Good morning, and welcome to the Alerus Financial Corporation Second Quarter 2020 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. Please note, this event is being recorded. This call may include forward-looking statements. And the company's actual results may differ materially from those indicated in any forward-looking statements. Important factors that could cause actual results to differ materially from those indicated in the forward-looking statements are listed in the earnings release and the company's SEC filings. I would now like to turn the conference over to Alerus Financial Corporation Chairman, President and CEO, Randy Newman. Please go ahead.

Thank you, and good morning, everyone. This is our fourth earnings call since our IPO in September 2019. This morning, we intend to discuss our second quarter 2020 financial results and the current impact of the COVID-19 pandemic. I might also mention that we've updated our investor presentation for our second quarter performance, and you can access that on our website. Today, I'm joined by our Chief Financial Officer, Katie Lorenson; and our Chief Risk Officer, Karin Taylor. As always, we appreciate your interest in our company. In today's call, I will first highlight our record-setting earnings for the quarter and other key points before turning it over to Katie and Karin. After that, we would welcome your questions. Our financial performance in the second quarter mirrors what other banks with diversified business models are reporting. Significant balance sheet growth as a result of almost $360 million of PPP loans, weaker net interest margins and record mortgage revenue growth. All of this resulted in Alerus reporting a record quarter with net income of $11.5 million. Although the pandemic has been incredibly disruptive, we are blessed with very talented, loyal and committed professional employees, who are driven to providing exceptional client service. Despite the challenges of moving to a remote work environment and the impact of COVID on personal lives, our employees worked above and beyond to deliver record-setting mortgage production of $431 million to over 2,200 clients. Additionally, our banking division made 1,600 PPP loans providing over $360 million of funding, which also included loans to 370 new banking clients. We also introduced the first of several virtual webinars in the second quarter to provide guidance and help clients with their financial issues in a number of different areas. At our last earnings call, I recall our past experience in…

Thank you, Randy. Good morning, everyone. Thank you for joining our call today. As Randy noted, the second quarter produced an incredible $11.5 million of net income and year-to-date total asset growth of 22%. We are very pleased to see our investments in our One Alerus culture, our talent and our technology translate into results. Although the uncertainty remains, it is clear the franchise value of our company is strong and resilient to incredible challenges. This morning, I'll briefly walk through some of the highlights for the quarter, and then I'll turn it over to Karin, who will give an update on credit-related matters as well as provisioning. During the second quarter, we saw truly tremendous changes to our balance sheet. First, our loan balances increased over $300 million or 18%. The increase included, of course, the PPP loans, which equated to approximately 20% of our total loans. We experienced increases in our C&I portfolio outside of both PPP loans due to extraordinarily low levels of utilization in our lines of credit. We also experienced, of course, a headwind in the residential portfolio due to the level of refis and lower-line utilization in our HELOCs. On the funding side, we continue to see incredible inflows from many different sources. We had some really nice commercial new business generation. Our synergistic deposits continued to build, and we also saw cash reserves continue to build within our client base. We estimate approximately $200 million of the proceeds from the PPP loans came in and is still sitting in our deposit base. This dynamic has weighed heavily on our net interest margin, which moved down 21 basis points in the linked quarter. The highlight of the quarter outside of the level of PPP loans was certainly the record volume of mortgage origination. This…

Thank you, Katie, and good morning, everyone. First, I'll provide a brief update on our banking markets. We continue to effectively serve our clients in all markets, virtually, digitally via the drive-thru and in-person as conditions allow. The North Dakota market was never subject to a stay-at-home order. There were restrictions in place for certain businesses, and those were lifted at the end of April. By and large, Grand Forks and Fargo are widely open for business and have been for some time. The twin cities market was subject to a stay-at-home order until mid-May. Minnesota then implemented a 4-phase stay safe plan to reopen businesses, and the market continues to make measured progress in reopening. The situation in Arizona has been more serious with the resurges in cases. We continue to focus on serving clients via technology and the drive-through in that market. Employees across our company worked with urgency during the second quarter to deliver relief to our clients. As Katie mentioned, loans increased by $313 million during the first half of the year, fueled by the addition of $360 million in PPP loans. This was offset by decreases in consumer loans and commercial line usage since the end of the year. The utilization rate on commercial lines decreased to approximately 23% at the end of the second quarter, down from 38% at the end of the first quarter and compared to a 14-quarter average utilization level of 37%. This was primarily the result of increased liquidity of borrowers due in part to various relief programs, including the PPP. Through June 30, we've granted close to 1,600 PPP loans, again, totaling at $360 million. Approximately 370 of those loans were made to clients new to Alerus. These relationships have helped build up our pipeline for business development, particularly…

We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Jeff Rulis of D.A. Davidson. Please go ahead.

