Good afternoon and welcome to the Alerus Financial Corporation Earnings Conference Call. Please note, this event is being recorded. This call may include forward-looking statements, and the company's actual results may differ materially from these indicated in any forward-looking statements. Important factors that could cause actual results to differ from those indicated in the forward-looking statements are listed in the earnings release and company's SEC filings. I would now like to turn the conference over to Alerus Financial Corporation President and CEO, Katie Lorenson. Please go ahead.

Thank you. Good morning, everyone, and thank you for dialing into our call today. Joining me today in Minneapolis is Karin Taylor, our Chief Risk Officer; and Al Villalon, our CFO. I am proud to announce that during the quarter, we added Jim Collins, a seasoned bank leader in the Twin Cities to our executive team as our Chief Banking and Revenue Officer. Jim will lead and support the continued new client growth and existing client expansion, while building on our recent successes in adding talented bankers and advisers in the Twin Cities and throughout our footprint. On July 1, we closed on the acquisition of Metro Phoenix Bank, the 25th acquisition in the company's history. We are pleased to have Metro Phoenix join the Alerus franchise. The Phoenix-Scottsdale-Mesa is one of the fastest-growing areas in the country over the past five years. Metro Phoenix Bank started by Steve Haggard, is a well-established, high-growth and highly efficient bank with a strong commercial presence. With the approval and closing, Steve has now assumed leadership over the entire market as the Arizona President. Together, our combined organizations are one of the largest community banks and SBA lenders serving the market. This acquisition significantly increases our presence in Phoenix, Scottsdale and demonstrates our commitment to growth and client expansion in Arizona. Looking back on the quarter, we reported EPS of $0.53, which included a $0.05 negative impact related to merger expenses. We continue to experience good loan growth as loans grew 17.3% on an annualized basis ex PPP. Growth was across products, but highlighted by additions to our commercial client base, a proven catalyst for growing our retirement business. Year-to-date, new plan sales in the retirement division are nearly 50% higher than last year, while loss plans have remained at stable levels. Our…

Thanks, Katie. I will start my commentary on Page 14 of our investor deck that is posted in the Investor Relations part of our website. For the second quarter of 2022, reported average loans increased 4.0% on a linked quarter basis. Excluding the impact of PPP, average core loans increased 4.6% on a linked quarter basis. The increase in core average loans was driven by a 9.2% growth in C&I and a 5.4% growth consumer. Within C&I, we saw a pickup in loan production, along with an uptick in utilization rates as clients continue to tap into their existing lines. C&I utilization increased from 28% to 32% during the quarter. At the end of the first quarter, we had approximately $6.9 million of PPP loans outstanding. Average deposits declined 2.7% on a linked quarter basis due to a seasonal decline in interest-bearing deposits. The decrease in interest-bearing deposits was due to a seasonal decrease in our public unit funds. We typically see a drawdown in these public funds in the summer with an increase happening during the fall usually. Turning to Page 15. Credit continues to remain very strong. We had net charge-offs of 7 basis points in the first quarter compared to 3 basis points of net recoveries in the prior quarter. Our nonperforming assets percentage was 16 basis points compared to 15 basis points in the prior quarter. While our allowance is 1.66% of period-end loans. On Page 16 are some key revenue metrics. On a reported basis, net interest income decreased 5.1% on a linked quarter basis. Excluding the impact of PPP, net interest income increased 6.9% due to higher loan growth and higher net interest margin. Noninterest income declined 0.8% on a linked-quarter basis due to lower retirement revenues offset by improved mortgage and wealth management.…

The first question comes from the line of Ben Gerlinger with Hovde Group.

Offset of this, I think there's been a lot of rumor and a little bit of speculation. And hopefully, we can put anything to . And I hate to start the Q&A off on this somewhat, somber tone, but Al, after you -- throughout the first pitch, did you cheer or for the further Yankees?

I cheer for baseball in general, but I appreciate the question there. I am -- my roots are from New York, but I've been in the Twin Cities for a long time. I support baseball in general, I love. So whoever win that game, I'll support off of.

Yes, of course, you cheer for whatever going that will be the Yankee. But anyway, so when you guys think about the market as it is today, obviously, of the different segments within the company and they're hold a different market forces. So the core bank should have higher rates coming forward used to have a stronger revenue. And with that, it gives you an opportunity to reinvest within the broader business overall. When you think about priorities and internal investment, where would you put that next incremental dollar? Is it there any one segment, that technology investment priority or anything to that degree that would allow Alerus to be better set up for the next decade?

I think Katie, take that one for sure.

