Earnings Call Transcript - OSBC Q4 2021

Operator, Operator

Good morning, everyone, and thank you for joining us today for Old Second Bancorp, Inc's Fourth Quarter 2021 Earnings Call. On the call today is Jim Eccher, the company's CEO, Gary Collins, the Vice Chairman of our Board, and the company's CFO, Brad Adam. I will start with a reminder that Old Second's comments today may 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 to refer to the company's SEC filings for a full discussion of the company's risk factors. On today's call, we will also be discussing certain non-GAAP financial measures. These non-GAAP measures are described to reconcile to their GAAP counterparts in our earnings release, which is available on our website at oldsecond.com, on the homepage under the Investor Relations tab. Now I will turn it over to Jim Eccher.

Jim Eccher, CEO

Good morning, and thank you for joining us. I have several prepared opening remarks, and I will give my overview of the quarter and then turn it over to Brad for additional details. I will then conclude with some summary comments and thoughts about the future before we open it up for questions. Okay. Net loss was $9.1 million or $0.26 per diluted share in the fourth quarter. Net income, excluding acquisition-related adjustments to our provision for credit losses and merger-related costs, was $12.5 million or $0.36 per share in the fourth quarter. On the same basis, return on assets was 1.15%, return on tangible common equity was 14.1%, and the efficiency ratio was 66.1%. Earnings this quarter were favorably impacted by the inclusion of one month of the legacy West Suburban net interest income, as well as a $2.3 million reversal provision for credit losses due to more favorable unemployment projections over the next year. In addition, a MSR valuation mark-to-market gain of $1.5 million was recorded in the fourth quarter. We closed the West Suburban acquisition on December 1st, which resulted in some transformational changes to our financial statements. For the full year, earnings were $41.9 million or $1.36 per diluted share, excluding the merger-related charges and CECL adjustments. ROA was 1.20%, ROTC was 13.66%, and the efficiency ratio was 65.8% on the same basis. Overall, we're very pleased with the financial performance we delivered in 2021, but the acquisition of West Suburban and what it can mean for us in the future is clearly the story for us. We now have $6.2 billion in assets, including $3.4 billion in loans and an incredibly granular low beta, $5.5 billion in deposits. We are focused on deploying liquidity in order to more fully leverage the quality of the deposit base by building commercial loan origination capability for the long term and making prudent investments in the securities portfolio in the short term that do not carry excess spread or credit risk. The goal is obviously to build back towards an 80% plus loan-to-deposit ratio in order to drive returns on equity commensurate with our recent historical performance. We have a plan and are making progress. In regards to the quarter and the balance sheet specifically, security and loan growth quarter-over-quarter including the growth from the inclusion of the West Suburban portfolio at year-end. The West Suburban securities portfolio was fair valued at $1.07 billion and it was recorded in its entirety within our available for sale portfolio. We executed $570.8 million of security sales, or 54% of the portfolio immediately upon acquisition close in order to align the portfolio with our investment strategy. This included subsequent purchases of $533.9 million of securities throughout the fourth quarter of 2021. We significantly improved the liquidity and reduced the duration of the portfolio, thereby reducing extension risk. There was certainly a cost to doing this in both income and fair value associated with these actions. Our outlook that we shared with you when we announced the transaction is unchanged. Period-end loans for the fourth quarter included the addition of $1.5 billion from the West Suburban merger, as well as organic growth of $81.6 million exclusive of PPP loan pay-downs of $29.7 million for the quarter. Only $38.4 million of PPP loans from both the first and second rounds remain outstanding as of the end of the year, which includes both legacy Old Second and West Suburban portfolios. We are encouraged both by returning to growth mode and that our pipeline at quarter end is by far the strongest we have seen since the pandemic began. We are seeing significant pipeline builds and commercial real estate and healthcare. Although CNI activity and line utilization remains soft. After a strong fourth quarter last year, equipment leasing will ramp up as the new year unfolds. With the new CRE team that started with us in the third quarter, along with a senior leasing officer and an experienced team leading a new sponsor finance vertical added in the fourth quarter of 2021, I'm optimistic we can see solid loan growth in 2022. Non-performing loans increased by $15.7 million compared to the prior quarter, with the addition of the West Suburban portfolio. The increase is attributable to three newly acquired West Suburban credits. Importantly, legacy Old Second non-performing loans decreased by $2 million in the quarter. Additionally, we charged off two large credits in the fourth quarter on a commercial from legacy Old Second and one commercial real estate from legacy West Suburban, resulting in net charge-offs of $4.7 million for the quarter. Both of these large credits were fully allocated in prior quarters. Total classified loans increased $39.6 million to $74.5 million due to the inclusion of the West Suburban portfolio. We remain confident in the strength of our portfolios. Other real estate owned did not increase materially, as the West Suburban portfolio had minimal issues at acquisition and two of the three properties we did acquire were sold in December. Details are available in the earnings release tables on these changes. The allowance for credit losses totaled $44.3 million as of December 31st, which is 1.3% of total loans. During the fourth quarter of 2021, the credit marked at acquired PCD loans of $12.1 million increased the ACL, as well as the day two provision for credit losses adjustment based on the estimated future credit losses and non-PC loans acquired of $12.2 million for loans. In addition, $2.4 million was recorded to the provision for credit losses for the day two unfunded commitments future losses estimate. At quarter-end, $2.3 million of provision for credit losses on loans was reversed, and $49,000 of reserves for unfunded commitments was reversed based on our review of market realization trends. Our outlook is cautiously optimistic as the underlying economy continues to improve, albeit with significant uncertainties. We believe that we are more than adequately reserved under base case scenarios, but continue to modestly overweight more pessimistic scenarios, given the high degree of uncertainty. Expense discipline continues to be strong and we're making good progress on cost-saving targets announced with the acquisition. Write-downs on legacy Old Second branches of $3.8 million were recorded in the fourth quarter of 2021, with the potential of marketing these properties in the near future. These branches are an addition to the nine West Suburban branches that have been identified as overlapping with newly acquired branches. Total merger-related costs of $12.8 million were recorded in the fourth quarter, which includes this $3.8 million fixed asset write-down, as well as other merger costs, including severance and retention, data reconversion, legal, investment banker, and other consulting fees. With that, I'll turn it over to Brad for additional color in his prepared comments.

