Good morning, and welcome to the Alerus Financial Corporation earnings conference call. [Operator Instructions] 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's Chairman, President and CEO, Randy Newman. Please go ahead.

Thank you, Rachel, and good morning, everyone. This is our fifth earnings call since our IPO 1 year ago in September of 2019. This morning, we intend to discuss our third quarter 2020 financial results and the current impact of the COVID-19 pandemic. Today, I'm joined by our Chief Financial Officer, Katie Lorenson; our Chief Risk Officer, Karin Taylor; and our Chief Revenue Officer, Ryan Goldberg. As always, we appreciate your interest in our company. During the third quarter, we continued to ensure that our employees were safe and that we meet the needs of our clients during this period of uncertainty. We remain confident in our ability to continue to navigate the uncertainties of this downturn, while also driving significant value for all of our stakeholders. As we navigate through the remainder of 2020, I'm very proud of how our organization has responded to this uncertain and challenging environment. Our company has accomplished so much in 2020 despite COVID-19, which is a testament to our team and our business model. I'd like to thank our employees for their extraordinary efforts during these unprecedented times. For the third quarter 2020, we reported record net income of $17.7 million or $0.99 per share -- diluted earnings per share. While our net interest income remains under pressure from historically low interest rate, our fee income businesses continue to produce solid results, a testament to our high-value professional services business model in our diversified financial services company. This is most notably seen in our mortgage, retirement and benefits and wealth management divisions, all of which grew from the previous quarter. During the third quarter, we saw several other areas of improvement. Our capital ratio strengthened at both the bank and the holding company. Many of our asset quality indicators, including net charge-offs improved,…

All right. Thank you, Randy. Good morning, everyone. Thank you for joining our call today. I'll briefly walk through some of the highlights for the quarter. And then as Randy mentioned, I'll turn it over to Karin to provide an update on credit-related matters and provisioning and our COVID response. Let's start with mortgage. Results for the quarter were simply stunning. Originations exceeded $500 million, and we surpassed the $1 billion mark for the year. This unprecedented volume would not be possible without the long-term investments made by the company in recent years. From a technology aspect, over 90% of our applications were processed through our digital channel and our printing has been reduced from 200,000 pages to 20,000. From a talent perspective, the company's investment and move to mandatory delivery was extraordinarily well timed as margins are even higher than expected due to the operational constraints facing the industry. Our Alerus team members continued to produce strong purchase volume at levels exceeding 2019. The mix of purchase has moved to less than 50% of the volume, and September was our largest month of [indiscernible] ever in the division. The pipeline for the quarter reached historic levels. The combination of the strong pipeline and the higher margins moved the mark-to-market on the hedge up $6 million in the quarter, bringing the year-to-date change in fair value of the hedge to a gain of over $11 million of the nearly $45 million of revenue that's reported. We anticipate fourth quarter volume to remain strong, with originations near Q3 levels. However, the application volume declined 12% in September, a trend we do expect to continue with seasonality. As such, we expect the value of the forward pipeline or the hedge to decline in the fourth quarter and into 2021, putting pressure on…

Thank you, Katie, and good morning, everyone. First, I'll provide a brief update on our banking markets. Both North Dakota and Minnesota have seen recent increases in the number of cases of COVID-19. To date, there have not been changes in business restrictions at the state level in either state, however, some cities have reduced capacity limits for certain types of businesses, primarily bars and restaurants. The situation in Arizona showed steady improvement over the third quarter. We continue to serve our clients in all markets by virtual and digital means as well as via the drive-through and in-person based on market needs and conditions. Loans have increased by $337 million since December of 2019. The increase is attributable to PPP balances of $349 million, and an increase in commercial real estate of just over $40 million. This growth was offset by a decrease in consumer loans and commercial line usage over the same period. The utilization rate on commercial lines remained low at the end of the third quarter at just under 24%. This compares to normal seasonal utilization rates of 35% to 40%. Increased borrower liquidity due to various relief programs, including the PPP, is contributing to the lower utilization rate. We granted over 1,600 PPP loans for $363 million, 784 of those loans or about $16 million are $50,000 or less and qualify for the SBA streamlined forgiveness process. As of October 22, we had submitted 79 applications to the FDA for forgiveness, totaling $51.7 million. To date, we have received approval for forgiveness from the SBA on just 1 small loan. Request for payment release tapered off during the third quarter. We have granted 552 deferrals with a total outstanding balance of $151 million. This represents about 9% of the portfolio. As of September 30, 27…