Sure. Good question. And I referenced in my opening comments, the commercial banking being the catalyst for many components of our company. And so as we focus and laser in on where we bring the most value to clients, we are very much bringing. Obviously, Jim Collins on board, who is a proven leader and grower in commercial banking. That is where we're focusing on and growing our franchise because it does give us the opportunity to expand on the fee income at a very high level of success.

Got you. Okay. So it's a bit of a lead into a broader relationship, if I'm kind of squaring that circle a bit here. So -- and then my follow-up really kind of stems to the next kind of bigger picture question going forward. Is there any opportunity that you can trim out more expenses with throughout the franchise overall, assuming that kind of mortgage doesn't move? Or is it really dependent upon kind of -- I mean, if rates don't change much from mortgage, shouldn't change much, i.e. compensation doesn't change much. Is there anything from a structural perspective from an expense within that, that could improve overall profitability?

Yes. Absolutely.

I could take that one. Go ahead.

Sorry. Go ahead, Al.

Yes. So Jim has been on board here now for about 60 days, and he and I have been sinking up on various things, and I've been here for about a little over six months. As we kind of look at the structure, we do see that there's opportunity to kind of rightsize some expenses, but also, too, we're dealing with an inflationary environment right now is that we are dealing some of those inflationary pressures that are -- everybody else is dealing with what too. So for us right now, trying to keep expenses flattish in this high inflationary environment is, is our goal right now. But as we look for the long term, though as Katie is going to comment here as well and probably build on this is that we're trying to build a structure to that's going to allow us to grow for the long term because there's so much opportunity for us as we're -- as I kind of keep working every day and kind of understanding the potential of this Alerus story, Jim and I and everybody here see that there's so much runway for us to grow, and some of that growth has required investment as well. And that's what we're kind of trying to work on now that what is the investment and growth that we're going to make -- investments we're going to make to help support that growth for not just the short term, but for the very long term. Katie, do you want to add anything to that?

Yes. I would add. Yes, a key focus for us in the past three to five years has been on a couple of things. It's been on developing the credit infrastructure as well as bringing on technologies that allow us to be more efficient to grow. And so our opportunity to scale without adding overhead is impressive. And under Jim's leadership and our ability, as you can see by our past recent successes in bringing on talent, we think is the real catalyst to support that growth going forward at a higher level than what we've been with the right credit and operating infrastructure behind it.

Got you. That's helpful. If I can just sneak one more in. I know that the kind of the core bank is a bit of the gateway to all-encompassing relationship. And I don't think that you guys are on the hunt for necessarily a full bank acquisition today, but if you were to think about any incremental lender or any type of lending would be a banker or a team of banks or a team of bankers, is there any geography or any lending class that kind of is top list? I know don't think much of anything for high-caliber talent, but if you could kind of write the script on who the next incremental banking hire would be or would be that characteristic?

Sure, Absolutely. So C&I bankers, mid-market, strong treasury management, and we think we've got great opportunities here to do so in the Twin Cities. In regards to full bank acquisitions, we continue to look and we keep that funnel pretty wide at the top as we look at businesses that could add scale or just bring a client base that gives us that opportunity to expand relationships. But certainly, talent acquisitions, which we've done a number of continue to be our highest or one of our highest priorities.

The next question comes from the line of Jeff Rulis with D.A. Davidson.

Question on the deposit flows. Yes, I think the pandemic clearly disrupted kind of seasonality. And as you guys spoke to, I think you mentioned that I just want to check in on the confidence that you do see those public inflows, maybe you've seen some quarter-to-date, but I want to get a sense for -- the other part of that is there's seasonality, but there's also some changing deposit behavior and deposit retention. We're seeing some outflows for the industry. So just kind of your take on confidence and seasonality as well as are you seeing some kind of rate chasing activity as well?

Thanks for the question, Jeff. We actually just did a study on a seasonality approach, and it has been over the last several years, pretty much tried and true that those public funds go from us in the summer, and that's a couple of talking about them on the call today because -- and we're starting to see again a slight pickup again in the deposits from the public funds because it's just that the 2Q, a lot of those public funds are being used, a, for features, they've been paid out there in the summer and then they start building back in coming to fall. So we feel comfortable about that. But you're right, though, there is some seasonality that we're watching it very closely and especially with the Fed hike that just happened, we're just going to be watching behavior very closely. So that is definitely on our radar.

Outside of that public fund movement, do you -- are you seeing some of the other regular way customers kind of chasing raise? Or is there any piece of the deposit mix that you've seen that change quarter-over-quarter?

