Old Second Bancorp, Inc. (OSBC) Q3 2016 Earnings Report, Transcript and Summary

Greetings, and welcome to Old Second Bancorp Third Quarter 2016 Earnings Conference Call. At this time, all participants are in listen-only mode. An interactive question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Mr. Doug Cheatham. Thank you, you may begin.

Thank you. Good morning, everyone, and thank you for joining us. I will start with a reminder that our comments today may contain forward-looking statements, which are based on management's existing expectations in the current economic environment. These statements are not a guarantee of future performance and results may differ materially from those projected. I ask you to refer to our SEC filings for a full discussion of the company's risk factors. With me today are Mike Kozak, Executive Vice President and Chief Credit Officer and Jim Eccher President and CEO. And now, I'll turn it over to Jim.

Thanks Doug and good morning everyone. Thank you for joining us today for third quarter earnings call. I have a few opening remarks and then will give my overview of the quarter and turn it over to Doug and Mike for more detailed report on our operating performance in our recently announced acquisition of the Talmer branch and then we'll take your questions at the end. Third quarter operating performance was mostly positive in many areas. Core earnings continue to show improvement as key business lines reported improved results. And as we've discussed in prior quarters, we've been very focused on building and growing quality earning assets and we feel we made very good progress particularly in building the loan book this quarter. Reported third quarter net income available to common stockholders is $3.5 million, or $0.12 per diluted share compared to $3.6 million or $0.12 of per diluted share in the third quarter of 2015. We did incur some meaningful acquisition related expenses in the quarter that led to lower earnings, adjusting for the nine core items would have added an additional $0.04 to earnings per share in the quarter which is about 23% greater than last quarter and approximately 33% better than the same quarter a-year-ago, Doug will provide additional color in his prepared remarks shortly. On August 01, we agreed to acquire the Chicago branch of the Michigan based Talmer Bank & Trust including approximately $80 million of deposits and approximately 238 million of loans. We have received all regulatory approvals and expect to close in the fourth quarter. We view this acquisition is very attractive and strategic for our Company on many levels. In addition, to bringing the board of veteran Chicago management team we are adding several in-market commercial managers with deep relationships in the Chicago market. Our new relationship managers with the Talmer Group have done a great job with client retention; they have actually started cultivating new opportunities during challenging transitional period. For our company expanding into an attractive Chicago office will provide additional future, organic growth opportunities along with the potential add additional Chicago based bankers. We expect the financial impact of the transaction to be accretive to earnings per share and 2017 by greater than 15%. Additional highlights in the quarter included solid long growth, a stable net interest margin, very strong performance in our mortgage business, controlled noninterest expenses and continued good credit performance. So, overall we're very encouraged by our progress this quarter and we feel we are very well positioned with our low cost deposit base and future prospects for quality growth heading into 2017. And with that I'll turn it over to Doug.

Thanks Jim. As Jim mentioned, net income in the quarter was $3.5 million or $0.12 per share compared to $3.6 million or $0.12 per share in the third quarter of ’15. For the year to date, net income was $10.7 million or $0.36 for share compared to $9.7 million or $0.33 per share in 2015. Earnings in the quarter and the year-to-date were impacted primarily by $2 million in losses on security sales. These securities were sold in order to execute the purchase of the Chicago branch of Talmer Bank which is now Chemical Bank that we announced on August 01. As far as its immediate impact on earning assets, we are shifting from securities to loans at a materially higher yield. I would also add that while the investment portfolio was reduced by over 200 million during the third quarter the book yield increased from 2.32% to 2.55%. As Jim mentioned, on an after tax basis, the loss and securities related to the branch purchase was about $0.04 per share for both the quarter and the year-to-date. The net interest income was $15.3 million in the third quarter compared to $14.8 million in the third quarter of 2015. For the first three quarters of the year, net interest income was $45.9 million in 2016, compared to $44.3 million in 2015. In large part, the increases are related to loan growth of $70 million from September 30, 2015 to September 30, 2016 which increased earning assets by similar amount. The net interest margin was $322 in the third quarter of both 2015 and 2016. The net interest margin was $325 in the first nine months of 2015 and $323 in the first nine months of 2016. Non-interest income was $6.6 million in the third quarter of 2016 compared to $5.6 million in the third quarter of 2015. The securities lost in the third quarter of 2016 and the loss and disposal of fixed assets in the third quarter of 2015 which gives this comparison. Excluding these two items, non-interest income increased from $6.8 million in the third quarter of 2015 to $8.6 million in the third quarter of 2016. However, for the year-to-date, this figure declined from $23.1 million in the first nine months of 2015 to $22.1 million in the first nine months of 2016. These differences were significantly impacted by two related items, the mortgage division had an excellent quarter and at the same time the value of mortgage servicing rates continued to decline. Gains on sales and mortgage loans were $2.2 million in the third quarter of 2016 compared to $1.4 million in the third quarter of 2015, an increase of 800,000. For the year-to-date gains on sales with mortgage loans were $5 million in 2016 compared $4.7 million in 2015 or about $300,000 higher. Also, we had marked to market losses of $147,000 in the third quarter of 2016 compared to a loss of $688,000 of third quarter of 2015. However, we had marked to market losses of $1.9 million in the first three quarters 2016 compared to $1.2 million in the first three quarters of 2015. This is a category that tends to being negative when interest rates fall and positive when interest rates rise. Non-interest expenses were $16.6 million in the third quarter, this was an increase of $338,000 from the third quarter of 2015 and a decline of $118,000 from the second quarter of 2016. Non-interest expense were $52.3 million in the first nine months of 2015 and decline of $14.5 million in the first nine months of 2016, a decline of $2.8 million or 5.3%. Efficiency has improved as the efficiency ratio declined from 73.66 in the third quarter of 2015 to 66.69 in the third quarter of 2016 and for the year-to-date period, the ratio was 70.88 in 2015 and 68.83 in 2016. And finally I want to return to the overall earnings picture. For comparative purposes, if we use pretax pre-provision earnings and also exclude the securities loss in 2016 and the loss and disposal of fixed assets in the third quarter of 2015, we have what I would call before earnings, this figure was $7.3 million in the third quarter of 2016 compared to $5.4 million in the third quarter of 2015. For the year-to-date core earnings were $18.6 million in 2016 and $15.2 million in 2015, an increase of $3.3 million or 21.9%. Now that hopefully provide some perspective on earnings for the quarter and the year-to-date, now I'll turn it over to Mike.

