Old Second Bancorp, Inc. (OSBC) Q2 2017 Earnings Report, Transcript and Summary

Greetings, and welcome to the Old Second Bancorp Second Quarter 2017 Earnings Conference Call. At this time all participants are in a listen-only mode. A question-and-answer session will follow-up 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, Jim Eccher, CEO and President. Please go ahead, sir.

Thank you, and Good morning, everyone, and thank you for joining us today for our second quarter earnings call. With me on the call today is Gary Collins, Vice Chairman; along with our new CFO, Brad Adams, who joined our team early in the second quarter. Prior to joining our Executive team, Brad was an Executive Vice President, and Director of Corporate Development and Strategy at TCF financial; and prior to that, an Executive Management Director of Corporate Development and Strategy for Talmer Bancorp. Brad's extensive industry experience is a welcome addition to our senior team. 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 would ask you to refer to our SEC filings for a full discussion of the company's risk factors. Please refer to our website, under the Investor Relations tab, for access to our earnings release. I have several prepared opening remarks this morning, and I'll give you my overview of the quarter and then turn it over to Brad for more detail on second quarter performance. Before we review second quarter highlights, just a couple of brief comments. We believe that over the past few quarters, we have been successful in executing our strategy to improve and grow our earning asset mix, which has led to a more diversified balance sheet and improved earnings momentum. The acquisition of the Talmer Chicago office and integration helped drive solid loan growth last year, and it continues to be a catalyst for solid organic loan growth this year. We have remained focused on growing net interest income, stabilizing our net interest margin by remaining disciplined in our pricing, while continuing our strong efforts to improve credit quality. Our execution on these initiatives has helped us drive stronger operating leverage and consistent improvement in core earnings. Second quarter operating performance was highlighted by solid loan growth, further expansion in net interest margin and stable credit trends. I'll now turn it over to Brad for more detail on the quarter.

Thanks, Jim. Let me first say that I'm excited to be here and thankful for the confidence that Jim, Gary and the rest of the members of the Board placed in me. It's become clear to me, both before I was hired and over the last few months, that Old Second has a great deal of positive momentum. I think the numbers this quarter obviously reflect that fact. Net income for the quarter was $5.5 million or $0.18 per diluted share. These numbers represent an increase of 42% over last year and 19% over the first quarter of 2017, unannualized. Of note, second quarter net income includes $294,000 of non-recurring expense, associated with the recruitment and relocation assistance for a certain executive, who shall remain anonymous. Bad joke, sorry. I can only feign confidence that, that executive is worth the trouble. Net total revenue increased by $1.6 million from first quarter levels, with noninterest expense remaining relatively flat. Net interest income made up the bulk of that increase at $1.35 million, primarily driven by the combination of higher yields on variable rate loans and securities, further aided by loan and lease growth. The very strong 23 basis point increase in the taxable equivalent margin to 381 was driven by higher average yields in the variable and adjustable rate portfolios, as short-term interest rates have increased, and very low pricing movement on the liability side of the sheet. On a GAAP basis, the margin increased 13 basis points. This level of performance is indicative of a few things. Primarily, the granularity and long-term nature of the deposit franchise, which is highly concentrated in low cost transaction accounts. There's increasing traction on the loan and lease side, linked to our loan growth totaled $52 million, and the current state of the pipeline fuels a bit of optimism here for the remainder of the year. The growth drove an improvement in loan-to-deposit ratio to 81% from 77% last quarter. I will say that most of the loan growth was concentrated in the back half of the quarter. There's a full quarter impact for the first time this quarter on the security portfolio transition to munis that was executed late in the first; and there's been a broader transition to floating rate issues overall. Looking forward, the third quarter 2017 will reflect an accounting change whereby premium amortization on the bond portfolio will accelerate from stated maturity to call date. The adoption of this timing difference will reduce realized yields within this muni portfolio by approximately 90 to 100 basis points in the quarter. This has never really shown up in the movement before. We had not had a very high concentration of callable securities prior to the new muni transition. From an aggregate margin perspective, this implies a reduction of approximately 10 basis points, expected in third quarter. Core margin beyond this impact maintained a slight positive bias, with the bulk of Q2 loan growth coming toward the end of the quarter, as I said, and the timing of the most recent rate increase in mid-June. Whether that bias is realized or not will depend upon deposit pricing trends in our market, though I must say I remain somewhat optimistic at this point. One additional point to add, given the magnitude of the margin increase that we see this quarter, Jim and the Old Second team, including my predecessor, Doug Cheetham, are to be commended for the discipline to maintain the investment in the core deposit franchise, through was a very long period of time, when it was relatively expensive to do so, both in terms of cheaper wholesale funding alternatives and the absolute level of deployed funding. They have clearly been committed to the long-term value of the franchise, and I believe the benefits of that are obvious today. On the fee income side, we saw strong growth in our wealth management trust income, and they continue to perform above budgeted expectations for us. MSR's took a fairly significant hit during the quarter with interest rate-driven valuation impairment of approximately $247,000 during the quarter. Originations and gain-on-sale margins remain robust at this point in excess of 300 basis points. Expenses remain well-controlled despite the previously mentioned one-time HR expenses. Operating leverage remains the focus overall. Not much really to talk about here, though investments are underway in a number of areas, including risk management, management reporting and compliance. I'm not sure that those investments will be discernible in the near-term run rate, beyond what you see in this quarter. We have additional leverage elsewhere for the remainder of the year that should mask those investments. We've added a number of lenders on the commercial side recently and continue to look to hire talented bankers. You will probably see some impact from those efforts, as I believe our story is becoming more compelling with the increased Chicago presence and recent momentum. Asset quality overall remains very well-controlled. There's one significant credit moving to non-accruals during the quarter and one charge-off of note. We believe we are well positioned on both of these credits. Provision of $750,000 was reported during the quarter based on the strength of loan growth. The flow of ratings changes overall in the portfolio continues to be positive. The effective tax rate for the current quarter was 28%, down from 32% in the first quarter. The full quarter impact of the tax-exempt securities growth in the first quarter '17 -- 2017 was the primary driver of the decrease as well as the more modest impact from vested stock option tax benefits being recorded as a direct credit to income taxes expense. Going forward, we expect the tax rate to increase modestly driven by recent legislative changes in the Illinois tax rates, which was effective July 1. Best guess here at this point is in the neighborhood of 30%. With that, I'll turn the call back over to Jim.