No, Jeff. We actually haven't. I mean the thing that's been really impressive here is how sticky our customer base is right now. We've been able to lag our deposit costs right now. And it's been -- there hasn't been a lot of movement out there. And that's why our -- when I said that we're expecting our deposit beta pick up, it's still below what I would have anticipated to be in a rising rate environment like this. So it's been a pleasant surprise for us to see how -- for me, I should say, because I've only been here for six months, how sticky our customer base is.

Got it. I want to circle back on the expenses. I know you tackled kind of some structural big picture efficiency-type questions. But the -- could you remind us of the timing now of where you think Metro Phoenix, the conversion of that occurs and what maybe could be carved out on the targeted cost saves with that and timing?

Yes. So we're targeting conversion in later part of third quarter this year -- I'm sorry, third quarter of this -- so sometime late in the third quarter, we in a conversion. We are still anticipating the cost saves that we've originally disclosed, but it's going to be -- there might be just a little bit plus or minus in that range, I'd say, just a little bit.

Okay. And then lastly, just maybe housekeeping related to the deal. Any kind of adjustment on goodwill or tangible book dilution, given sort of rate movement we've had. I don't know if the marks change, but basically at announcement, are those -- any update on goodwill or tangible book impact?

Yes. Actually, we just got those in not just recently, and I'd say that there's really no change to that. And that's why I put that highlighted in the guidance that we still don't anticipate a material impact to our tangible common equity or capital ratio. So we just got those marks in.

The next question comes from the line of Nathan Race with Piper Sandler.

Yes. I appreciate the guidance for retirement and benefit services revenue in 2Q. But I think in longer term, love to get an update just in terms of just with the natural attrition within . How you guys are kind of thinking about the opportunity to add clients organically with your sales efforts and also just given how you guys have kind of increased the capture rate as plan participants and to return when you guys onboard those assets into wealth management and kind of how that translates to future growth after 3Q, assuming equity markets kind of stabilize from here?

Katie, do you want to take that one or do you want to take that one?

So I'll start and then you can fill in, Al. Nate, thank you for the question. In regards to retirement, as I mentioned in my opening comments, we are seeing a higher level of new plan sales than we have in previous years as well as reduced levels of attrition. And so many of those plans are not asset based, the new plans, many of them are on a per plan, per participant base. And so we've got a couple of tailwinds, I believe, certainly the market on the asset-based fees as well as on the new plan basis. And as those plans grow, our fee income naturally increases at participation in the plan increases. So that's one catalyst of the growth and then commercial client expansion. So as we grow our commercial banking client base, our typical success rate with commercial clients is about 50% and also getting the retirement plan over time. It doesn't always come day 1. But certainly, as the relationship develops, we absolutely get a chance to talk to the clients about the services that we can offer. And half the time, we end up getting that plan to transition to us. And again, the retirement business is a significant feeder system to our wealth management business and more than it has ever been in the past. We've always been good at capturing rollovers on a reactive basis. And over the course of the past year or two, we've been much more focused on being proactive with that participant base, engaging with those individuals that are potentially nearing retirement or are just in a place where financial planning is something that they're thinking about and something that they're in need of. And so that opportunity within that division is significant for building out the rest of our fee income opportunities in the future.

Yes. I think Katie gave a great overview. The only thing I could add to that is that our leader in the retirement business, Rob Woytassek. He's really stepped in and really done a great job in that commercial client expansion story there. And he's identified opportunities for us to really kind of get that overlap and synergies in terms of deeper penetration with our clients. So we've already seen some initial success in that commercial expansion strategy, and he's targeted some opportunities for us, and we're going to continue executing on that probably for foreseeable future.

Got it. And just going back to what Katie said initially in terms of kind of the mix shift change in clients being added. I imagine that also reduces kind of the market sensitivity of this revenue source going forward, if I'm kind of hearing you guys correctly?

Right. It does. Most of the new business is not all tied to asset base. Some components of it, trust and custody, of course, would be advisory services, would be that the administrative and recordkeeping tend to be more tied to just a per plan fees and per participant fees.

Okay, great. And then, if I could just kind of switch gears and kind of think about overall balance sheet dynamics. With Metro Phoenix adding roughly $450 million or so in earning assets here in the third quarter, how do you guys kind of think about overall deposit flows from here? It sounds like you guys are going to compete on deposit pricing going forward? Is it kind of fair to expect kind of the earning asset base kind of stabilizes around $3.5 billion from here? Or how do you guys kind of think and that would in turn kind of support margin expansion just given kind of the asset-sensitive nature of your balance sheet? Or how are you guys kind of just thinking about the overall balance sheet flow and just level going forward?

