Q4 2022 Old Second Bancorp Inc Earnings Call
Fourth quarter 2022 earnings call.
On the call today is Jim <unk>, the company's CEO .
Brought items, the company's CFO and Cao.
Collins, Vice chairman of our board.
I will start with a reminder, that all 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 and the current economic environment.
These statements are not a guarantee of future performance.
Our 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 Companys risk factors.
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.
It is available on our website at old second BOL com.
On the homepage under the Investor Relations tab.
Now I will turn it over to Mr. Jim Mack.
Good morning, and thank you for joining us today.
Same format as prior quarters I have several prepared opening remarks.
My overview of the quarter, then I'll turn it over to Brad for more additional details.
Well, then conclude with some summary comments and thoughts about the future and then open it up for some questions.
Net income was $23 6 million or <unk> 52 per diluted share in the fourth quarter net income adjusted to exclude what suburban acquisition related costs less net gains for branch sales was $24 1 million or <unk> 53 per diluted share in the fourth quarter on.
On the same adjusted basis return on assets was 161%.
Return on tangible equity was 28, 33%.
The tax equivalent efficiency ratio was 50, 129%.
Fourth quarter earnings were also negatively impacted by a combined $1 $3 million in pretax security losses and.
And fair value adjustments for mortgage servicing rights.
In aggregate, obviously, an exceptionally strong quarter with more than 20% earnings growth linked quarter on annualized.
Our financials continue to be favorably impacted by the increase in market interest rates with a 15% increase in net interest income.
$5 million over the third quarter of 2022.
Due to relatively stable funding costs and increasing asset yields across the balance sheet.
The fourth quarter marks a full year since our acquisition of West suburban Bank and I believe both our execution and the positive impacts of the acquisition are apparent in our financials.
We have outperformed our own internal expectations on cost saves.
Loan growth and revenue that we had set out for ourselves these internal targets became more aggressive.
As we move from deal announcement to the months following the closing of the transaction.
We've been more successful than we had hoped and bringing on new sales teams along with experience back office managerial talent.
We are a better company today than we were at the close of the acquisition.
Plenty of work remains and this will be the full extent of our self congratulations but it seems appropriate to close the loop on this for the full year behind us.
Overall, we cannot be more pleased with where things stand today from both a balance sheet positioning and operational.
The fourth quarter of 2022 reflected minimal loan growth due to both the usual seasonal slowdowns and reduced demand with an increased cost of borrowing.
Exclusive of PPP loan runoff, we had $1 1 million of loan growth quarter over quarter.
Prepayments continue at a lesser rate than prior years, but origination activity slowed considerably in the fourth quarter.
However, the activity within loan committee remains better than expected for this time of year.
Our confidence in loan growth in 2023 has not changed.
January pipelines are building nicely and we believe originations will be strong in 2023.
The net interest margin continued to expand this quarter with loan yields reflecting recent increases in market interest rates.
Overall, the tax equivalent net interest margin was 463% for the fourth quarter compared to $3 96 in the third quarter.
The margin benefit resulted from balance sheet mix improvement the impact of rising rates on the variable portion of loan portfolio and.
Strong loan growth for both the second and third quarter turned now represented in the growth in net interest income.
Loan to deposit ratio is now 76% compared to 73% last quarter.
As we said last quarter the focus for US now is shifted to balance sheet optimization, and Brad will talk about that more in a minute.
Turning to credit we recorded a net charge offs of 940000 in the fourth quarter of 2022 compared to 68000 of net charge offs in the third quarter.
Total classified loans decreased $4 8 million.
Two $108 9 million from $113 $7 million last quarter.
Other real estate own reflected no change in the fourth quarter and remains de Minimis at $1 6 million.
We remain confident the strength of our loan portfolios.
The allowance for credit losses on loans increased to $49 5 million at the end of the year from $48 8 million at the previous quarter, which is 128% of total loans and just a few basis points more than the total ACL to gross loans at September 32022.
At quarter end $1 6 million of provision for credit losses on loans was recorded partially offset by a reduction of 74000.
The provision for unfunded commitments.
The increase in the ACL on loans was primarily driven by a slightly higher loss rates in the fourth quarter compared to the prior few quarters, primarily due to the sale.
And related charge offs, resulting from one larger nonperforming credit.
We have spoken about on this call for over a year now.
Our outlook is cautiously optimistic as the underlying economy appears strong, albeit with significant uncertainties.
We believe that we are more than adequately reserved under base case scenarios, but continue to overweight more pessimistic scenarios.