Okay, thanks Brad. We're very encouraged about our performance in the second quarter on a number of fronts. The first is obviously loan growth. We saw good production from various business lines, particularly C&I, and deal flow remains fairly steady. Additionally, I'm very pleased with the cultural integration of our Chicago Talmer office. We're seeing meaningful contributions from this team and the transition has gone extremely well. I'm also very encouraged about the stability of our core funding base. 80% of our deposit base is considered core, and our demand deposits are up 6% year-to-date. We believe this core deposit franchise will continue to position our company well in a rising rate environment. Recap: the Chicago Talmer branch acquisition closed in October of last-year. It continues to contribute to the bottom line. With loans purchased of 221 million, the purchase accounting discount recorded was approximately 2.8 million, last fall at closing. As of June 30, the PAA owner discount totals 1.3 million. Last year, purchase accounting accretion income was 604,000. For the first six months of this year, 850,000 has been accreted to income. And that concludes our prepared comments this morning. So I will turn it over to our moderator to open it up for questions.

[Operator Instructions] Our first question comes from Chris McGratty with KBW. Please proceed.

Jim, maybe start with you on growth. It seems like you're expecting pretty healthy growth the back of the year. I'm interested on some comments, number one, on pipeline, but also team hires, the potential to bring over lenders, given the big dislocation we've seen in Chicago.

Yeah, sure. Chris, thanks. Yes, we had obviously very strong growth in the second quarter. What I'm most encouraged about is over half of it was in C&I business and the rest of it was pretty granular in nature, across different lines. We have had some success in hiring a couple of new Chicago-based lenders. As Brad mentioned, our story is becoming more compelling. Having a downtown presence is certainly helpful from a recruiting perspective. And based on what we're seeing in deal flow, we feel pretty good about our pipeline for third quarter; obviously, too early to tell about the fourth quarter. But seasonally, our second and third quarters have generally been our strongest.

Okay, great. And if I could switch to capital. Brad, now you've been in there a little bit. You guys have obviously repositioned the invest portfolio, which is paying off. Any other notable shifts that we should be expecting in the balance sheet? I know you still have the trust preferred, though, but any comment on how you're viewing capital at this point?