Yes, let's take questions first. Thanks.

[Operator Instructions] The first question comes from Jeff Rulis from D.A. Davidson.

Just trying to gauge the expense line, Katie, we got your comments on some of the near term. I just wanted to take a step back. I think a pretty strong spike in revenue this quarter without a big increase in cost, I think that's a product of the prior investment, I'm sure. But is that sustainable in '21, i.e., kind of holding moderate expense growth? Or are there a few expenditures coming up in the next year? And I -- we got your 4Q comments that there's a couple -- some noisy items. But bigger picture, if you could frame up '21, how that -- how -- what your expectations are for expenses?

Yes, absolutely. Thanks, Jeff. From a '21 perspective, we don't anticipate any ramp-up in any expense line item from a compensation standpoint with the outlook of mortgage likely decreasing in terms of originations into 2021. We do expect to actually see a decrease in overall compensation. And so as I look at the line items outside of compensation, I think run rate in third quarter should be pretty consistent moving forward. And we'll have a little bit more color again next quarter in regards to some of the changes that we look to make and decisions we look to finalize in the fourth quarter that will impact, of course, 2021 run rate.

Okay. And just to follow on that, the mortgage, we can kind of make our projections there if it's a lighter year. Is there a range-bound expectation for this line? Obviously, 3Q was a huge number. But trying to get a sense for the start of the year, that's a big range. So just trying to kind of get a full year expectation.

And your -- and from the expense side, Jeff?

No, on the mortgage revenue line.

So the mortgage revenue line, the MBA is predicting that originations will decline 29% from 2020 to 2021. We think we can do better than that. What is, I think, very critical to note, as I mentioned, we do have the mark-to-market unrealized gain on the hedge of $11 million right now in the revenue line item. We believe that, that will run off closer to 0 over the next 5 quarters. And so that's a factor to take into play as we look at mortgage revenue. The margins, of course, have been elevated. We think they return closer to somewhere in the 2 75 to 2 80 range for us into 2021. And so those factors, we believe, will both impact the revenue for this particular business line pretty significantly into 2021, potentially cutting it in half.

Got it. Okay. And maybe one last one, perhaps for Randy. Just on capital management, I would think kind of ideal priorities would be sort of funding organic growth and the M&A, maybe dividends and lastly, buyback. But I guess the environment may not bring that or allow for that ideally. I guess maybe your ideal deployment versus the reality or what -- if you could frame up what your capital plan would be?

Sure. Well, our first priority was to create a fortress-like balance sheet, make sure that we're well prepared to handle anything that came up with COVID and any credit-related issues. And I think that has been our focus up to this time. Obviously, we're now in a position to really to begin to continue to look to the future in capital deployment, and all of the things that you mentioned are certainly alternatives for us to consider. But we would like to focus, obviously, on organic growth and looking for acquisitions, primarily on the fee income side to both support the model that we have built.

And then I guess, the near-term use of a buyback is certainly well down the line of what you'd prioritize.

At this time, yes.

Your next question comes from Nathan Race from Piper Sandler.

I want to just start on credit. Maybe, Karin, a little bit of an increase in special mentioned in the quarter in substandard. I imagine that was -- maybe you can find the commercial real estate credit that is remaining on deferral. So just any commentary on those upticks? And just how we should be thinking about additional reserve builds into the fourth quarter? You guys obviously continue to provide a pretty substantial level here in the third quarter. And it seems like, with deferrals trending the way they are, there may be less need going forward, but there's still, I think, a high degree of uncertainty out there. So just curious with any thoughts along those lines?