Given that a high degree of uncertainty.
Recession probabilities increase relative to last quarter in our estimation credit remains very well behave that way.
We remain mindful and diligent in monitoring trends, both within the portfolio and more broadly.
Noninterest income continued to perform well with growth noted in the fourth quarter of 2022 compared to the third quarter of 2022 and wealth management fees.
Bully income and card related income.
Pre tax losses of 910000 security sales were incurred related to strategic repositioning within certain security types in our portfolio.
Expense discipline continues to be strong and we are far ahead of schedule on cost save targets announced with the acquisition.
Total merger related costs of 645000 were recorded in the fourth quarter. In addition, we recorded net gains on branch sales of 28000 all pretax.
The branch sale gains are recorded within occupancy expense.
The sum total of these nonrecurring noninterest expense items discussed.
<unk> discussed total a net 457000 expense after tax which resulted in adjusted earnings per fully diluted share of <unk> 53 for the fourth quarter.
As we look forward, we are focused on doing more of the same managing liquidity building commercial loan origination capability for the long term.
And making prudent investments in the securities portfolio.
In the short term that does not carry excess spread or credit risk.
Our goal remains to continue to build back towards that 80% plus loan to deposit ratio in order to drive the returns on equity commensurate with our recent historical performance.
With that I will turn it over to Brad for more color.
Thank you Jim.
Net interest income increased eight $5 million relative to last quarter, and $35 5 million from the year ago quarter.
Margin trends increased due to loan portfolio growth as well as due to the increases in security and loan yields from market interest rate increases.
Total yield on interest, earning assets increased 76 basis points to 489 basis points over the linked quarter.
Partially offset by an 88 basis point increase in the cost of interest bearing deposits and a 15 basis point increase.
And interest bearing liabilities aggregate.
Obviously exceptional margin performance.
The fourth quarter continued to see a significant move in rates.
At this time in the opposite direction with inversion across the entirety of the curve that leads many.
To read this or that from the tea leaves.
Obviously, the short end of the curve remains high.
And this is where old second largely lips.
I won't bore you with my take on macro things other than to briefly mentioned that I don't believe that a fed focused on inflation.
Is going to whipsaw short rates absent a significant shock of some sort.
The once popular belief that zero interest rate policy had no risk has proven shockingly misguided.
And any expectation of a reversion to that mean is foolish in my opinion.
Obviously, I'm biased as a decade long suffer the belief that core deposits matter.
Take that opinion for what it's worth and feel free to unsubscribe from my newsletter going forward.
The implications for investors in old second is that we aren't in a hurry to place large bets on the path of interest rates.
Duration is being added to reduce asset sensitivity in numerous ways.
Including Remixing out of the variable securities that have served us so well.
And the addition of received fixed swaps.
You saw this coming and fewer stilwell nail attempted inflection point trades.
Second is a very good bank in my opinion and should not attempt to be a hedge fund.
Our positioning over the last 18 months was undertaken to provide us with flexibility to fund and in an environment where deposits become expensive.
The success of that strategy is somewhat on display this quarter was $76 million in liquidity provided from the securities portfolio with only a small loss realized.
The loan to deposit ratio remains very low and our ability to source liquidity from the portfolio has increased relative to the color. We gave you last quarter.
I would like to remind you that longer duration portfolio portfolios with longer duration than old second's would have seen relative outperformance to ours.
Given the sharp conversion from the short end.
The Mark on the securities portfolio remains high, but well be recaptured relatively quickly.
The net result is that old second should build capital quickly as evidenced by the 57 basis point improvement in the TCE ratio linked quarter.
At 12 31, the portfolio duration was approximately three years the weighted average life was approximately four and a half years and.
And a little less than a third of the entire portfolio is still variable.
I would also remind that old second has not moved anything to held to maturity. So what youre seeing is not maybe directly comparable to others.
The tax equivalent yield on the securities portfolio increased by approximately 55 basis points during the quarter and we are continuing to project, a little less than $50 million per quarter in cash flow from the portfolio quarterly.
If necessary, we can quickly sell several hundred million dollars at a loss approximating, 3% to 4% of net book value.
That may not sound, great at first blush, but I think it compares exceptionally well to others on a relative basis.
The end result of that is that I don't think it gets a whole lot worse with tangible book value increasing by more than 8%. This quarter I'm optimistic we have turned the corner.
The trend should be very positive from here.
The rest of the balance sheet looks fantastic deposit base as many of you know is extremely granular and insensitive to rates on.
