strong profitability in any environment. I would now like to turn it over to Adam Metz for a discussion on our balance sheet. Adam?

Adam Metz, COO

Thank you, Tom, and good morning, everybody. Loan growth was relatively modest this quarter, but we believe that the loan pipeline is strong. Total loan growth was 6% for the quarter on an annualized basis. Annualized commercial loan growth was 2%. During the quarter, we saw a good mix of C&I and CRE and also a good mix between floating and fixed. We believe our overall loan pipeline is strong. Currently, it's the highest it's been since the merger of the two companies. This reflects the strength and resilience of our regional economy, the deep engagement of our team with our clients, and the impact of new talent we've attracted, including individuals with middle market experience. As I said before, talent matters and we feel confident in the team we have in place and continue to build upon. It does remain a competitive lending environment, but we remain confident in our ability to grow loans the right way. Credit quality remains sound. We believe that the work we have done since the merger to protect credit quality has been very beneficial. Net charge-offs were again nominal in the second quarter. Classified loans and nonaccrual loans decreased quarter-to-quarter. Nonaccrual loans to total loans decreased to 0.57% for the second quarter compared to 0.59% for the first quarter. And we continue to build capital, which will create flexibility for us in the future. Capital ratios increased across the board quarter-to-quarter. We remain well capitalized by all measures. We continue to prioritize shareholder value. Late in the second quarter, the Board of Directors authorized a share repurchase program of up to 500,000 shares of common stock. The company repurchased 2,134 common shares during the quarter. We plan to utilize this authorization judiciously to support our currency as well as we believe we remain undervalued. The board voted to increase our quarterly dividend by $0.01 per share from $0.26 to $0.27 per share. This is the third dividend increase in the past year, and our dividend has increased 35% since the merger. Neil Kalani, our CFO, will now discuss our second quarter results in more detail. Neil?

