Old Second Bancorp, Inc. (OSBC) Q4 2016 Earnings Report, Transcript and Summary

Greetings and welcome to the Old Second Bancorp's fourth quarter 2016 earnings conference call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. Doug Cheatham, Executive Vice President and CFO. Thank you Mr. Cheatham, you may begin.

Thank you. Good morning everyone and thank you for joining us. I will start with a reminder 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 this morning are Jim Eccher, President & CEO. Mike Kozak, Executive Vice President and Chief Credit Officer, and Gary Collins, Vice Chairman. And now I will turn it over to our President and CEO, Jim Eccher.

Good morning. Thank you for joining us today for our fourth quarter earnings call. I have a few opening remarks and will give you my overview of the quarter and turn it over to Mike and Doug for a more detailed report on our operating performance and our recently closed acquisition of the Talmer Branch, and then we'll take your questions at the end. Fourth quarter operating performance was highlighted by solid organic loan growth and the completion of the Chicago Talmer Branch acquisition. Core earnings continued to show increased momentum on the strength of solid growth and net interest income. We continued our strategy of generating quality earning assets, particularly in building a loan book this quarter. The acquisition of Talmer and strong organic growth helped drive a 23% increase in the loan book for the quarter. It was a particularly strong quarter, in that even excluding the acquired loan book; the loan portfolio would have posted 18% annualized growth. With that backdrop, I will start with some of the quarterly highlights. Fourth quarter net income available to common stockholders is $5 million, or $0.17 per diluted share, compared to 3.8 million, or $0.13 per diluted share in the fourth quarter of 2016. For the year ended December 31, 2016 net income available with common stockholders was 15.7 million, or $0.53 per diluted share, as compared to 13.5 million or $0.46 per diluted share for the year end 2015. As we reported in the third quarter, we agreed to acquire the Chicago Branch of Michigan based Talmer Bank and Trust, including approximately $49 million of deposits and approximately $221 million in loans. The transaction closed October 28, and we realized $604,000 in purchase accounting accretion in the fourth quarter. More importantly the transaction, the conversion and integration with the Chicago team has progressed extremely well. Our new relationship managers with the Talmer Group have done a great job with client retention. And have already cultivated new opportunities that will lead to strong organic growth in the coming quarters. And as we reported last quarter, we expect the financial impact of the transaction to be accretive to earnings per share in 2017 by greater than 15%. In addition to solid loan growth, some additional highlights in the quarter included an expansion our net interest margin, improving credit trends, control non-interest expenses and improvement in our core funding base. As a result of the Talmer acquisition and approved earning asset mix, our net interest margin jumped 32 basis points in the quarter. Doug will provide more color around margin in his prepared comments. Overall, we are very encouraged by our progress this quarter and in 2016. We also feel there is room for improvement with a stronger performance expected in our wealth management, and treasury groups next year, as we invested additional resources in those divisions. In closing, we feel generally optimistic heading into 2017. And we feel we are well positioned to continue the momentum we have built in last few quarters. With that backdrop, I will now turn it over to Mike Kozak, our Chief Credit Officer for more detail on credit and the loan portfolio.

All right. Thanks, Jim. Again, I will be providing a little more information on our loan book as well as some of the basic credit metrics. Loans increased by $276 million, or 23% from the third quarter. As Jim indicated, excluding the $221 million in loans we acquired in from Talmer Bank in October, our loan growth was $55 million from Legacy Bank. That is about 4.6% increase from prior quarter. The main segments of the $276 million in quarterly loan growth were C&I owner occupied real estate about 42%, investor real estate 36%, construction and development 13%, and multi-family 5%. Credit metrics are also noteworthy in the improvement with NPAs reducing to 1.87% compared to 2.59% from the prior quarter and down from 2.93% from the prior year-end. Non-accrual loans were reduced by $1.5 million from the prior quarter to $15.3 million. There were 15 non-accrual loans totaling $4.5 million that were repaid during the quarter, while there were 15 loans totaling $3.3 million that were added in the quarter. I should mention that one of these additions of non-accrual was for $1.2 million and was a retail strip center that we previously rated as a problem credit. In addition, there was approximately $300,000 in normal repayments on various non-accrual loans. Problem loans were reduced by approximately $300,000 from the prior quarter to $11.2 million. There were three loans totaling $1.5 million that were removed from problem status. One of these was above referenced $1.2 million retail strip center which moved to non-accrual. There was only one loan totaling $1.4 million of C&I credit that did move to problem status in the quarter. And based on current information we have on that credit it is trending favorably, so we are cautiously optimistic on that front. In addition, there was approximately $200,000 in repayment on various problem loans. We also had good success in our OREO portfolio. OREO was reduced by $2.2 million from the prior quarter as a result of the sale of 15 properties. There was only one property that was added in the quarter and that was for $560,000 approximately. Valuation write-downs for the quarter totaled $265,000 compared to $365,000 in the prior quarter. Of the $11.9 million in OREO, approximately $8 million is land carry. There are only two properties with a basis over $1 million, with the largest being $2 million. Charge-offs for the quarter was $683,000. While recoveries were $1,108,000 for a net recovery of $425,000. That concludes my comments and I will turn the call back to Doug now.

