Earnings Call Transcript - OSBC Q2 2025

Operator, Operator

Good morning, everyone, and thank you for joining us today for Old Second Bancorp, Inc. Second Quarter 2025 Earnings Call. On the call today are Jim Eccher, the company's Chairman, President and CEO; Brad Adams, the company's COO and CFO, and Gary Collins, the Vice Chairman of our Board. I will start with a reminder that Old Second's comments today will contain forward-looking statements about the company's business, strategies and prospects, which are based on management's existing expectations in the current economic environment. These statements are not a guarantee of future performance and results may differ materially from those projected. Management would ask you refer to the company's SEC filings for a full discussion of the company's risk factors. The company does not undertake any duty to update such forward-looking statements. On today's call, we will also be discussing certain non-GAAP financial measures. These non-GAAP measures are described and reconciled to their GAAP counterparts in our earnings release which is available on our website at oldsecond.com on the homepage and under the Investor Relations tab. So I will now turn it over to Jim Eccher. Over to you.

James L. Eccher, CEO

Good morning, everyone, and thank you for joining us. I have several prepared opening remarks. We'll give you my overview of the quarter and then turn it over to Brad for additional details. I will then conclude with summary comments and thoughts about the future before we open it up to Q&A. Net income was $21.8 million or $0.48 per diluted share in the second quarter. Return on assets was 1.53%. Second quarter 2025 return on average tangible common equity was 15.29% and the tax equivalent efficiency ratio was 54.54%. Second quarter earnings were significantly impacted by a couple of items, the first being a $531,000 and MSR mark-to-market losses or a penny per share. And an $810,000 charge in merger-related expenses or $0.01 per diluted share primarily related to the Bancorp Financial merger, which closed on July 1. Despite these items, Old Second remains exceptionally strong and book value continued to compound heading into the July 1 close of the Evergreen Bank acquisition. The tangible equity ratio increased by 49 basis points from last quarter from 10.34% to 10.83% and has increased by 144 basis points over the like period one year ago. Common equity Tier 1 was 13.77% in the second quarter, increasing from 13.47% last quarter. We feel really good both about profitability and our balance sheet positioning at this point. Brad will provide additional color on our capital positioning in his comments. Our financials continue to reflect a very strong net interest margin with pre-provision net revenues increasing from exceptionally strong levels. For the second quarter of 2025 compared to last quarter tax equivalent income on average earning assets increased $1.7 million, while interest expense on average interest-bearing liabilities increased $343,000. Net interest margin improved 22 basis points year-over-year on a tax equivalent basis and decreased 3 basis points compared to last quarter. Total cost of deposits was 84 basis points for the second quarter compared to 82 basis points for both the prior linked quarter and for the second quarter of last year. The loan-to-deposit ratio is 83.3% as of June 30 compared to 81.2% last quarter and 87.9% as of June 30 last year. I'll let Brad talk about that more in a moment. Second quarter 2025 reflected an increase in total loans of $58.4 million from last quarter, driven by growth in construction and lease portfolios during the quarter. Tax equivalent loan yields reflected a 3 basis point decrease during the second quarter of 2025 compared to the linked quarter and a 4 basis point decline for the quarter year-over-year. Asset quality was largely stable this quarter with nonperforming assets essentially flat and only a modest increase in classified assets as well. We recorded a $1.2 million gross charge-offs in the second quarter of 2025, of which the majority was associated with a single C&I credit, which is fully reserved for. One property was moved to OREO during the quarter with a favorable outlook regarding its disposition this year. The allowance for credit losses on loans increased to $43 million as of June 30 or 1.08% of total loans from $41.6 million at March 31, which was 1.05% of total loans. Unemployment and GDP forecast used in future loss rate assumptions remained fairly static from last quarter, with no material changes in the unemployment assumptions on the upper end of the range based on recent set projections. The impact of global tariff volatility was considered within our modeling. Provision levels quarter-over-linked quarter reflect no material change as our projections continue to be aligned with the prior quarter's assumptions for allowance allocations. Noninterest income continued to perform very well in the second quarter compared to prior year like quarter after excluding $893,000 in debt benefits in BOLI realized in 2024 as wealth management fees increased $324,000 or 11.7% and service charges on deposits increased $280,000 or 11.2%. Mortgage banking income reflected a slight increase in the second quarter of 2025 compared to the prior linked quarter, and a decrease in the prior year like quarter primarily due to volatility of mortgage servicing rights, mark-to-market valuations. Excluding the impact of mortgage servicing rights, mark-to-market adjustments, mortgage banking income increased nominally quarter over linked quarter and from the prior year like period. Other income was flat in the second quarter compared to the prior linked quarter and higher compared to the prior year like quarter. Expense discipline continues to be strong with total noninterest expense for the second quarter of 2025 at $1.1 million less than the prior linked quarter. Our efficiency ratio continues to be excellent as the tax equivalent efficiency ratio adjusted to exclude core deposit intangibles, amortization, acquisition costs and OREO costs was 54.54% compared to 55.48% for the first quarter of 2025. Our focus now is on the effective integration of Evergreen Bank and optimizing the balance sheet for its impacts. We have sold the bulk of the acquired securities portfolio from Evergreen and reduced reliance on wholesale funding within the legacy Evergreen Bank as it was merged in Old Second. Nothing really has changed relative to our expectations in terms of financial performance and targets associated with the transaction. Cost savings estimates are on target and earnings expectations are maybe biased to slightly higher. Next quarter will, of course, be slightly messy and feature the bulk of acquisition-related expenses. With that, I'll turn it over to Brad for additional color.