Neelesh Kalani, CFO

Thanks, Adam. Good morning, everyone. We had a very strong second quarter, both from a GAAP basis and adjusted for some of the residual merger-related noise. We've achieved normalized ROA over 1.5% and expect improvement from there. Tom already walked through the numbers at a high level, so I'll just jump into the details starting on Slide 4. The margin remained very strong and improved to 4.07% in the second quarter. Cost of deposits declined by 12 basis points. This was partially offset by loan yields declining by 7 basis points due to the lower purchase loan accretion than the prior quarter. Absent the impact of the loan accretion, loan yields remained relatively flat compared to the previous quarter. This highlights our continued discipline on both loan and deposit pricing. The environment remains very competitive on both fronts, so the potential for margin pressure is real, but I do see further upside in margin into the third quarter with the expectation that it stabilizes after that point. Assuming rates remain unchanged, we do remain asset sensitive. As noted on Slide 5, fee income was $12.9 million for the second quarter, up by $1.3 million from the prior quarter. For the second quarter, fee income was almost at 21% of total revenues, but our goal remains to continue to exceed 20%. The team had an excellent quarter from a swap fee generation standpoint with just short of $700,000 in swap fees. Service charges increased by $200,000 as our treasury management team continues to successfully grow its pace and the broad fee waivers that we've discussed previously that we had temporarily implemented are no longer in place. Wealth Management had another very strong quarter and remains a significant focus for Orrstown to boost our noninterest income going forward. Obviously, there was a rough start to the stock market in the beginning of the quarter that did have some impact quarter-over-quarter, but we're very happy with the income generated from that business and the opportunities that lie ahead. The quarter also included some solar tax credit income and other items that are not necessarily consistent from quarter to quarter. I don't expect the current fee income run rate to continue in the near term; it is a longer-term expectation for us. But several components do remain dependent on timing; a quarterly run rate around $12 million is likely reasonable there, but certainly within the range of $11.5 million to $12.5 million. Noninterest expense is covered on Slide 6. While we had a little more noise than we expected during the second quarter, the picture of our efforts on expenses is becoming more evident. Noninterest expense declined by approximately $600,000 in the quarter, and that includes merger-related expenses of almost $1 million and severance costs of approximately $600,000. The efficiency ratio continues to come down, as Tom noted, and I've been messaging a go-forward run rate around $35 million each quarter. If you back out the items that I just talked about and about $1 million of consulting fees that were kind of in excess of normal in the quarter associated with the continued process improvement work that we have going, it gets you to that $35 million number. Merger-related expenses this quarter were associated with the final components of our core system conversion, and we don't anticipate any associated cost of significance going forward associated with the merger. The excess consulting costs are expected to decline over the next couple of quarters. So I expect the quarterly expense run rate in the $35 million to $36 million range for the next few quarters, and early next year approaching a 55% efficiency ratio inclusive of amortization costs. However, I will continue to reiterate that the primary reason for our success over the years has been our ability to attract strong talent to set us up for growth. So that approach will continue and could potentially impact the expense run rate. We would obviously expect that those decisions, if they do happen, would impact the revenue side of the equation over time as well. Credit quality is covered on Slide 7. We recorded a small provision this quarter primarily from a negligible amount of charge-offs on a net basis. Classified loans decreased by 14%. Nonaccruals were down slightly as well. Our allowance coverage ratio was 1.22%, which we continue to believe adequately addresses the risk in the loan portfolio. Slide 8 highlights our key performance metrics as adjusted for merger-related expenses and in the second quarter, normalized EPS reached 1.04. Adjusted ROA was 1.51 and adjusted ROE was 15.1%. With both the expected impact of our loan pipeline on interest income and the momentum we have on expenses, we do see some upside in those numbers, which puts us near the top of our peer group. In addition, now that we're a year out from the merger, we built TCE back over 8%. Moving to the balance sheet slide on Slide 9. Total loans grew to $3.93 billion, while commercial loans, as Adam mentioned, grew only by 2% annualized. We do have a strong pipeline heading into the third quarter, and we remain prudent in our lending decisions and continued focus on risk and long-term relationships. The average yield on loans was 6.5%. As mentioned earlier, the yield was impacted by the lower purchase accounting accretion which will vary each quarter based on timing of prepayments of acquired loans. On Slide 10, deposits did decline by $117 million as we continue to shift away from promotional time deposits and money markets. Cost of deposits declined from 2.14% to 2.01% in the quarter due to the impact of pricing decisions in the first quarter and new funding at lower cost. The 87% loan-to-deposit ratio provides us with sufficient liquidity to fund our loan pipeline without placing a heavy reliance on alternative funding sources. As I've indicated in the past, we're fairly comfortable in the low 90% range. So we feel good about where we are from that standpoint. And then as communicated previously, and shown on Slide 11, we used some of our liquidity to enhance the securities portfolio and generate additional interest income as loan production ramps up. We purchased $50 million of securities in the quarter, and the portfolio is now up to $885 million, and we'll continue to look for opportunities as the market creates some to strengthen our balance sheet and create strong yields. The duration remains relatively short at 4.5 years, and unrealized losses are still around 3% of the book balance at June 30. On Slide 12, you can see that our regulatory capital ratios are now at or above premerger levels. As we've said previously, the capital levels and expected growth in the ratios as we move forward presents us with many options to continue our growth trajectory. I'd like to now turn the call back over to Adam Metz for some closing remarks. Adam?

Adam Metz, COO

Thank you, Neil. We believe that the work we have done since the merger to protect credit quality, enhance liquidity and build capital has presented us with significant strategic flexibility going forward. Capacity to accelerate commercial lending for strong relationships considering buybacks as we believe our stock is undervalued, contemplating redemption of subordinated debt and the ability to take advantage of other strategic opportunities. We remain 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.

Operator, Operator

Your first question comes from Gregory Zingone with Piper Sandler.

Gregory Zingone, Analyst

You guys had a pretty clean quarter on credit. I was wondering though, are there still other credits in the Codorus Valley deal that you were still looking to move off or sell?

Adam Metz, COO

Well, we've in the past engaged in some loan sales. We haven't in the past two quarters because we've, as you've seen, been relatively successful working them out with very little in the way of any charge-offs. There might be a couple of loans that we may see as an opportunity in the next couple of quarters. But I wouldn't look for anything really substantial in terms of major loan sales.

Gregory Zingone, Analyst

Okay. And then as a follow-up, is there a capital level that you guys have in mind that you would like to reach before seriously considering another acquisition?

Adam Metz, COO

I'm sorry, you asked about the capital level we want to achieve.

Gregory Zingone, Analyst

Yes.

Adam Metz, COO

Yes, as we've mentioned before, we believe we're in a strong position. We're back to premerger levels now and will continue to progress positively over the next few quarters. I think we’ve reached a stage where seeking external capital isn't necessary for our plans. Of course, this depends on the nature and size of any potential deal, but we feel confident about our current position and believe we can further strengthen it in the upcoming quarters.