Brad Adams, CFO

Thank you, Jim. I think probably the best use of the time we have remaining is to talk a bit about how things have changed and what we got right and wrong, and the estimates we put out in July at the announcement. Certainly, the macro environment is a bit different with the world's seemingly waking up to the reality of inflation here very recently. Credit and facility marks for the West Suburban acquisition were consistent with expectations. Though the day two adjustments were slightly larger than our initial expectations once the model runs were completed. The rally in rates in late November and early December appeared to be inexplicable on our end and provided us with an opportunity for a much larger than we expected portfolio repositioning that substantially reduces the risk posed by the prospect of higher rates. The West Suburban portfolio was around a billion dollars, as Jim said, and the duration on that portfolio was reduced from an excess of six to well under three without a meaningful change in yield. I am extremely pleased that we were able to get this done here given the illiquidity as some of the issues that were in that portfolio. Obviously, I don't have a crystal ball, but whether that will turn out to be worth it or not, the bias and results so far indicate that it favors significantly higher rates than where we are today and certainly higher than where we were in early December. As we moved towards the announcement of this deal, we discussed internally the things that we needed to do to be successful with the investment we are making and in the years ahead more generally. In the short term, we decided we needed to double our loan origination capability within a year of the close. I'm pleased with where we are in this effort, and we are much further along than I expected to be at this point. On the cost-save front, I would love to tell you that we expect to outperform the $21 million number we gave you in July, and we are. But we have already spent the difference in new talent acquisition, and I'm optimistic additional opportunities are out there, and we will keep you posted on these efforts. From a cultural standpoint, there are always challenges to overcome, but I would say that the communication is very good. We're getting to the right answers, and things feel even better than we expected. With that said, I'll move more into the results. Net interest income increased $6 million relative to last quarter and $4.8 million from the year-ago quarter. Margin trends were stable on a core basis due to the securities portfolio growth, which mitigated the continuing increase in liquidity. The reinvestment rate on the portfolio was slightly less than 100 basis points as we continued to avoid duration throughout the fourth quarter. Given the more recent moves that we've seen, we have been going quite a bit longer, but we do remain somewhat cautious on that front. We continue to have strong deposit inflows and substantial excess liquidity persisted for the entirety of the quarter. Our margin trends will be a function of loan growth primarily, and we will continue to deploy liquidity within the securities portfolio as well. I would have even more confidence if we were able to see positive developments in CNI and utilization rates both of which remain depressed. We do feel quite a bit better on the loan growth side of things though, as was mentioned, actually substantially better. The forward curve is accurate, the first few rate hikes will benefit us, but not to the degree of any subsequent moves would. We do have significant floors in the loan portfolio that West Suburban did not. I would add that we expect our deposit beta to be excellent in a rising rate environment. With the sum total of that discussion is that we currently expect loan growth trends to drive net interest income growth with modest margin improvement. If things move further along and rate hike could develop, obviously that would bias it upward further. But I feel like we're on a chicken or the egg discussion here. I don't want to count on that yet. Non-interest income increased from last quarter with an increase of $1.7 million quarter-over-quarter and MSR mark-to-market gains and service charges on deposits growth at $256,000. Wealth management income remained strong with $2.4 million in both the current quarter and the prior quarter. Excluding the $14.6 million day two acquisition-related provision for credit loss adjustments, a provision for credit loss reversal of $2.3 million was recorded in the fourth quarter, compared to a $1.5 million reversal last quarter. The economic outlook for us assumes continued improvement with an unemployment rate projection remaining at approximately 5% to 6% through December 31, 2022 and over the remaining life of the loans, which is going to sound high to you but it's just a substantial decline from the approximate 5.25 to 6.75 from last quarter. I certainly recognize that our assumptions are probably more pessimistic than most at this point and I expect the severity of these assumptions to be lessened in the coming quarters. As those assumptions are relaxed, I would expect loan growth to outpace provision growth in the near term. I am extremely pleased with how our credit has performed through the pandemic. Credit metrics have remained stable to improving, and a number of credits that I would have been concerned about have been resolved favorably. Expenses are difficult to manage in 2022. Absent the acquisition with mid-single-digit increases in salaries and double-digit increases in benefits, reflecting wage inflation and a difficult environment. We are managing through this and are thankful for the flexibility and opportunities for synergies that exist for us right now. We had expected to realize more synergies from scale on the benefit side, but inflation is very real on this front. Fortunately, we were able to look to other opportunities on the expense side to get to where we need to be. Our efforts in the coming quarters will be on delivering on the synergies that we promised, continuing to bring additional loan growth talent on board, and helping our customers fund quality loan growth with the expectation of a stable and improving margin. This all assumes that liquidity remains robust and risk spreads remain unreasonably tight. With that, I'd like to turn the call back over to Jim.