Bradley S. Adams, CFO

Thank you, Jim. Net interest income increased by $1.3 million or 2.1% to $64 million for the quarter ended June 30 relative to the prior quarter of $62.9 million, also increased $4.5 million or almost 8% from the year-ago like quarter. Tax equivalent yields increased 16 basis points and loan yields were 3 basis points lower than the second quarter of 2025 compared to the first quarter. Total yield on interest earning assets decreased 2 basis points over the linked quarter to $568. Interest-bearing deposits and total interest-bearing liability costs experienced a 2 basis point increase. The end result was a 3 basis point decrease in the tax equivalent NIM to 4.85% for the quarter ended from 4.88% last quarter. We believe this continues to be exceptional margin performance. Average deposits increased $51 million or 1.1% quarter-over-linked quarter, that's primarily seasonal and not a lot going on underneath the hood there. Old Second should continue to build capital as evidenced by the 144 basis point improvement in the TCE ratio over the past year, which means we have added $1.78 of tangible book value over the last 12 months, pretty strong performance. Evergreen will absorb some of this capital cushion, however, Old Second will still have an exceptionally strong and flexible capital position. To that end, and subsequent to the end of the quarter, we repurchased approximately 327,000 shares in a privately negotiated transaction at a modest discount to market. Our perceptions on capital return continue to evolve given the Evergreen Bank acquisition consumed significantly less capital than almost any other potential deal we could have done. Our financials remain relatively uncluttered by the impacts of purchase accounting going forward due to the lack of significant fair value marks associated with the transaction. Noninterest expense was materially on track with the previous quarter, increasing $1.1 million primarily due to significantly lower OREO expenses in the current quarter. Noninterest expense is running higher year-over-year, increasing $5.5 million compared to the same quarter last year, primarily due to higher salaries and employee benefits as well as occupancy cost, computer and data processing and core deposit intangibles. Most of the core deposit and tangible expense related to the 5 branches we acquired late last year. Overall, we are hopeful we can keep core expense growth, exclusive of acquisitions in the kind of 4% area. Not a lot going on in terms of this quarter, I think it's pretty transparent. The trends remain very strong, still feel very good, as Jim mentioned, about the estimates we put forward as it relates to Evergreen. You also mentioned a bias slightly higher. I think that from a rate standpoint, things still feel roughly balanced to me in terms of status quo versus some level of recession and/or rate cuts. I don't see rate cuts happening absent a recession. Obviously, there's some butterfly somewhere that's flapping its wings that can make things very different than that expectation. But as we sit here right now, I feel exceptionally good about how we're positioned. And I believe that while it's difficult to get the margin forecast for next quarter, given we're not done with the fair value marks. I'm very bullish that our market will remain at exceptionally strong levels over the remainder of the year and into next. With that, I would like to turn the call back over to Jim.