On the loan side old second is transitioning quickly to a higher rate world with rapidly improving profitability.
Coming quarters will likely see us pay down the notes payable with $9 million coming off in the first quarter.
And our attention turning from here to the senior debt, perhaps later in the year.
On the expense front, a little bit elevated in the fourth quarter in large part due to incentive compensation and old second's performance. This year, our loan growth and bottom line performance relative to budget there.
There should be some relief in the first quarter of 2023.
Wage pressure continues to be real in our markets, but as lessen considerably in recent months.
The fourth quarter did represent the first full quarter impact of wholesale wage increases across the retail network.
That being said I would expect quarterly wages and benefits to more closely approximate $22 million going forward.
Given the revenue performance investment has been running high but we will maintain the ability to dial back as conditions conditions warrant.
I am very pleased with the way the team has come together in identifying the improvements we need to make to transition into a larger and more dynamic company.
Deposits declined three 2% from third quarter levels, primarily from tax payments seasonality some parked funds exited.
We also had a modest impact from a rate sensitive acquired accounts in aggregate, though trends were stable throughout the quarter.
Resulting in <unk> and improvement in the loan to deposit ratio clearly benefited the margin 67 basis points of margin improvement is by any measure a lot.
Margin trends from here will be more subdued the trend remains positive and soon the fixed rate portion of the loan portfolio will begin to contribute as well.
As Jim mentioned, we do feel good on the loan growth side.
But I would expect slower growth until the until the second quarter of 2023.
Deposits are a tougher game now with a couple of local banks recently going very big on the time deposit in teaser rate front.
I still believe the old second pulled second will perform as well or better than it did during the last tightening cycle and.
The end result is that margin trends are expected to continue to trend in the right direction.
Noninterest.
<unk> income decreased from last quarter by $2 6 million driven by a $1 1 million net decrease in mortgage banking revenues.
Primarily stemming from a reduction in MSR income.
As well as 910000 net losses on security sales.
It's a reduction in other income due to pre tax gains recorded in the third quarter of 743000 from the sale of our visa credit card portfolio.
And $180000 due to the sale of a land trust business, both acquired with the West suburban acquisition.
Wealth management boldly and card related income each reflected growth in the current quarter.
Provision for credit losses of $1 6 million and our economic economic outlook remains largely unchanged from the third quarter with an unemployment rate projection of approximately four 5% to 575% through December 31 of this year and over the remaining life of the loans.
I would expect loan growth to be roughly consistent with provision growth over the near term.
Although that could change with significant worsening in the macro environment.
We recorded a reversal of a provision for credit loss of approximately 74 grant on unfunded commitments.
Nonaccrual loans declined a bit this quarter 90 days past due declined considerably from the $20 8 million balance from the third quarter to $1 3 million at year end.
Classified loans increased modestly as Jim noted and I would add that a larger credit we downgraded in a prior quarter was sold early in the first quarter of 2023, resulting in an $800000 charge off taken at year end.
Overall, we are pleased with how credit has performed and continue to consider credit metrics is both stable and excellent.
Expenses were difficult to manage this year and into 2023 with mid single digit increases in salary and double digit increases in benefits, reflecting wage inflation in a difficult environment to hire.
We are managing through this and thankful for the flexibility and revenue strength that exists for us right now.
Our efforts in the coming quarters, we'll be continuing to bring additional talent on board, helping our customers and funding quality loan growth.
With the continuing trend of excellent overall core profitability.
We expect loan growth to outpace earning asset growth for the bulk of 2023.
We are continuing to look to build capital back a bit following our investment in west suburban and think it will happen quickly.
With that I'd like to turn the call back over to Jim.
Okay. Thanks, Brett.
In closing we remain confident in our balance sheet and the opportunities that are ahead for old second we're paying close attention to both expenses and credit.
Believer underwriting has remained disciplined and our funding position is strong.
Today, we have the balance sheet and liquidity flexibility to take advantage of a rising rate environment.
And we will be aggressive in looking at new talent and new relationships.
That concludes our prepared comments. This morning, so I will turn it over to the moderator and open it up to any questions.
Thank you the floor is now open for questions. If you have any questions or comments. Please press star one on your phone at this time, we ask that while posing your question. Please pickup your handset if listening on speaker phone to provide optimum sound quality.
Please hold while we poll for questions.
Thank you. Our first question is coming from Jeff <unk> with D. A Davidson. Please go ahead.
Thanks, Good morning.
Good morning, Jeff.