Yes. Thanks for that, Nate. This is -- as we think about the balance sheet right now, I mean, I highlighted in there. I mean, we are seeing really strong loan growth. And on our -- just on a lower stand-alone basis, we're thinking high single digits there on a linked quarter basis. But Metro, talking to that Steve Haggard down there, we are really excited about the opportunity and we're expecting that book to grow in the double-digit range as well. Our preference is loan growth right now with a 14.19% Tier 1 capital, common Tier 1 capital. We have a lot of dry powder to support loan growth and we'd like to keep supporting that loan growth. So right now from an investment portfolio side, though, we're kind of letting some of that stuff mature and to help continue to support the loan growth there and remixing the balance sheet just a little bit. But with that loan growth we're putting on to, we're going to have -- we're expecting deposits to come and help support that as well from a funding standpoint.

Okay. Yes. And so just given the ongoing earning asset mix optimization with loan growth remaining strong year in the third quarter. And just given kind of the asset sensitive nature of the balance sheet, is it kind of fair to expect the margin to get kind of north of $3.20 and perhaps even north of $3.50 in both the third quarter and fourth quarter, respectively, of this year?

Yes, so on that, we -- NIM is always kind of an output function for us, but we are expecting growth in that right now. The question right now as we're pretty much having pretty frequent discussions on deposit pricing because we don't monitor it, given that the rapid raise in rates. It's hard for us to really say where it's going to pinpoint. But the one thing I could do say is that with Metro coming on board, though, there's going to be an uplift to our NIM, especially because their margins are definitely higher than us, probably in the tune of, I want to say, 40 to 50 basis points. If you look at their year-to-date performance for us and you're stripping up PPP for both companies, so they definitely have -- they have a lot higher margin for us, and that's going to help our margin as well. But again, one thing what I'm tempering it just a little bit now is that given what Jeff asked about previously question that we have a lot of rise in rates. There's -- we're just watching the deposit dynamic right now.

Got you. Makes sense. And if I could just ask one more. Credit has always been kind of a nonissue for you guys historically. And that remained the case in the second quarter. By and large. So just kind of thinking about the SBA team that you guys added in the Twin Cities fairly recently. And then I believe you guys are picking up an SBA team in Phoenix as well. And I guess, generally, that asset class has looked at higher -- looked at as kind of higher risk reward. So I guess I'm just curious if just given all the rate pressures that's impacting small businesses these days, if your plans to continue portfolio production, is still intact and kind of how you guys shift, if at all, kind of your underwriting approach to SBA relative to kind of conventional commercial loans?

Karin, do you want to take that?

I think in this environment, we're certainly looking to continue to grow SBA from a relationship perspective, but we'll also look at the potential to sell some of those on the secondary market. I think we're open to both approaches. I don't see us changing our underwriting standards. I think we've got strong standards in place and certainly with the guarantee that affords us a level of protection.

Okay, great. And sorry, perhaps one more for Katie. Just you touched on whole bank acquisition opportunities. But curious to maybe get an update in terms of what you're seeing in the retirement and benefit services space for additional deals there?

Yes. We continue to increase our sources in regards to partnering with advisers across the country who are in the business, finding these businesses and positioning them to sell within one, two, three, four years. And so that helped us grow our pipeline and get into a higher levels and volume of conversations. And so that's -- we're very pleased with that activity. There continues to be competition in the space, which I think just speaks to the value of the business of retirement and the annuitized fees and the lack of capital that has to be allocated to those fees. And so we like where we're at from a conversation from a pipeline standpoint, and we like even more, what we've got because clearly, there's tremendous value within that business unit.

This concludes our question-and-answer session. I would like to turn the conference back over to Katie Lorenson for closing remarks.

Perfect. Thank you. And thank you, everyone, for joining our call this morning. We thank you for listening. We thank you for the great questions. I'll close with just a few comments regarding clearly, our industry is facing some headwinds. Our company has historically outperformed, and we remain well positioned for future success because of our diversified business model and the momentum we're seeing in building our pipeline for new business, our client expansion across all products and the high level of engagement we have within our team and our leaders is very special. So we are very proud to be where we are. We remain focused on working together to grow our company and the steady and strong foundation that we have is allowing us, again, to differentiate ourselves as we go out to the market and invest and recruit and retain top talent as well as serving the best interest of our clients and deliver long-term value for our shareholders. So, we thank our shareholders for their investment. We thank our team members for bringing value to our clients each and every day, and we thank all of you for your continued support and interest in our company. Have a great day, everyone.

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