James L. Eccher, CEO

Thank you, Brad. In closing, as Brad mentioned, we feel this is a very solid quarter for the company. We remain confident in our positioning and extremely excited about what the Evergreen Bank transaction will add for us. We're off to a strong start for the first half of 2025 and we are extremely optimistic about the rest of the year ahead as we welcome the Evergreen team and its product offerings. That concludes our prepared comments this morning. So I'll turn it over to the moderator and open it up to questions.

Operator, Operator

Your first question is coming from Jeff Rulis of D.A. Davidson.

Jeffrey Allen Rulis, Analyst

I wanted to inquire about the expected timing of the conversion for Evergreen. Regarding the expense run rate, it's twofold: the conversion timing and the run rate, which I estimate to be around 52 or 53 on a core basis. Does that seem reasonable?

Bradley S. Adams, CFO

Yes, I think some of that relates to the timing of the cost savings. We expect the conversion to occur in the early to mid fourth quarter. By the time we report the fourth quarter in December, you will see a clearer picture of the final run rate on operating expenses, and the first quarter should be relatively straightforward.

Jeffrey Allen Rulis, Analyst

Got it. And then if you could remind us that at acquisition date, the loan to deposit balances brought over?

Bradley S. Adams, CFO

For Evergreen, they were just above 90%.

James L. Eccher, CEO

Okay, 90% loan deposits.

Jeffrey Allen Rulis, Analyst

Got it. And just one last question about the owner-occupied commercial real estate that was classified. Could you provide a bit more detail about the geography or your position on that?

James L. Eccher, CEO

Yes, Jeff, it really stems from one large health care transaction in Oregon. We don't see a loss at all. We're in a very strong collateral position, 70% covered loan to value. The facility had some restrictions put on by the state of Oregon, which caused a drag on their ability to lease up the facility. A lot of those restrictions have been freed up and we expect cash flow to get stronger in each subsequent quarter. So we've got a good sponsor behind us as well. So we don't see any loss given the fault here.

Operator, Operator

And your next question is coming from David Long of Raymond James.

David Joseph Long, Analyst

Good morning, everyone. Just first question relates to just overall commercial client sentiment. When we were back in April, having this call, we were coming off a Liberation Day and everything seemed to be toned down a bit. Just curious what you're hearing from your commercial customers and their appetite to grow their business and close some of the loans that may be in your pipeline?

James L. Eccher, CEO

Yes, I believe our commercial clients are managing the tariff uncertainty quite well. The demand for capital expenditures has been low in the first half of the year, reflected in low line utilization rates. However, we are seeing some growth in our leasing division and in commercial real estate. Despite having a solid quarter in loan growth, our sponsored finance group did not experience any growth, which is notable given their historical performance. Loan demand in that area has been weak, although they are indicating a strong pipeline for the second half of the year. Additionally, Evergreen Bank, which traditionally performs well in asset generation during the second and third quarters in the powersports sector, is also showing promise. We remain optimistic about loan pipelines, and the second quarter was our best growth quarter in over two years. Therefore, we still believe that low to mid-single-digit growth is achievable for 2025.

David Joseph Long, Analyst

Got it. Appreciate it. And then as a follow-up, you mentioned the Evergreen deal and maybe having a little bit more of a positive bias than when the deal was announced. Is that tied to the performance of that bank since you've announced the deal? And then as a tie-in to that, just any turnover worth noting with that transaction?