Operator, Operator

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

Timothy Switzer, Analyst

I wanted to follow up on your comments about the potential for NIM expansion in Q3 and then maybe some stabilization. It sounds like that assumes rates stay unchanged. Can you provide some commentary on how 2 to 3 rate cuts in the back half of the year could impact that, particularly going into 2026, maybe where the exit NIM would be?

Adam Metz, COO

What was the end of your question, where the what would be?

Timothy Switzer, Analyst

Where would the exit NIM be at the end of this year, say we get 2 to 3 Fed rate cuts?

Adam Metz, COO

We are sensitive to changes in asset rates. As the floating rate loans reset, there will be a negative impact on our overall net interest income. However, we have the potential to continue lowering deposit costs. A couple of rate cuts would affect us negatively, but we will need to focus on the loan side to mitigate that impact. From a margin projection standpoint, deposit costs are likely to remain competitive. We have likely reached the level of reduction that we will see, and it should stay relatively stable without further rate reductions. However, the question remains about how much we can push on deposit costs if rates are cut and how competitive that environment will be. There is certainly some downside as rates decrease.

Thomas Quinn, President and CEO

I will add to that, something Adam mentioned that our pipelines have not been bigger since the two companies came together. And so properly pricing those loans will be critical as we see rate cuts.

Timothy Switzer, Analyst

Great. Okay. And I'd love to follow up on some of your commentary about the wealth management business. Obviously, you had a pretty good quarter, but it sounds like it's an area where you guys see a lot of opportunity for growth. I'm sure there are maybe some synergies you can achieve. I'd love to get some more details on maybe what initiatives you have there, where the growth is coming from, and your outlook for that business?

Thomas Quinn, President and CEO

I think it's encouraging to the bank right now. When you see in the RIA space that snapped up CW Advisors, a $13.5 billion acquisition of assets under management for $950 million. You're sitting on $3 billion AUM and you realize that you grow the franchise there, the value of your franchise should only improve. And I think Adam's got a real strong strategic mindset towards bringing in more advisors. Although you talk about it, Adam, share with them kind of some of the things we're doing, not only in Maryland but in Lancaster as well.

Adam Metz, COO

Yes, I do think we have an opportunity in front of us. A lot of that will be through talent acquisition and I think we're pretty close on some fronts there. We also have, as I said before, a lot of opportunity in what I say are our growth markets. So we are just sort of scratching the surface as it relates to our Maryland market, and there's a lot of opportunity there, but also in Lancaster and Harrisburg as well.

Operator, Operator

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

David Long, Analyst

In your prepared remarks, you talked about the strength of the economic backdrop within your footprint. And I just wanted to get some color from you guys as far as what you are hearing from your business customers? When we talked in April, I think sentiment was pretty poor. As you said, the market was much lower than where we are today and coming off a Liberation Day, how is the sentiment of your commercial clients adjusted or changed over the last few months?

Adam Metz, COO

Yes. I would just answer that question by saying our pipeline is the largest it's been since the merger of the two companies. So we're having daily conversations with our clients. But I would tell you, we've seen the pipeline not only grow but fund here in July, and we expect it to continue. So yes, there is some noise on the headlines on any given day. But right now, they're moving forward, and we feel good about where we are.

David Long, Analyst

Got it. As a follow-up, could you elaborate a bit more on your interest in adding middle market bankers? Are these bankers what you currently have in your model for ads? As you grow the team, are you sourcing bankers from larger institutions or smaller ones, and where are you finding the best opportunities?

Thomas Quinn, President and CEO

Yes. This is Tom. I'll turn it over to Adam in a second. But in recent weeks, we hired the #1 lender from a $40 billion regional bank. That individual was the #1 person in that company in the middle market space. And I think Adam can elaborate on some of the other areas that he wants to focus on. Adam?

Adam Metz, COO

Yes, I believe we have some potential for growth to balance out the team. We were very pleased to hire someone who has extensive experience across various industries, and we've also been successful in bringing in new talent for our Lancaster and New York markets. Talent is important, and we empower them to serve their clients in meaningful ways. However, we always prioritize risk. We feel like we've been conveying a compelling narrative and have been successful in attracting skilled individuals. We are continually on the lookout for exceptional talent, and I believe that will persist.

Operator, Operator

Your next question comes from the line of Dan Cardenas with Janney Montgomery Scott.

Daniel Cardenas, Analyst

Just a couple of quick follow-up questions on the lending side. Can you give us some color on what the line utilization rate is on your commercial portfolio? And how does that compare to historical levels?