Thanks good morning.

Good morning, Jeff.

Maybe just a follow-up for Karin. The – on the deferral, that sounds fairly positive on those that are presumed payment, I guess, do you have a figure of current deferrals as a percent of loans? If you're at 9%, it sounds like – is that number in half at this point?

Yes, it's pretty close to half of that, yes.

Okay.

4.7%, I believe.

Okay. So high, $70 million or so. That – and I just wanted to clarify the total deferrals that was all done on 90-day? Were there some 100 – 180-day-type deferrals?

We did not do any 180-day deferrals. No.

Okay. Great. And then, yes, just towards the margin, Katie the – if you could outline the impacts on PPP, sort of the excess liquidity headwind, what – in terms of what that did on margin? And then just any color on your ability to deploy or to deploy excess liquidity and kind of the margin outlook from here?

From a PPP standpoint, all else being equal, ex PPP, really, just on the couple of basis points impact for this quarter, excess margin was certainly the weight of it – if you just take out the excess cash that has been sitting on the balance sheet, probably, about $100 million of average balance, that probably jumps the NIM up to the 330. So outlook for Q3, we believe Q2 is certainly the low point, looking to continue to put this cash to work. In the investment portfolio I'm expecting some outflows. So we think some recovery in the NIM going forward as well as continued rate reductions on our money market accounts, which we expect to decrease into the 30 to 40 basis point range for the third quarter.

And my last one, just on the expense side, copy kind of cost-conscious approach. And I think – and it's more bigger picture maybe for Randy or Katie on the – kind of how you manage expenses. You've certainly done a lot of heavy lifting on investment into the platform. And I guess from here, it's more of watching costs. But as we move – accelerate more towards sort of a digital experience, I guess, your thoughts on kind of the expense run rate and how you manage kind of investments that you think are good for this climate versus kind of reminding costs and keeping those flat. Just an update on that?

Good question. I think what we're seeing in the second quarter is reflective of the urgency and the efforts in regards to a focus on managing expenses. And really, the bulk of the big investments in terms of technology are in those numbers, the future outlook and the need for any additions there in terms of serving our clients digitally. It's not really on the forefront. Those are in the run rate. We've made those investments already. So from an operational expense standpoint, it was really nice quarter in that regard. And very – the company all throughout is extremely diligent and focused on building efficiencies, whether it's through robotics and automation as well as just capacity within our workforce. So outlook, I think ex the mortgage incentives, we can continue to grow revenue in this company without adding any incremental expense.

Okay, thank you.

The next question comes from William Wallace of Raymond James. Please go ahead.

Actually, a great follow-up to that last question to your last comment was, what was the increase in the comp line from variable comp on the mortgage business?

Good question. It was $3 million for the quarter.

That's the increase of $3 million or the total was $3 million?

That was the increase of $3 million. We went from $2.3 million to $5.3 million.

Okay. And then in your prepared remarks, I apologize, you gave a lot of information, so I just couldn't write it down fast enough. You – I believe you said on the mortgage business that, you expect mortgage volume will be – will continue to be elevated year-over-year, but then you said, something about the gain that I missed that. Could you kind of restate that and then quantify – help us quantify what your thoughts might be?

Absolutely. So we do anticipate really nice volume moving into the third quarter based on where pipelines are today in our application volume, et cetera. We expect the margins to hold where they are. But as Q4 seasonality comes in, in that forward pipeline decline, which is just natural and a typical year, so you know that this is a typical year, we would expect to see the value of that unrealized gain decrease in the third quarter. And so you can think about it a little bit as just – a little bit of an offset to the revenue total.

Okay. Okay. So that variable comp, the $3 million increase, that might not be the – what you see on the volumes today that you might have production in line with the second quarters or down slightly. Is that a fair characterization?