Bradley S. Adams, CFO

Yes. They're performing well ahead of what we had assumed. I mean the way M&A works is you basically have stub period that you have to project in terms of what it's going to be and what level of profitability is performing at and you project it forward one year, two years, three years as a stand-alone entity. That's for better or worse, that's kind of industry standard that was done. They are already on the stand-alone entity performing at the profit level that I had assumed for all of next year. So they are running better than what we had expected. It's a great asset mix. It's certainly pretty good probably to our margin, which I hadn't assumed it would be. That's difficult to say with fair value not completed. That's the bias right now. My gut is usually pretty good. You didn't give me credit. I was right on margin this quarter, even though nobody got mad that we missed it by 20 basis points last quarter, because I guess that we missed it in the right direction. But overall, things feel pretty good.

Operator, Operator

Our next question is coming from Nathan Race of Piper Sandler.

Nathan James Race, Analyst

I was hoping to talk about the outlook for charge-offs going forward. Obviously, you're picking up a higher risk reward business from Evergreen when you think about their lending specialties. So just curious with that business in the fold and all the improvement on the legacy Old Second side of things, how you're thinking about kind of the charge-off trajectory going forward?

James L. Eccher, CEO

Yes. Nate, I mean, I think obviously, a solid quarter for us from a charge-off perspective, I think we just had one about $1 million that was fully reserved for. But I think investors should know that in powersports lending in general, loss rates can run a little bit higher. But you have to look at that hand in hand with the contribution margin that that portfolio generates. So losses in that book could be anywhere between what, 1% and 1.5%. I feel like that's pretty good. But you're also looking at a portfolio with an average coupon today on new assets going on around 9%. So you have to look at those things hand-in-hand going forward.

Nathan James Race, Analyst

Right. So if I was doing some quick back of the envelope math on their portfolio and overlaying that loss rate? Am I in the ballpark of around kind of 30 basis points going forward on charge-offs?

Bradley S. Adams, CFO

Yes, I think so. I think that's good.

Nathan James Race, Analyst

Okay. Great. And then obviously, with Evergreen, you're picking up a higher beta deposit franchise, particularly relative to legacy Old Second. So just curious, Brad, to maybe get your updated thoughts on how you think the margin responds following a 25 basis point Fed cut at some point going forward?

Bradley S. Adams, CFO

Yes, what is that?

Nathan James Race, Analyst

I will let you pontificate on that, Brad.

Bradley S. Adams, CFO

I was just looking at the recent price changes, and what used to be $13 is now $16 within the last two weeks. I've also seen the price increases at Walmart over the past 30 days. My newsletter focused on interest rate predictions is having difficulty anticipating a rate cut this year, and I don't see a solid basis for it. It seems people will be eager for one. We're also seeing a resurgence in meme stocks; Jim had to step away from this call briefly to buy some GameStop and options. So, he'll return shortly. I find it against my principles to consider a rate cut this year, as it doesn't make sense to me. Previously, we estimated losing between 4 to 7 basis points for every 25 basis point cut, but I now believe that's conservatively at 25% less impact. Additionally, there is more movement in margins related to our balance sheet right now. As Jim mentioned, we sold our entire securities portfolio and reduced some wholesale funding. Those assets were underperforming with negative margin contributions. There are multiple factors at play that seem to be more significant than the changes in expected interest rates based on the Fed futures curve. For example, we experienced a decrease of 3 basis points this quarter despite nearly 40 basis points of movement on the SOFR curve. I believe we're less sensitive to changes than expected at this time. I've been pleasantly surprised by our margin's resilience considering the curve's performance over the past year. If I were to have three beers, I would probably adjust my view on what I believe the long-term margin floor is for Old Second even before adding Evergreen. This, if you know me, is about as optimistic as I sound, albeit in a monotone way. If I must consider a rate cut this year, I would say we might give up around 4 basis points. I realize that was quite a lengthy response.