Jim Eccher, CEO

Okay. Thanks, Brad. And closing, we are optimistic about the new year, confident in our balance sheet and loan growth opportunities that are ahead. Prolonged low rates are certainly not the best environment for a deposit base like Old Second, but it certainly appears we are near an inflection point in rates. Regardless, we remain extremely profitable given our focus on expense discipline. We expect to remain so. We believe our credit and underwriting has remained disciplined, and our funding position is strong. Today we have the balance sheet and liquidity to take advantage of a rising rate environment and have the financial strength to wait for this to occur. We continue to be active in the effort to bring additional sales people to our team, and are making substantial progress on the systems integration to ensure a smooth transition for West Suburban customers and employees. We are excited about the opportunities that exist for Old Second in 2022 and beyond. That concludes our prepared comments this morning, so I will turn it back over to you to open it up for questions.

Operator, Operator

Ladies and gentlemen, the floor is now open for questions. We ask that while posing your question, you please pick up your handset if listening on speakerphone to provide optimum sound quality. Please hold while we poll for questions. Your first question for today is coming from Chris McGratty. Please announce your affiliation, then pose your question.

Chris McGratty, Analyst

Good morning. I'm Chris McGratty from KBW. Jim and Brad, the outlook for loan growth seems like a little bit of a divide, right? Commercial real estate is doing better, but the CNI is stuck. Can you elaborate on the outlook for organic loan growth in light of the team hires and those comments in your prepared remarks?

Jim Eccher, CEO

Sure, Chris. We've added some substantial talent over the last couple of quarters. Not to mention, we are seeing some increased demand across all fronts. But we feel we have an opportunity with our new teams to generate mid to upper single-digit loan growth, really fueled by a pretty good pipeline of CRE and healthcare. The CRE team and our newly formed sponsor finance team, which will probably deliver results later in the year. But we're certainly more optimistic today than we have been. Moreover, the West Suburban legacy portfolio we had originally expected more significant runoff in the near term, we're not seeing that, so we're optimistic we can generate some growth with that team as well.

Chris McGratty, Analyst

With that in mind, your 80% target on your loan-to-deposit ratio, you talked about that. How do we think about just the remix here over the balance sheet? I know you took actions with West Suburban's bond portfolio, but should the security book be used as a source of funds to fund the growth or will you grow that as well?