Thanks Doug. As Jim mentioned, our loan growth was strong during the third quarter, reporting an increase in the loan portfolio of 3.6% from the June 30, quarter end and up 6.1% from 12-31-15 yearend. This increase for the nine months period was over 60% in the C&I Books, so we are very pleased about that. Credit quality continues to trend favorably as well. Our credit metrics improve with NPA at 2.59% at quarter end compared to 2.94% from the prior quarter. With the expected addition of the approximately 238 million in purchase loans from Talmer Bank, the NPA ratio will reduce to below 2.2% based on nonaccrual pay-off commitments and OREO sales contracts that we have in place, NPAs are expected to further reduce to probably around the 2% level by yearend. So again we continue to make good progress on that front. In terms of the categories, non-accrual loans decreased by approximately $1.5 million in the quarter due in large part to charge downs based on updated appraisals on two of our non-accrual loans, our problem accruing loans did increase by 2 million in the quarter as a result of the migration of two loans that we previously had in special mention to the problem loan status. OREO assets decreased by $2.1 million in the quarter, largely due to the sale of 11 properties, valuation write downs for the quarter totaled 365,000 compared to 489,000 in the prior quarter. As far as charge offs for the quarter, the gross charge offs were 1,197,000 against recoveries of 358,000 for a net number of 839,000. And just to comment on the pending purchase of the Talmer loans to 238,000 million portfolio, we don't expect this to have a significant impact on our portfolio mix. Our calculation is that investor real estate loans in the combined portfolio will increase from 26% to 29% C&I loans will increase from 15% to 17% and owner occupied real estate loans will actually reduce slightly from 24% to 22%. So with those comments, I will now turn it over to Jim.

Thanks Mike. At this point Matt we can turn it over to you and open up to questions.

At this time we are conducting the question and answer session. [Operator Instructions]. Our first question comes from Chris McGratty from KBW. Please go ahead.

Good morning. Jim, may be a question for you, you're getting at loan growth that we've been waiting for which is great, and you have got the momentum with Talmer, how should we thinking about any expenses that need to come from additional hiring of lenders or kind of as you build out this business, maybe that will help on kind of the expense run rate for the next few quarters.

Sure. With the Talmer Group, we're picking up obviously a very seasoned management team but we're also. It’s almost like a team lift out. I guess if you look at it that way Chris we will be picking up six very experienced Chicago based lenders. We do anticipate some cost saves with the integration. So we'll have a probably on that basis, probably an addition of three lenders when it's all said and done.

So we should think of kind expense run rate that's in kind of in [below] 16, kind of pick up from here as you are investing in the business or are there other areas to kind of pull cost of the company?

I think we can probably expect some moderate increase in overhead because we are picking up a pretty good lending team here but as always we continue to look for operating efficiencies and we've got some things we're working on in future quarters.

And maybe Doug, on the credit quality, it continues to move in the right direction, as we think about the kind of the accounting impact from this portfolio purchase, how should be thinking about future provision and requirements. You haven't done provision in quite some time but of course picking up, I assume this will be marked to market, you wanted to provide for what's on the books but how about, maybe a little bit on the reserve ratio and kind of provision your requirements please thanks.

Well, obviously we've had some pretty good growth. And we haven't done a provision in a while so logically we're getting closer to that point. However the trends are all still good. So we'll have to run it through the process and see where we are in the fourth quarter. I do think the portfolio that we're buying is very clean. So we did a very deep dive in due-diligence headed by Mike and so we feel really good about the quality of the portfolio we're taken on but with growth it's logical but at some point we'll need to take a look at that.