James L. Eccher, CEO

Yes. I mean, I would say that we're three weeks after the close, right, of Evergreen. And you're right, they have a higher beta funding shop, but we started bringing high-yield money markets down and deposit levels have been remarkably solid. We have not seen a whole lot of runoff. Again, it's only been three weeks, but I would agree with Brad right now, things are about as good as we could have hoped.

Nathan James Race, Analyst

Got it. That's really helpful color and thoughts. So Brad, just maybe starting for the third quarter, given the repositioning of some of the securities portfolio at Evergreen and some of the other impacts on the deal, how are you thinking kind of like a range for the margin for the third quarter?

Bradley S. Adams, CFO

Nate, I'm going to go flat, but there's a wider margin error than is typical with me. So it's flat plus or minus 10 basis points instead of plus or minus five. And bearing in mind, when I answered that last quarter, I said flat and then it went up by 20 basis points. So without the fair value work being done, it's difficult to say with any precision, but it doesn't feel like down, this is what I'd say.

Nathan James Race, Analyst

Okay. That's helpful. It sounds like you're more keen on the margin outlook than tax rate. So I'll leave it there.

Operator, Operator

And your next question is coming from David Konrad of KBW.

David Joseph Konrad, Analyst

Just a little bit of a follow-up to that recent discussion. Just maybe add a little color to absent of what you paid down in wholesale deposits. Kind of what is their cost of funds bringing over and maybe the leverage you guys have over the next year plus of just working down that with your strong deposit franchise?

Bradley S. Adams, CFO

I mean, you can see what their cost of funds were and in their stand-alone financials. It's in the 4% range. Where do I expect to be by the end of next quarter? I would expect reliance on purely market rate funds, and that's something with a 4% handle to be $100 million to $200 million less. So I'll let you math your way to that. But in aggregate, the overall stand-alone cost of funds within Evergreen should be down somewhere between 30 and 70 basis points. Again, there are movements here. And I'm speaking about a quarter that is only 1/3 of the way done. So it's a little difficult; decisions are being made on the fly here. For example, nobody has asked me yet, but I don't think we'd be able to sell that solar loan portfolio that we had mentioned previously because I don't want to sell it where we have to market, then the mark is so steep that it actually becomes a pretty good asset. So we're learning as we go here, but that's about as precise as I can get at this point.

David Joseph Konrad, Analyst

But moving past this quarter, I guess, can your deposit growth absorb their loan growth or you continue to kind of fund marginally with that set of...

Bradley S. Adams, CFO

We've got a substantial amount of ring given where our stand-alone loan-to-deposit ratio is and time deposit runoff coming in future quarters. It's not an overnight thing. But as we exit next year, if I had to guess, I would say we would be at a 90% loan-to-deposit ratio and an overall cost of funds that's substantially better than A+B. I spoke previously about a desire to pick up some supplemental small deposit franchise equivalent to, say, First Merchants branch deal that we did prior that would meaningfully basically return us to where we were before. So there's certainly room for that. Will it come to fruition? I don't know. Hope so.

Operator, Operator

Your next question is coming from Terry McEvoy of Stephens.

Terence James McEvoy, Analyst

Maybe just a follow-up, Brad, on that last question, would your preference be to wait until Evergreen is integrated before your next transaction or something along the lines like you just mentioned became for sale, would you take a serious look this year?

Bradley S. Adams, CFO

We are always exploring opportunities, but the ideal timing for any potential acquisitions wouldn't be before October. I believe there would be significant risks involved, and I would likely face internal pushback. Acquisitions require a substantial amount of effort, and the notion that it's only four, five, or ten branches is a considerable oversimplification of the workload involved. This particular opportunity does have some advantages due to a similar core, which facilitates the process somewhat, but there are numerous details and costs that need careful attention to ensure a successful execution. While the process has improved compared to the past, small mistakes during transitions can attract negative media attention, as we've seen with some recent discount deals. We certainly want to avoid any negative publicity.