Brad Adams, CFO

That will be grown as well in the near term, largely going to be driven by what happens to liquidity and if rates do in fact go up, I would expect that some of liquidity to drain. But it's been far more persistent than I expected. I would expect to see another couple of $100 million in portfolio growth for us over the next two quarters. And then we will also focus on loan growth. Getting back to a loan to deposit ratio that looks more like us is going to take some time, but obviously represents a long-term opportunity.

Chris McGratty, Analyst

Maybe if I could squeeze one more. The $21 million you said you're doing better on the cost saves, but you're putting it back into the business. How far along are we on the cost saves? And I guess, how should we be thinking about just the expense cadence over the rest of the year?

Brad Adams, CFO

I would expect that at some point this year we will get to the fully phased-in run rate.

Chris McGratty, Analyst

Outside of that, we're seeing inflationary pressures. Core bank is growing what, 3%, 4%?

Brad Adams, CFO

If we were standalone today, we would probably be staring at expenses that got north of four. A couple of things embedded in that 1. The increase that we saw on the benefit side was far in excess of my expectations. A little bit of that is fueled by people actually going to the doctor again, thank goodness, and filing claims. But some of it is also provider-driven in terms of what's being passed through. And then obviously there are people with much bigger workforces that can speak to the dynamics that is going on within hiring markets. But there is substantial wage inflation in the competition to hire people. And though we have not seen excess turnover at this point, filling roles is difficult. People have a lot of choices on who they can work for. It is showing up in wage markets.

Nathan Race, Analyst

Yeah. I'm Nathan Race with Piper Sandler. Morning, guys.

Brad Adams, CFO

Hey, Nate.

Nathan Race, Analyst

Just a question on the outlook for the reserve going forward within the mid to high digital loan growth expectation that you guys have. Just curious in terms of remaining unallocated reserves that you guys have in terms of expectations from a provision perspective in terms of being happy to provide for that growth over the course of 2022.

Brad Adams, CFO

Yes. A lot is going to determine and make sure about what assumptions go into the model, obviously. But given the fact that we've stated that our assumptions probably will be relaxed at some point, if nothing else changes in the world, I think it's safe to assume that the provision growth will lag loan growth. The magnitude of that, I am not fully confident in laying that out for you. For example, I'm not going to say there is no provision growth in 2022. But it will be substantially lower than what you would expect if everything stayed the same.

Nathan Race, Analyst

Understood. It seems that the elevated charge-offs we experienced in the fourth quarter may have been a necessary adjustment as we begin this year. Brad, it sounds like you and your team are feeling quite optimistic about the outlook for credit quality moving forward. We would like to hear your expectations regarding charge-offs throughout 2022.

Brad Adams, CFO

The credit that was a legacy issue from Old Second that we charged off was first discussed on these earnings calls about five quarters ago. We've also mentioned it in two other calls, so it's not a new topic. We made provisions for it 12 to 15 months ago, so if that's your only concern, it's somewhat outdated, which suggests you are feeling fairly confident. The other credit, as Jim noted, is a West Suburban credit that has been on their radar for quite some time. Regarding new issues, there haven't been any significant concerns or bad news brought up in recent meetings. Overall, I think we feel positive. Jim, do you have anything to add?

Jim Eccher, CEO

Yes. I mean, we track obviously early-stage delinquencies are very benign. We're seeing very little migration from watch list credits to problem credits and that accruals. So remarkably stable at this point, so our outlook in the near-term, anyways is very positive.

Nathan Race, Analyst

Okay. I don't mean to oversimplify the margin outlook, you've done various moving pieces there. But perhaps, Brad, just any comments on the starting point for the core margin, ex-PPP in accretion? And would be interested to hear from the reported margin basis, your expectations for purchase accounting accretion, starting off in 2022? And then, I imagine running off thereafter, incrementally.

Brad Adams, CFO

That's a significant question. I believe the reported margin will remain relatively stable. There might be a small boost from purchase accounting, though it's not a large amount. Looking at the full year, we anticipate around $2 million in benefits from this, lasting about two years. Initially, we expected the combination with Old Second to dilute our reported margins by approximately 25 basis points due to their excess liquidity and lower loan-to-deposit ratio. We've managed to integrate that through our liquidity deployment. To ease any concerns, we've primarily focused on a duration curve between one and a half and three years and are taking on variable rates that are less than or close to 100 basis points. We're also taking precautions in case of one to three rate increases followed by a downturn. We're being careful. Old Second is particularly suited for higher short-term rates, which aligns with our deposit base, and West Suburban shares those characteristics. We're a strong bank, managing prudently with margins trending higher, and purchase accounting will provide some support. We're just looking ahead and waiting for it to materialize before relying on it.