Right and then maybe one last one and I will hop back. The earning assets we mix, just kind of told here, natural that will be accretive to your margin, kind of working your way through that and kind of balancing the environment, is kind of the high 330, around 340 about where the company operates in this environment, kind of when it's all said and done.

Well, I don't want to put a prediction out there and where the marginal will be. Certainly, the addition of that loan portfolio is pretty significant boost and with the securities we selected for sale in order to do the transaction, we were able to increase the overall yield of our investment portfolio at the same time. So I feel very safe saying it's going to be higher but I hesitate to give you a number on the call here.

Okay, thanks for taking the question.

Thanks Chris.

Our next question is from Andrew Liesch from Sandler O'Neill, please go ahead.

Hey guys, how are you?

Good morning Andrew, how are you?

Good morning. Good to see that the loan growth coming in this quarter, just kind of curious to see if you have comments, on where the pipeline stands, heading here into the fourth quarter, was some of this growth in the third quarter pulled forward or what's your outlook generally for loan growth coming up?

So, Andrew, generally fourth quarter for us, historically has not been as strong as a second and the third but we are seeing pretty good activity in deal we saw early in the quarter we expect it to slow down obviously around the holidays and then we obviously got the Chicago Talmer Group team joining us as well. So we're hesitant to get a lot of guys but we are more optimistic about the fourth quarter and first quarter than may be we were over the past couple of years.

Great and then just one quick question on the security sales, do you have a plan of any more that was done on third quarter is that correct?

That's correct.

Okay, that's all. Thanks so much.

[Operator Instructions] and our next question comes from [indiscernible] Please go ahead.

Good morning guys. Most of my questions have been answered. I just wanted to confirm. So, Doug I think when you said you cleanse the quarter, if I'm not mistaken, it looks like an operating earnings would have been about $0.16 for the third quarter. I just want to make sure that's in line with what you guys sort of said.

Yes, I mean if we take that $2 million loss and we have some other deal related expenses and tax effect that it would have been about $0.04 per share.

Okay and then again the accretion income to 2017 that sort of based upon your run rate for 2016, correct? Wasn't that?

Yes.

That’s good. Nice quarter guys thank you.

Thank you.

[Operator Instructions] And our next question comes from Brian Martin from FIG Partners, please go ahead.

I joined a bit late to say if you already covered this, I will apologize in advance, but just one Doug, if you could just talk a little bit about the expenses going forward and just kind of opportunities to improve the run-rate, just kind of, if there's anything you guys are looking at specifically that help that number going forward and then maybe just separately on the credit expenses kind of, I guess I thought the trend is continuing to go lower.

Right. Okay, first on non-interest expenses, we don't have any specific things to announce or anything like that. Of course we've been pretty successful over the time of bringing things down, expenses down as opportunities present themselves but nothing specific on the horizon. We will of course have some expenses with the branch acquisition. Obviously that's a clear net positive but we'll have some expenses associated with that. We'll try to offset that at least in part by saving on this side on the second side of it but I don't see anything major that we can do on the expense side just more of a singles and doubles instead of home runs to continue the playoff metaphor. On as far as credit expense I kind of just answered that I mean I think the portfolios getting bigger and bigger. The credit trends have been very good but at some point we'll have to and we run it through a fairly rigorous process each quarter and at some point that's going to result in a provision. But I hesitate to try to predict exactly what will happen and when.

Brian, during the call in our comments we indicated our valuation write downs for the quarter were 365,000 compared to roughly 500,000 in the prior quarter. So valuation seem to be stabilizing before 11 properties during the quarter. So things are moving along quite well.

Perfect. And then maybe just a question on the loan growth, obviously with the new edition coming out, we are going to benefit, we've heard from some other banks just with the C&I demand is a bit sluggish, a little bit down, when you guys look at kind of legacy absent, the acquisition here I mean how would you characterize C&I demand across the market, if you didn't have the acquisition, I mean would you expect to see some sluggishness and I know you have talked about the seasonal fourth and first quarter but just kind of beyond the seasonal issues, are you seeing a slowdown or may be just skipping the time that will be helpful.

When we look at our production numbers for the last three quarters, we're consistently seen roughly around 60% of it is C&I, so while I would acknowledge that the market is very competitive, we are getting our lucks and we're seeing a number of opportunities. We have been purchasing some lease paper from one of our correspondent banks which has helped a little bit as well. But again, pretty consistent out of about 60% of our new growth for our new production for the last three quarters. So obviously we hope that continues to sustain itself.

Okay, all right that’s all I have, thanks guys.

Thanks, Brian.

I’d now like to turn the floor back over to management for any closing comments.

Thanks for calling in today and we appreciate your support and we look forward to talking with you again in the fourth quarter. Thank you.