Thank you, Mike. Yesterday we announced fourth quarter net income of $5 million, or $0.17 per share, compared to $3.8 million, or $0.13 per share in the fourth quarter of 2015. For the full year net income was $15.7 million, or $0.53 per share, compared to $13.5 million, or $0.46 per share in 2015. Net interest income was $17.5 million in the fourth quarter, a $2.8 million, or 18.7% increase year-over-year, and a $2.2 million, or 14.1% increase sequentially. In percentage terms the net interest margin ratio was 3.54%, compared to 3.22% in the third quarter of 2016 and 3.17% in the fourth quarter of 2015. As we discussed in the release, the acquisition of the Chicago Branch helped fuel this increase with $221 million in loans and purchase accounting accretion of $604,000 in the fourth quarter. Non-interest income was $8.4 million in the fourth quarter, compared to $7.4 million in the fourth quarter of 2015. For the full year, non-interest income was $28.6 million in 2016 and $29.3 million in 2015. As we have previously discussed $2 million in security losses were incurred to fund the branch acquisition. Excluding securities losses, non-interest income was $8.6 million in the fourth quarter of 2016 compared to $7.4 million in the fourth quarter of 2015. This increase was almost entirely due to increased mortgage banking activities, especially a $1 million write up in mortgage servicing rights. For the year, non-interest income excluding securities and excluding a one-time loss on fixed assets that occurred in 2015 was 30.8 million in 2016, compared to 30.6 million in 2015, or essentially flat for the full year. Non-interest expense was 17.2 million in the fourth quarter of 2016, compared to 16.1 million in 2015. As explained in the release this increase was primarily related to the branch acquisition. However, even with these added costs non-interest expense declined 1.7 million to 66.8 million for the full year. The efficiency ratio was 61.78% in the fourth quarter of 2016, compared to 69.59% in the fourth quarter of 2015. For the full year the efficiency ratio was 70.49% in 2015, and 66.76% in 2016. As I pointed out in previous conversations, one of the best things we can do for the efficiency ratio is to increase the net-interest margin. This quarter shows the impact that the income side can have on the equation. In the fourth quarter we paid off subordinated debt of 45 million and replaced it with the proceeds of the senior debt offering of 45 million. The senior notes mature in 10 years interest will be fixed at 5.75% for five years and then float at 385 over LIBOR. While this is a step up in interest costs, as sub debt was set to mature on March 31, 2018 so this gets that issue behind us. At this point, other than overnight funding, our debt structure consists of senior debt of 45 million, that I just described, trust preferred of 25 million at 6.766 until June 15 of this year, which will then go to 4.35% fixed. So this decrease will offset some of the increase related to the senior debt, and trust preferred securities of 31.6 million at 7.8% fixed. This being the highest cost instrument in our debt structure would be a potential to take out at some future point; however it is tier one capital. Capital ratios declined in the quarter but are still at healthy levels. The declines resulted from an increase in total assets; a shift in risk related assets related to loans acquired offset the sale of lower risk weighted securities, and the addition of intangible assets resulting from the branch acquisition. All regulatory ratios at the Bank and the Holding Company are well above required levels. The consolidated tangible common equity ratio, which is not a regulatory ratio, was 7.41% at year end, and it will increase with retained earnings. Finally, I want to recap the branch acquisition now that we have a full quarter under our belt. We paid a $6.5 million premium. With that we acquired 221 million in loans and 48.9 million in deposits. The final mark on the loans was about 2.8 million and the core deposit intangible was 660,000. Goodwill is about 8.4 million. August 1, when we announced the agreement we estimated 4% dilution on 2016 earnings, and 15% plus accretion in 2017. Based on current run rate and trends I would reiterate that estimate. And now I will turn it back over to Jim.

That concludes our prepared comments. At this time we will turn it over to the operator and open it up for any questions.

Thank you. [Operator Instructions] Our first question comes from the line of Chris McGratty with KBW. Please proceed with your question.

Good morning everyone thanks for taking the question. Jim, maybe a question on loan growth. Obviously the organic growth was really strong; I am interested in the pipeline in the outlook commentary. Whether the pipelines will pull forward or how you're feeling about 2017 loan growth?