From the comp side, there is a lag. So I would actually expect to see the mortgage comp in the third quarter not go down and potentially increase upwards to even $1 million, but then falling off back to kind of Q1 levels into the fourth quarter.

Okay. Great. And then if you – maybe on the – then as a follow-up on the NIM commentary. If you were to keep liquidity where it is, what do you think the opportunity is on NIM to kind of help us think about what you can do with NIM and then maybe getting back at 15 to 20 basis points as you deploy liquidity? That makes sense?

Yes. So even with the changes, again, the money market accounts have that automatic reset. So even all things being equal, we see a few basis points pickup in that regard. Even if the balance sheet stays static in terms of cash.

Okay. Great. That's very helpful. Thank you. And then you talked about the opportunity or – and looking at the expenses and opportunities to be more efficient. I'm curious, if the experience of your customer is a little bit different than what we're hearing from a lot of the other banks around the country, given that your markets North Dakota never really shut down, or do you think there's an opportunity on the branch side for consolidation? Or is the customer activity not really changed that much? I guess, that's probably broken into the difference between North Dakota versus the twin-cities, but I'd like to know, just big picture, if you think there's opportunity on the branch side? And how you're trying to figure out that opportunity?

Yes. It's a great question. I can tell you, I've been amazed at how busy our North Dakota locations are to the point of waiting lines in the drive-through before we opened our lobbies. That sometimes exceeded 0.5 hour or so. The activity there, especially on the commercial side of use of our branches really has not slowed. As a reminder, we are not a branch-heavy company. We have just 15 locations across our entire footprint of North Dakota, Minnesota, Arizona. That being said, we are closely monitoring all of the trends and uses as well as our digital engagement. We actually, as a company, were at capacity when it came to our facilities. And so adding a new hire was like fitting in a jigsaw puzzle. And so this certainly gives us more capacity in our current locations, but we are exploring opportunities. We have made a decision, as of today, to not reopen at least one location, but we'll continue to evaluate all locations and all of our office space across the company.

Okay. And then last question is just on the retirement and benefit services business. Just talk about continued headwinds or tailwinds there and expectations maybe in the back half of the year?

As I look at the second quarter and where the assets have rebounded, I do believe this to be a low point for the quarter. And so I think we track back up to the $14 million in terms of revenue for the third quarter. The headwind for us in this business will be related to ESOP transactions, which of course will be – are on a pause. Businesses aren't moving forward at all at this time as well as the new business generation, but it's a long sales cycle. So I believe that to be more of a 2021 headwind.

Okay. So do you think that, that just results hopefully and maybe slightly slower growth in 2021? Or do you think that you could see some fallout as there's potential pressures in the small business community?

We've evaluated our book of business within our retirement division, much like we did with our credit division, and we really have much like our loan portfolio extraordinarily diverse. And we're not seeing pressure on levels of contributions or planned terminations or anything in that nature. So I don't believe it's a 2020 issue. We have seen a slow in attrition, which we think potentially offset some of that headwind to new business generation.

Okay. Thanks. I will set back. Let somebody ask question.

[Operator Instructions] The next question comes from Bob Shone of Piper Sandler. Please go ahead.

Good morning. This is Bob on for Nate.

Good morning.

My question revolves around provisioning going forward. And if you guys could maybe provide any color around, if we're going to see consistent provisioning to the level of 2Q 2020? Or how high the reserve might go? Thanks.

Sure. Obviously, that's a tough question, given the uncertainty. And of course, the payment relief has potentially masked. Some of those traditional flags that we look at. I would just say that we remained very cautious and that given the uncertainty, we expect that we'll continue to remain at an elevated provision level next quarter as well.

Okay. And then looking at the line utilization, you guys mentioned that it's below the three-year average. Have you seen a bounce back in that utilization so far in the third quarter?

We have not. It's remained very low.

Okay. And then kind of related to that, given the strong core deposit growth, do you anticipate as PPP funds are being used and with tax season being pushed back, that there will be some anticipated runoff in 3Q?

Yes. I think we expected to see that in Q2 also. So it's a little bit of a mystery, but we would – we are expecting that there will be outflows in the third quarter.