Sure. Thanks, Nate. This is Karin. We did have an increase, particularly in the special mention. The actual increase when excluding those PPP balances that are part of the special mention relationship was about $8 million from quarter 2 to quarter 3. I would generally characterize the increases as fairly normal migration. There was one relationship in there that has some COVID impact. But as business has returned to more normal levels, the company has taken some proactive actions, and we expect that to improve. And so -- and really, they were across different industries and some was commercial real estate related, some had operating lines as well. So no real patterns there. With regard to reserving, our provisioning has continued to be driven primarily by 2 factors related to the economic uncertainty, and we would expect that to continue into the fourth quarter. But as we look forward, we've spent 2020 really prudently building a robust reserve. And so, absent significant deterioration in credit, I think the pace of that build may be less as we get into 2021.

Okay. That's helpful. And it seems like loan growth was a nice positive in the quarter as well, ex-PPP. So just curious kind of where you guys are seeing opportunities? Is it related to some of those new clients that you guys have onboarded as part of that program? Or just any thoughts on how we should be thinking about overall loan balances ex-PPP into the fourth quarter and into '21 as well?

Sure. Some of that increase has been a result of new opportunities. There continue to be some really good opportunities out there. There's a lot of competition for those, obviously, but there are companies that are doing very well through this crisis. And so we've seen some nice commercial opportunities. We've seen -- continue to see some nice commercial real estate opportunities that are structured in a way that we're comfortable moving forward with those. And so I think we'll continue to see those, but we do have significant headwinds with the amount of liquidities our borrowers have. As we've mentioned before, we expect that most of our loans will be fully forgiven. And we do have borrowers that are generally conservative and maybe putting off some capital expenditures and things until there's a little bit more clarity around the economy.

Okay. Got it. That's great to hear. And then if I could just ask one more clarifying question for the fourth quarter, I apologize, it's short-term orientated. But Katie, mortgage, it sounds like it's supposed to come down in the fourth quarter, but is it expected to be higher than what we saw in the second quarter. And I imagine the comp increase that we saw in the third quarter was mainly tied to that increase in production, so just curious how we should be kind of thinking about those 2 components within the revenue line and also overall expenses in the fourth quarter.

Sure. So from a revenue standpoint, we think originations will hold. But we do anticipate some pressure on revenue just as the value again of that forward hedge decreases. And so that will be an offset to the revenue component. On the expense side for mortgage for the fourth quarter, I would anticipate the compensation to go up or the variable expenses related to that in both the mortgage lending expense as well as the compensation to go up, probably $1.5 million as our compensation levels are tiered, and so as our producers hit that highest tier, along with the origination volume, we will see an increase in the expense line item.

[Operator Instructions] Your next question is from William Wallace from Raymond James.

Katie, just -- since you just were on topic of mortgage, did you say that the hedge gain was $6 million in the third quarter?

It was $6 million in the third quarter, so year-to-date, we're sitting at about $11 million.

Yes. Okay. And you anticipate giving all that back over the course of next year?

We do. With typical seasonality, we would anticipate that.

Yes. Okay. And then you just said expense up about $1.5 million in the fourth quarter, but the expense line, I think I heard earlier, you think maybe you can kind of hold the line to third quarter next year as variable comp, et cetera, comes down and...

Yes. Yes, sir.

Okay. Great. And then on your prepared remarks, you mentioned -- I missed the word you said, you said something on the net interest margin to 3%, excluding noise from PPP. Is that -- was that guidance for the fourth quarter or where you think the margin trends over the coming quarters?