Sure, Chris. It was a very strong fourth quarter. In fact we had quite a bit of business that closed earlier than we anticipated. We are pretty optimistic about next year. Although certainly the run rate based on the fourth quarter is probably realistic at 18%, but we feel high-single-digits is a reasonable target.

Okay. And maybe Doug one for you on the margin, certainly the remixing played a big role in the expansion. Help us if you could, the outlook for the net interest margin from here and your expectations for future rate increases and how that might flow through the numbers.

Well, I think on the second part first, I think rate increase would help us. Our balance sheet even though we shifted a large amount from securities to loans is still positively impacted by an increase in rates. As far as the margin going forward to the extent that we can continue to shift from securities to loans, of course that's a positive. We may begin to see competitive pressure on the deposit side. But that remains to be seen. Traditionally, the whole industry tends to drag their feet and increasing deposit rates in an up cycle. So we will probably be okay there. And we do have, this quarter it was $604,000, we do have the purchase accounting adjustment that works through as loans mature or are paid off early. It was $604,000 in the fourth quarter. We will have some of that going forward into 2017. But it may not be non-necessarily consistent quarter-to-quarter but that will be a benefit as that neck gets folded in as well. That added about 8 basis points to the net interest margin in the fourth quarter.

What is that declining pool of accretion? What is that doing? Will it come in over the next couple years?

Let me look for that while we go forward here. I think I can get that. It is about $1.3 million.

That is how much is left over the life of the?

Yes.

Okay. Great. And maybe a last one if I could on the remixing, Doug. In terms of the dollar amount of the investment portfolio does that continue to strength as you replace with loans or is it more of a percentage basis that we should be looking at?

Probably more percentage basis. I think, we are going to be looking at increasing assets; previously we were looking strictly at mix but now I think we are more positioned to grow.

All right. Thank you very much.

Thanks Chris.

Thank you. Our next question comes from the line of Andrew Liesch with Sandler O'Neill. Please proceed with your question.

Hi, guys. Just a quick question on the provision for me, I, presumably there was quite a bit related to that the organic growth we had this quarter, is this the level that you may be providing for, regardless of charge-offs and recoveries for the pace of growth? Or do you think this provision was more outside this quarter given where the loan growth came in?

I think it was a little bit outsized. But we are certainly at an inflection point right now. Where any future growth will likely need to begin a consistent provisioning process here. So I would expect similar provisioning going forward, assuming our growth rates at high-single-digits.

Got you. And then the Talmer deals obviously helped. Any other acquisition opportunities out there in your markets that you might be looking at?

You know, our first order of business, Andrew, is obviously we have got very good organic loan growth momentum. That is our first priority. If an opportunity does come along we will certainly consider it. But we feel our operating leverage is improving. We still have a ways to go on the efficiency side that working hard with and we feel our first order of business is continue to grow organically.

Very good. Thank you for taking my questions.

[Operator Instructions]. Our next question comes from the line of Brian Martin with FIG Partners. Please proceed with your question.

Hey, guys.

Good morning, Brian.

Doug, just the part about the accretion and I think you said it was 600,000 this quarter but there's only 1.3 million left to come in over time. So it could drop pretty dramatically in the coming quarters if you will, from this quarter's level? Or did I hear that wrong?

I want to correct that number.

I thought the mark was around 6 million versus 2 million but maybe I was wrong.

The loan mark was about 2.7 million and I was quoting that consists of two pieces. One is a credit mark and the other is a market value mark. Combined they were about 2.7 million. So that would leave about 2.1 million remaining going forward. I want to correct that for Chris' question as well.

Got you. That is helpful. Thanks. And then just going back to the margin for a second, outside of the accretion Doug, the rate changed in the fourth quarter of December there, can you give some color as to how much of an impact that's had on the net-interest income just the recent rate increase? A guidepost to think about, if we see other rate increases later this year. How much has that benefited you? And then just secondly on the margin, I assume if the Talmer deal closed when it did timing wise, there is still a bit more upside to that margin this quarter just as you realize a full quarter impact in the first quarter. Is that accurate?

Yes. Well, as far as the rate increase, I forget the date the Fed changed, but that was not a full quarter either. But you're correct with regard to the branch acquisition. We closed that on October 28. So we had roughly two thirds of a quarter with that in house. So the impact is on a full quarter would be a little bit more than that.

Okay. The rate change, I realize it came late in December, but I guess your thought right now as how much of a benefit that provides based on what you have seen as far as maybe not seeing deposit pricing pressure? Is it is a couple of basis points is it something more significant than that, from what you're seeing thus far early on?

I do not have a ready number to give you on that. Your interpretation is correct. We have a interest sensitive balance sheet. Rates are not going to move real quick so there will be, I would expect, some upward movement. But I do not have a number to give you at my fingertips.