Okay. And then last one for me. Just kind of a modeling question. For the PPP income, I think you guys said it was around $2 million this quarter. Is – was there any accelerated fee income in that number? Or was it just the 1% interest plus the standard kind of 24-month amortization of the fee?

Good question. No, it actually was – it's a little bit shy of where it should have been. And probably $200,000 short of where it should have been because the average balance has changed a little bit. So no, the system actually calculates the income incorrectly. So we did make a manual adjustment. So we were not overstated in the quarter.

Okay, thanks. I will step back.

Katie, it's Randy. To Bob's question on the deposits, would you happen to know the breakout of the deposit increase? Some of that came from the synergistic side or the synergistic deposits from the benefit side, which should remain with us. The deposits that may have come from the PPP funding, of course, that will probably run off. But would you happen to know what that split is?

Yes. $90 million, excuse me, of the increase was related to the synergistic deposits of the retirement and wealth management.

Okay, thanks.

And we have a follow-up from Jeff Rulis of D.A. Davidson. Please go ahead.

Yes, thanks. I just wanted to clarify the retirement and benefits number, that was a recovery to 1 4, $14 million [ph] in the third quarter or something north of that?

Yes, we believe so.

Okay. And I guess anyone – guess is to, how you climb back to – I think you just mentioned transaction volume is light. So maybe it's inhibited getting back to kind of your ceiling levels. But any thoughts on further growth as we continue to sort of reopen? Or if we do, there's some upside to that number?

There's certainly is a big focus for our sales. Our advisers in that front is – the client expansion, either at the participant level and engaging participants individually and in terms of IRA rollovers, wealth management opportunities. But then also expanding into health savings and payroll are real interest for companies today.

Okay. Kind of a cross sell. Got you. And then, just 1 last one. Could you touch on sort of organic loan growth or net or just expectations for the – maybe through the balance of the year as I think PPP sort of stunts some of that, whether it's line utilization or other, any thoughts on kind of net of PPP moves, if forgiveness comes in that, just isolate that, but just kind of the portfolio as you see it kind of the balance of the year? Thanks.

Sure. Our pipelines were fairly strong earlier in the year. We did have some nice growth initially. And then obviously, with the onset of COVID-19, everything just kind of stopped there. Some of our borrowers just paused. Waiting to see what the impact was. We are feeling pretty good about our pipelines now early in the third quarter. People are getting back to business, picking up some initiatives that they had. But we're cautious in our outlook, simply because we feel there are some headwinds. Obviously, there's going to be competition for the best credits out there. And we're being prudent in our underwriting as well. And so while we think there's opportunity, I think that growth will likely be muted the rest of the year.

Jeff, its Randy. I might say to it. A significant strength of Alerus is our business model. And if the economy does slow and traditional banking organizations may find it difficult to find good loans or increase loan volumes. Our sales staff or business development staff does not sit idle. We have other things. I mean we report these as separate divisions, but inside the company, we really operate as one combined sales force. So our people do not sit idle, and they're able to go out and really sell the other areas of our company to remain active and thus continue to bring in revenue into our company.

Got it. Yes. I guess the other piece of that is your own appetite for risk and you got to kind of manage that. But it sounds as if you're – the markets you're in, you're still looking for incremental business where it's – I think where it makes sense. So I appreciate the color. Thank you.

[Operator Instructions] Okay. Then at this time, this concludes our question-and-answer session. I will now turn the call over to Randy Newman for concluding remarks.

All right. Thank you. First, let me extend our appreciation to everyone who joined our call this morning. Thank you for listening and asking questions. The first half of 2020 has brought about a tremendous impact to the lives of our clients and employees as well as our business. We acknowledge the economic and uncertainty that lies ahead and are preparing for this challenge by maintaining a fortress balance sheet, strengthening our coverage for loan loss reserves and preserving robust capital levels. The backbone of our company is serving in the best interest of our clients. We continue to focus on this commitment by engaging our team and meeting the holistic financial needs of our clients. Our business may be interrupted, but it is not disrupted. We are a very resilient company. We have a strong balance sheet, a strong leadership team and a business model that is envied by many traditional banks. We believe the diversification of our business model and geographic markets will allow us to perform better than our peers, especially in the current environment. We're very proud of our financial performance this past quarter and our team's ability to perform well through this period of economic uncertainty. Thank you again for joining today’s call.

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.