Adam Metz, COO

Yes. We've not seen a material change in line utilization in the quarter. I think it's remained fairly stable. Utilization rates are fairly modest right now in the commercial portfolio.

Daniel Cardenas, Analyst

As you consider growth for the second half of the year, will it mainly be driven by commercial real estate, or where do you see the greatest opportunities within your operations?

Adam Metz, COO

Yes. In the first half of last quarter, most of our loan growth was from commercial and industrial. In the latter half, we secured some positive commercial real estate deals. We are currently at 293% of risk-based capital in our commercial real estate segment. As we have previously discussed, there are various strategies in place to manage that, but we now believe we are positioned to pursue the right commercial real estate opportunities with strong partners. Overall, I feel that our pipeline is well balanced for the future, but we do have the capacity for more commercial real estate.

Daniel Cardenas, Analyst

So the wins on those deals, is that primarily pricing driven? Or what's kind of the secret sauce that will allow you to get the transactions that you want?

Adam Metz, COO

Yes, I'm sorry. I didn't necessarily hear your question there.

Daniel Cardenas, Analyst

I was curious about what drives your success in securing loans, considering the competition. Are those successes mainly based on pricing, or are there other factors that influence your ability to attract customers?

Adam Metz, COO

Yes, I would like to talk about our relationship model. While being competitive on loan pricing is important, we emphasize the value we provide through our pricing. It's essential to highlight our relationship-driven approach, which goes beyond just being a commercial lender; it also includes treasury management, retail services, and wealth management.

Thomas Quinn, President and CEO

Yes. I would add to that, that if you go back to 2020 when our lending team embraced clients to help them with PPP when they couldn't get them at the banks they were at. When you go back to the SIB failure, and we contacted all our clients to help them as they were nervous about liquidity challenges they might have or might not have. When you look at the consultative nature of how we approach, we're looking for bankers, not just people that can lend money. And so sometimes you're saying no to the client and in winning a relationship because the client truly appreciates what you're doing in the long term. And I think Adam has spoken at length to our lending team about the importance of managing the relationship, being there for the relationship, and fostering kind of an attitude that we're there to help them and their businesses. That approach seems to work right, and has paid long-term dividends.

Daniel Cardenas, Analyst

Excellent. And then my last question. It's been a year since the Codorus Valley deal has been consummated. Are you guys ready to do another transaction? And what kind of parameters are you looking for in potential targets? In terms of size and geographic location?

Thomas Quinn, President and CEO

Yes, that's a question we don't usually answer publicly. However, I can say that the bank has done an excellent job integrating the Peoples Bank merger, achieving an 18% reduction in costs by the end of 2024, surpassing our target set for June 30. We are continuing the integration process and have selectively moved some loans out of the bank. Now, we are focusing on identifying the best ideas and practices that will benefit our clients in the long run. We're finalizing a few additional aspects, and as we look ahead, we seek opportunities that would add significant value to our operations. We're interested in products or services that we currently lack in nearby geographies, reflecting our ongoing strategy. Historically, we have conducted three bank acquisitions in 106 years. This is a matter we discuss extensively with our Board, and we approach it thoughtfully. Our focus isn’t on ego; it’s about what serves our shareholders best, and we adhere to that principle daily.

Operator, Operator

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

Timothy Switzer, Analyst

I just had one follow-up. I appreciate you guys have gone through, I think, most of the work derisking the loan book, which has resulted in some good credit trends. I'd love to hear the details on what kind of loan review you guys have done to gauge the risk of tariffs and what the outcome of that has been.

Adam Metz, COO

Yes, sure. We took a couple of different approaches on how we tried to assess the risk relative to tariffs. The one thing we did was we just did a full stress of the entire C&I book. We stressed our NOI at 10% and 20%. The outcome of that was that under that 20% stress scenario, our classified total risk-based capital ratio would still be below our 25% threshold that we've set internally. So we feel pretty good about the resiliency of the portfolio as it relates to any risk around tariffs.

Operator, Operator

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

Thomas Quinn, President and CEO

Thank you again, Kate, and thank you all for participating today. As always, if we can clarify any of the items discussed on this call or in the earnings release, please feel free to give us a call. Wishing you all a wonderful day. Thank you very much.

Operator, Operator

This concludes the Orrstown Financial Services, Inc. Second Quarter 2025 Earnings Conference Call. You may disconnect your line at this time.