David Long, Analyst

Good morning, everyone. It's David Long from Raymond James. I wanted to stick with the discussion on the net interest margin, Brad, and that will put you on the spot again. But as you're thinking about rate hikes and the sensitivity, it sounded like from your prepared comments that the first couple of rate hikes may not have as much of a positive impact as the second couple of rate hikes. So my question, on the first rate hike, what does that impact the margin, all else equal versus maybe the third or fourth rate hike?

Brad Adams, CFO

The first rate hike and the subsequent ones have a very positive impact on us. Depending on when they occur in the quarter, a rate hike can influence our margin by a few basis points to upper single-digit basis points if it happens mid-quarter or later. Annually, a rate hike can add between $2 million and $3 million to our net income, even considering burning through floors. This effect increases as more rate hikes occur, as we expect the impact of the first two to be minimal, with a minor effect from the third and fourth. Our asset side has a short duration, and we are funded by high transaction accounts, making our balance sheet well-suited for higher rates at the short end of the curve.

David Long, Analyst

Got it. That's helpful. Shifting topics, you're close to the West Suburban and are still working through that. Do you have an interest in pursuing additional deals, and if so, what is the timeline for when you might start considering them again? How do you view the M&A environment for Old Second in 2022?

Jim Eccher, CEO

Yes. David, obviously this is a significant transaction for Old Second. We've got system conversions in late April, got to digest that. We've got plenty to do here internally to work through branch rationalization and integration changes. So we certainly aren't in a position to do anything in the near term. Clearly, the regulators would want us to definitely integrate this in a satisfactory manner before green lighting us. But we'll probably entertain something later in the year before we can do anything now.

Brian Martin, Analyst

Hey, good morning. Brian Martin with Janney Montgomery.

Jim Eccher, CEO

Hey, Brian.

Brian Martin, Analyst

Could you provide one last clarification, Brad, regarding margin or asset sensitivity? What percentage of loans are variable? Also, if you experienced a 125 basis point increase at the start of a quarter, what impact would that have on margin from the hike?

Brad Adams, CFO

So roughly half the loan book is variable. And I don't have completely reliable data in terms of what has floors within the West Suburban portfolio. They're not fully integrated into our models yet. Obviously, we still have system conversions ahead. So there's substantial uncertainty here, uncertainty in only one direction, and that's the magnitude of the positivity. If we were to get a rate hike in March, I would say that second quarter's margin everything else would be probably 10 basis points. We are still in the re-evaluation stage.

Jim Eccher, CEO

Yes, Brian, we are actively seeking to add talent to the team. We are pleased with the new hires from the past few quarters. As we move into 2022, we have high expectations and consider cost savings to be as important as expense control. Additionally, we have experienced a few retirements, which gives us more opportunity to pursue additional talent.

Brad Adams, CFO

Yes, I mean, last rate hike cycle, Old Second experienced over the duration of the cycle a deposit beta of around 10%. I don't think there's anything within the West Suburban deposit portfolio that looks substantially different from us. So I think we performed similarly. Yes, it is. At this point, before they've come, I had probably more hope than most that they would actually do something yesterday in the face of mid to high single-digit inflation. But the reality is that it's substantially beneficial to margin. I would point you to when we were 150 basis points higher on the short end of the curve a couple of years ago, Old Second was running at a 425 margin. Today, we're below that. If we get back to that level, and I'm trying to steer you towards a longer-term look here. I don't know how many basis points hit which quarter. And if you think back two years ago when people ask me that question, I got it really wrong. Because I was telling people we'd get 5 or 6 basis points, and we wound up getting 20. So it's hard to know what the speed and what loans pay down and what pays up, how many basis points are going to fall in which quarter. But I can tell you there's nothing structurally different about Old Second from a contribution analysis standpoint that says we can't be north of a 4% margin if we get back to that 150 type rate level on the short end of the curve.

Chris McGratty, Analyst

Thanks for taking the question, guys.

Jim Eccher, CEO

Sure. Thank you, Nate.

Operator, Operator

There are no further questions in the queue at this time.

Jim Eccher, CEO

Okay. Thanks, everyone for joining us this morning and we look forward to speaking with you again next quarter. Goodbye.

Operator, Operator

Thank you, ladies and gentlemen. This does conclude today's conference call. You may disconnect your phone lines at this time and have a wonderful day. Thank you for your participation.