Just wanted to try to get some detail on the on the success of that.
NPA reductions in non accruals, if you could just kind of give us a little.
Color on.
With these loans acquired through west suburban with a legacy what type just trying to get a sense of what the.
Our clients in the quarter.
Yes.
The big the Big mover, Jeff was a large.
Commercial real estate property as a retail property that we have been.
It's been in our workout team for the better part of the year.
Finally, we're able to find a buyer who took a corresponding charge off.
Finally move that one off the books absent that it was a combination of some prepayments or paydowns.
Some upgrades.
But.
The large real estate property, where we took about a $900000 charge was.
It was a long standing workout credit.
Got you.
Okay, and so that was it was that of legacy <unk>.
Second.
Not acquired I guess, yes that was a legacy old second credits.
Okay was there any.
Interest recoveries.
Included in that.
The margins pretty Big I was just wondering if.
That added to any now okay.
Took a look we took a further charge on it.
Gotcha Okay.
Brad you rattled through the expense expectations, a little bit sorry, if I missed it.
Obviously, 'twenty two digesting some hires and comp increase I think.
You alluded to.
Sort of digesting some of that and I guess expectations for 'twenty three.
Growth as we kind of bundle through the year.
I think like I said or tried to hint to maybe gracefully maybe not.
I'll do a little maybe EMEA culpa here.
We kind of blew through stretch incentive.
<unk>.
And it had a big impact on compensation.
We beat our budget quite handsomely in 2022.
And that had implications for incentive comp.
Perhaps it would've been better.
Yes.
That could have been.
Crude more gracefully.
But we had well in excess of 100 basis points of margin expansion in two quarters less than two quarters.
So it was a bit lumpy on that front.
We should see.
Stepped down.
Compensation expense in the first quarter that will be somewhat mitigated by.
FICA coming back onboard full boat.
But I still think overall operating expenses are.
Kind of like a 4% to 5% type number on a full year absent that step down.
Yes.
Four to five off of.
Our base of the full year 20 to 151 or so.
Yes, I think so.
Okay. Okay.
Maybe last one just on.
On the on the fee income side, obviously impacted by the securities losses MSR.
So our expectation on.
We expect mortgage to stay low.
Can we look at a quarterly run rate in that.
<unk> $10 million range any any feel for fee income growth.
In the coming year.
Well, what I would like to see as I would like to see commercial loan fees and swap fees start to contribute more meaningfully we've seen some momentum here recently and.
In the second half of the year.
I think we will get a big kick from that I don't expect mortgage banking to to perform very well in 2023.
I don't think I'm alone in that opinion.
So I think we'll see.
Kind of mid single digit growth.
On the fee side. This year I think I think we'd be pretty happy I think thats been our trend with especially with wealth and card related income low to mid single digits.
Got you. Thank you I think self congratulations sir are warranted. So I'll step back thanks, hopefully that wasn't too over the top.
Okay.
Thanks, Jeff. Thank you. Our next question is coming from Chris Mcgratty with <unk>. Please go ahead.
Hey, good morning.
Hey, Chris, Chris Hey, Brian Hey, Jim.
The comments about earning asset trailing loan growth if I heard you right, Brad $50 million coming off of the bond book.
Is it I mean, it feels like that could fund mid single digit loan growth by itself.
So it sounds like no growth in Q1 kind of seasonally or low growth and then.
What mid single over the course of the year is that.
Kind of flat, earning assets.
Do you think I mean assets will grow.
Chris I mean, historically, we have been.
A shop, that's had pretty good loan growth in the second and third quarters.
Obviously fourth quarter was pretty flat.
I will say in <unk>.
<unk> weeks.
Activity loan committee is picking it up for you. If you remember we set out the double our origination capacity last year, we actually tripled it.
<unk> gone from about 500 million to about $1 five.
Certainly don't see that kind of production.
<unk> thousand 23, but certainly could see.
So somewhere in that.
And the $1 billion range and production.
So I'm kind of optimistic I think I think mid single digit growth is very achievable.
Okay.
And then on the margin.
There was a comment in the release about upward pressure on.
On deposit costs, but I think you the word was moderate so.
I guess, maybe a little bit of color. There I think the banks that have held out so far on deposit betas have more more or less signal an acceleration or are you signaling.
Perhaps not not the same degree of pressure, Brian and margin lift from that four six.
So.
You can see we've seen a little bit of deposit attrition, it's largely been concentrated in public funds.
Who are districts that sort of thing.