Okay. But that upward movement would be in addition to what you will get from the Talmer upward for the full quarter?

That’s correct.

Perfect. Just going back to the balance sheet and remixing. You talked about a continued shift from securities to loans. Can you talk about what you're targeting there? Where are you at today? And where would you like to be as some of these loans from the acquisition materialize and the growth maybe momentum continues? Here on at least on the loan side?

Well some of that may we will need to manage as we go forward. I think at this point, it's going to be less of a remix than we did previously, and more of just continuing to manage the balance sheet. Depending on growth, it may be more a matter of maintaining a percentage of assets, rather than strictly a remix. But that much remains to be seen.

Okay, so the securities percentage of assets today, the thought would be if that stays consistent with that, as you go forward? Or do you think that drops a bit from where it is that today?

Probably within the range it is now.

Okay.

Brian, we still have some opportunities to take out some leverage and re shift if it is optimal. We will get about 24% of the securities portfolio as a percentage of assets, about 80% loan to deposit ratio. We feel like we can still increase our leverage a little bit but we are at a point now where we would like to start growing at core funding base again. And we are confident we are going to be able to do that. But we are clearly trying to optimize the balance sheet still.

Okay. Perfect that’s helpful, Jim thanks. And just the last two things for me. The MSR write up this quarter. Is there any more opportunity for that or did this take care of what was out there? Where does that stand today?

It could increase in the future because it is so interest rate based. Although, there is other aspects to that asset as well. Because the servicing on that can actually be reduced depending on refis or payoffs. So there is a number of variables. But in terms of interest rate expectations there is some upside there.

Okay. I got you. All right. The last thing for me, just on the credit side it sounded like, Mike and Jim quickly, but just the 15 credits exited 15 new ones in. But only one of those new ones is already a known problem credit. Was there anything with the 15 new inbound credits, I guess anything systemic with that? Or anything that changes your outlook and continued improvement if you will on credit quality going forward?

No, not really, Brian, there is nothing systemic. Actually it was a small increase or small amount of that inflow was C&I. We had the usual amount of real estate. But we continue to have some residential loans that we moved to non-accrual due to non-payment of current payment. And there is some of a long process in terms of remediating those. But we expect that to slow down as well. So I would suggest even though it was 15, again the nothing really significant other than the one strip center which we already identify this problem.

Got you. Okay. The last thing for me and I will hop off. You guys mentioned and I don't recall maybe, if it was Jim mentioned on the room for optimism on maybe there is wealth managers, one of the areas of fee income. And just can you elaborate a little bit on that, if there is people hired? Were there just some initiatives you guys put in place, but if you could comment on that? That is all I have and I think nice quarter, guys.

Thanks Brian. If there is one area we feel like we need to improve our non-interest income, it was a challenging year in wealth. The first quarter, you recall, last year was a very difficult market. So we had a lot of headwinds trying to catch-up from lower asset base. We have recovered, we have added new assets under management, we have a new chief investment officer and we brought onboard along with some new people administration. The latter half of the year was pretty positive by way of new assets under management. So we got some work to do there, but we definitely see that as an opportunity for improvement. Same goes with our treasury group. We've brought on some new talent in that group that we are excited about. That coupled with the opportunity to leverage our new Chicago Talmer group in the treasury area leads us to be very optimistic next year. So fee income is going to be a primary focus in 2017.

Okay. That is helpful. Thanks guys.

Thanks Brian.

Thank you. Our next question is a follow-up from Chris McGratty with KBW. Please proceed with your question.

Thank you for taking the follow-up. Doug, the tax rate, how should we think about the effect for '17?

Well, I think that now that we're further along in our earnings growth I think we can once again look at tax exempts as a legitimate option. So we’ll try to eat into, it was, the effective tax rate has increased overtime so it was up to around 36%. I would like to bring that down going forward. But we will see how much impact we can have on that.

Okay. And then lastly, the investments you're making. Is the current run rate sustainable? And maybe tack on a little bit for inflation and growth? Or is there additional synergies you could potentially realize? Thanks.

In terms of the efficiency ratio?

Yes, I mean the absolute dollars of expense or the efficiency ratio [indiscernible].

Well, I think the efficiency ratio is going to be coming down. In terms of dollars there is not a lot of low hanging fruit. But we continue to look at the things that we can do to decrease it, or increase the savings that we can achieve on the expense side. No easy answers, but I think there may be, especially in relative terms as we grow, I think there will be opportunity to improve efficiency.

Thank you very much.

Thanks, Chris.

Thank you. There are no further questions at this time and I would like to turn the call back over to Mr. Eccher for closing remarks.