Both. And so scraping for 3% is our goal, excluding the PPP for the -- for next quarter as well as the onward quarters. And again, that's assuming these cash levels continue where they're at. We had some hope at the end of the quarter that they were going to stay off, but it's quickly ramped back up. So if we can get the liquidity put to work, that's the assumption is that the NIM will drag down to that 3%.

And then sort of stabilize. It sounds like you get there quick? You think you get there quick?

Exactly. We're going to work really hard to stabilize at 3%.

Okay. Understood. Understood. And then on the PPP side, I think you said 1 loan has been forgiven, what's the -- what -- how is the kind of cadence of forgiveness applications that you're sending to the SBA?

Yes. Wally, this is Karin. We've sent initially 79 applications that was through October 22, and we're continuing to submit them. Actually, some of the initial applications we submitted were for larger loans. And we believe that based on what we're hearing with regard to what's being forgiven, we believe as we submit more of our smaller loans, they will probably be forgiven more quickly, that seems to be the approach the SBA is taking.

Okay. And are you all ramping up to start submitting the smaller ones? Or are you waiting to see if Congress does anything to make it easier for everybody?

No, once they indicated that the $50,000 loans or less had the streamlined process, we have started ramping up those applications.

Okay. Great. And then, Randy, just bigger picture. I'm curious if the uncertainty in the current environment has changed the cadence of conversations or conversations you're having with bankers or companies just around any potential M&A fee business lines. Or is it just started to come by now as it was before? Or harder?

Well, again, our focus is primarily on the fee income business for several reasons. And what we're beginning to see is there are some deal flow out there. And so I think we're in certainly a position given how we've managed the company throughout 2020, putting ourselves in this position to once again begin to engage in some of those conversations.

Do you think that this environment changes the appetite -- the demand from other buyers, in other words, should the pricing be improving based on anything you've seen? Or is that still the...

Well, I think there's a consolidation going on in that line of business as well for several reasons. And I think, given the low rate environment, that I wouldn't be surprised if there are more competitors out there who are looking to perhaps build the business model that Alerus has spent many, many years building. I think our scale and our experience in that gives us an advantage in certainly executing or whatever, but I wouldn't be surprised that their price may go up on some of those opportunities.

[Operator Instructions] There are no further questions at this stage. That does conclude our question-and-answer session. I would like to turn the conference back over to Randy Newman for any closing remarks.

Thank you. Let me close with some remarks by first extending our appreciation to everyone who joined our call this morning. Thank you for listening and asking questions. I'd like to continue to state that Alerus is a company focused on balance and diversification. And I think we've done a very good job over the years of balancing growth, risk and profitability. We manage for the long-term benefit of all of our stakeholders, and no doubt the timely investments we've made in technology over the last several years are helping us achieve even more success in today's unprecedented environment. We also believe strongly in diversification and have a long history of a diversified business model: diversification of revenue streams, diversification of market geographies, diversification across industries and a very strong diversified balance sheet. Our diversified model is proving to be a key ingredient to our incredible success this year. The performance of our company over the past 9 months has been extremely strong. 2019 was a record year for Alerus when we earned $29.5 million. Year-to-date 2020, we have already earned $34.5 million. So 2020 will go down as a record and historic year for Alerus as we navigate through these challenging times. We have built a fortress-like balance sheet that we will continue to reinforce until the environment proves more certain. We have a steady focus on client needs, investing in technology and the way we serve to meet the evolving expectations and needs of our clients. Most recently, we have been recognized by several sources for our risk/return performance, that includes being named to the prestigious Piper Sandler Small Cap All Stars Class of 2020. Yesterday, we were named in the American Banker Top 85 Best Banks to Work For in 2020. And while we are very proud of our past successes and performance, we are even more optimistic about our future. And lastly, we are a very resilient company. Our culture is built to do the right thing, embrace change and serve with passion. These beliefs have never shown stronger than they do today within each and every one of our employees. I'm very and incredibly proud of our performance this year, but I'm even more proud of how we do it as a company. And again, thank you for joining today's call.

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