And that is money that flowed in while the spigots, where unfold right I mean, everybody saw that.
Absent that we don't have a lot of very high balance accounts here we are.
<unk> said this before it's a little bit folksy, but.
We're funded largely by checking accounts.
And that serves us well in times like these.
We do have.
No.
From an Alco standpoint, we do have some some time deposit contribution and the cost of that is certainly going up.
There are 4% being thrown around in our market at this point.
And you see the usual games, where people are basically gaming the fed fund futures curve and trying to capture 10 basis points here in 25 basis points. There. It's the same old game.
We will keep some level of time deposit just to keep things balanced from an Alco standpoint.
There is obviously some pressure, but not a ton.
We're doing really well.
Okay.
So I.
Just a question on the margin again.
You talked about perhaps taking some of the asset sensitivity off but not making a huge bet.
If the market's right that we get another hike or two in the first quarter or two.
Where do you kind of see peak margins.
If we get if we get to more of our margins going above five.
Okay and then.
One of your peers in Chicago.
He has managed the balance sheet.
Well like you wouldn't that be the time that.
To make a little bit more of a bet to lock in that really really high margin.
Yes.
Don't Misconstrue I mean, we are certainly taking off.
Asset sensitivity and adding duration.
And doing so in a measured manner.
Big part of that is stepping out of these variable securities that we bought.
And that comes without a fee.
And it also comes without.
Accounting risk.
We I don't want to give the impression that we're not locking in to some extent, we certainly are.
But.
Right now what you see is you see a sharp drop off but that the three year portion of the curve and after you take the fee in your account and start looking at the economics of that and you balance that against what has shown up here recently, which is 50 basis point cut at the end of the year.
And.
Youre not locking in.
Four 5% margins you are locking in basically three 5% margins.
The net net of it.
So I think what I'm trying to say is that we're not lurching at anything, but we're certainly reducing asset sensitivity as quickly and as prudently as we can.
But bear in mind that it was never my intention that 30% of our securities portfolio and variables simply we had no choice.
Fixed rate yields were and what the risks were.
And if I could get out of them tomorrow with no loss of probably would.
Okay.
Do you haven't didn't I'll step back after that do you have the December margin by chance.
Yes, I do.
It's higher than what we reported for the full quarter.
So again.
Thank you once again, if there any remaining questions or comments. Please press star one on your phone at this time.
Our next question is coming from David long with Raymond James. Please go ahead.
Good morning, everyone.
Good morning, exploring David Brad like your.
Core deposits matter news letter do you have a balance sheet management newsletter I believe some of your peers may want to subscribe subscribe to that.
But no serious.
Non interest bearing deposits to total deposits still running around 40%.
I am very core fund in a lot of like you said $1000 deposit accounts, but do you expect that number to veer any lower can that do you see that close to a 30% 35% at some point or is 40% a good run rate.
Yes, it feels pretty stable right now.
Yeah things happen when rates go up and certainly one of them and it gets washed away in our headline is that liquidity at the liquidity evaporates.
And that always becomes more profound than people expect.
It's been a long time since we saw what happens in these scenarios but.
I can tell you that it's better to be a retail funded granular deposit base.
When liquidity gets tight and I think when you talk about volatility of those deposit base, it's lesser and that kind of makeup than than what you'd see in a commercial funded bank or something like that so it's good to be what we are right now I certainly recognize that that environment can change.
And we will do what we can but we are fundamentally what we are I've said that many times.
We shouldnt.
Art, making giant bets to be something different than that because there is not a darn thing we can do about it.
Got it cool thanks for that one and then.
One of your competitors did deal in your neck of the woods.
Any appetite for M&A at this point is there is there.
Are you having any.
Conversations have you seen an increase in dialogue there.
Yes, David.
We've obviously.
<unk>.
<unk> been working real hard to integrate west suburban it's been a year.
We'd certainly be open minded about a strategic opportunity I would say this dialogue in our markets.
Is ongoing but certainly not at the level it was.
A couple of years ago, but yes.
Yes, we would be.
We would be open to.
To a transaction if we found one that fit our criteria.
Got it thanks, guys I appreciate it.
Thank you David Thanks, Dave.
Thank you.
There appear to be no further questions in queue. At this time, so I'll hand, it back to Mr. Ankur for any closing comments.
Okay. Thank you thanks, everyone for joining us this morning.
And we look forward to speaking with you again next quarter.
Goodbye.
Thank you and this does conclude today's conference call. You may disconnect. Your lines at this time and have a wonderful day, we thank you for your participation.