James L. Eccher, CEO

Yes. I mean, Terry, I think in a perfect world, we'd like to pause here, digest the deal, integrate and start growing organically a little better. But as you know, M&A timelines are unpredictable; rarely do seller buyer timelines come into alignment. So we'll continue to be opportunistic, but we've got plenty to do today.

Bradley S. Adams, CFO

It was a private equity investment and it was subsequent to the deal closing. The execution price was $18 per share in the quarter. Buyback remains a viable option for us, Terry.

Operator, Operator

Our next question is coming from Brian Martin of Janney.

Brian Joseph Martin, Analyst

I'll leave the tax question, Brad, since it seems you don't want to finish on that. So perhaps one more regarding the margin, Brad, from a broader perspective. Once we reset in the third quarter and move past the current noise, it sounds like you are feeling more optimistic than pessimistic. Directionally from that point, how should we consider the margin in a flat rate environment? It's uncertain what the Fed will do, but after you reset and address the noise you've mentioned this quarter, can you share any directional thoughts about what impacts we might see on the margin outlook going forward?

Bradley S. Adams, CFO

In a flat rate environment, which means we won't see the fluctuations in SOFR and overnight index rates that we've experienced over the past 90 days, our margin remains stable and sustainable, with a slight increase due to what Evergreen contributes. Of course, there are various scenarios to consider, including a completely stable environment, which is rare as things are always fluctuating. However, I'm optimistic about our margin outlook. We're not in a risky position regarding any debt. There is a subordinated debt issue I'd like to address next year, which could negatively impact our margin, but I haven't determined a plan for that yet. If we can resolve it in a way that doesn't dilute our margin, I believe our margin will continue to be stable and sustainable.

Brian Joseph Martin, Analyst

Got you. And you talked about just kind of a long-term floor maybe being raised. Kind of how are you thinking about that kind of that long-term floor on where the margin is as you look perspectively?

Bradley S. Adams, CFO

I don't think there is a way back to a 0% interest rate environment. Our bank is in a strong position, even though there aren't many like us. I previously mentioned that our margin floor was likely around 4%. If I had to estimate today, I would say it’s probably closer to 4.25% as an absolute minimum.

Brian Joseph Martin, Analyst

I appreciate the information. Can you discuss your expectations for ROA once the deal is closed and integrated, particularly as we approach the first quarter of next year? What trends do you anticipate for ROA in 2026, whether you refer to a specific quarter or the full year? Whatever insights you can provide about your outlook from our current position would be helpful.

Bradley S. Adams, CFO

You are confusing me now. Are we discussing rate cuts again, or are we still focusing on stable interest rates? What are we talking about here?

Brian Joseph Martin, Analyst

We'll go with your scenario, Brad, I don't know, just like you don't know. I guess I'm just wondering where you think ROA is going to land in your thinking, which sounds like probably no rate cuts. So go with that. That's fine.

Bradley S. Adams, CFO

I would feel very comfortable above 1.50% ROA.

Brian Joseph Martin, Analyst

Above 1.50% okay. And then I think you answered the question about buyback; you're on the table at this point for...

Bradley S. Adams, CFO

Open to it, yes.

James L. Eccher, CEO

Second and third quarters generally are better quarters, Brian, do you know that? What I'm most encouraged about is having more lending verticals to help sustain that growth has been encouraging. Now to be fair, we did not have as many payoffs or paydowns in the second quarter, but it was one of our stronger origination quarters than we've had in some time. So I would expect some growth again in the third quarter and then probably some stabilization in the fourth and first quarter.

Operator, Operator

Thank you very much. Well, we appear to have reached the end of our question-and-answer session. I will now turn the call back over to Jim for any closing remarks.

James L. Eccher, CEO

Okay. Thanks, everyone, for joining us this morning and for your interest in our company. We look forward to speaking with you again next quarter. Goodbye.

Operator, Operator

Thank you very much. This does conclude today's conference. You may disconnect your phone lines at this time, and have a wonderful day. We thank you for your participation.