Well, just broadly, obviously return on average tangible common is the bogey. That's where we're focused, making sure that we deliver on promise to investors. Certainly there's a trust preferred out there that, should be opportunity present itself, I prefer to do that with cash, rather than a refinance, given issuance costs. I think that opportunity's there at some point. Beyond that, obviously, I like the level of leverage and very comfortable with where we are from a capital perspective. There are certainly opportunities that may present themselves at some point, so flexibility is important. But we're focused on growing organically and believe we've got a great opportunity from a competitive positioning standpoint here in the Chicago market. I've given my view on the deposit base. From what I've seen, it's as good as I've seen. I think that Old Second is somewhat unique in that we're generating account flow that is positive from an open-to-close ratio, and that's a relatively rare thing in our industry these days. All that makes me very encouraged that we'll be able to continue to fund loan growth and I certainly believe we have the capital production to manage the growth that we have. Here in Chicago, others aren't so fortunate to be where we are from a loan-to-deposit ratio or a leverage standpoint. And also, CRE concentrations are an issue in this market. I think both those factors provide us a very solid competitive opportunity to continue to grow with our existing capital base.

Our next question comes from Andrew Liesch with Sandler O'Neill. Please proceed.

Just a question on the loan growth in the quarter and, related to the pipeline as well, just curious on the geography of it. How much is it in Chicago and how much may be in legacy Old Second?

About 40%; Andrew was in Chicago, 60% with the Legacy group. And that's probably in line of where we kind of budgeted this year. We're obviously seeing more opportunities east of our core footprint here into Cook County. But we've been pretty pleased with overall production from a lot of different lenders.

[Operator Instructions] Our next question comes from Scott Durant with Kroll Bond Rating Agency. Please proceed.

Just a couple questions. Kind of piggybacking on the loan-to-deposit, what would be the guidance going forward as to where we can expect that to kind of move? Do you see that kind of moving upward or kind of give an idea?

Well, we continue to be focused on deposit growth. I think that, when you're talking about a higher flatter curve, flattening from the short end, the next two years in our industry are primarily going to be driven by your success in generating core deposits as well as the over quality of that base. I feel very good about where we sit today relative to that. So we'll continue to focus very hard on growing core deposits. We're not at a situation where we've got a bunch of teaser rates in the portfolio that we've got to overcome the churn on, it just doesn't exist here. And like I said, the account flows are positive. It is our intention to fund loan growth with deposit growth, there may be periods due to seasonality where one exceeds the other. But I don't expect rapid moves here. We're not leveraging into a higher flatter curve. It would be slow and steady, and that should generate very profitable growth and significant operating leverage.

Perfect. And one other question, kind of shifting gears a little bit. Looks like there was maybe some changes in the composition of classified loans. If you could provide some color, looks like maybe some movement in the multifamily sector?

Yes, we had 1 significant credit that went to nonaccrual. It was a multifamily property near a prominent university in our market. We feel we're very well positioned with this credit. Our collateral position is good. We've got good sponsorship. And now that the state of Illinois has passed a budget, we feel occupancy is trending in the right direction, and we will -- I think we'll be able to navigate through this. We do not see any loss exposure on this credit. That was really the only meaningful change in classified.

Our next question comes from Brian Martin with FIG Partners.

Welcome aboard, Brad. Just one question. We've heard some other commentary, Jim or Brad, about the upward funding pressure in Chicago. And just kind of wondering, given your comments about the core deposits, are you guys seeing any of that or, I guess, what's your expectation on the funding costs and pressure materializing?

So funding costs, as I said, in my view is the name of the game going forward. And I have seen the same thing in terms of an uptick across certain categories in various banks, not only Chicago but elsewhere. But it hasn't been broad-based. I think that one thing that's maybe underappreciated in our industry is we've all fought off margin compression. There haven't been meaningful changes on the asset side in terms of duration extension or anything like that within loan portfolios over the last 5 or 6 years. But we have seen a somewhat significant change on the liability side in our industry, and it's been broadly a transition to more wholesale type deposits, be those public funds, or jumbo, or just highly concentrated money market balances. That's been effective in stemming off margin compression through the rate trough, but it also means that you pulled forward or gave away some of your upside when an environment became more favorable for banks. That's the genesis of my comments for the Old Second team deserving some credit. They maintain that commitment to the core deposit franchise here. And I think that's the real driver that we've seen so far in terms of some increase in liability pricing. I think that you'll see pricing pressures in certain areas first. One is people that are on a teaser rate cycle within money market accounts; and another is earning credit rates on the commercial side. That'll be the first evidence of real pressure. In terms of the statements that we see from other banks, we're not seeing a lot of moments on ACR's at this point. So that tells me that we're still muted and there's not a ton of pressure.

The only thing -- other thing I would add, Brian, is we're very fortunate with our deposit base. I mean, 60% of our customers have been with us 10 years or longer. We are very fortunate we have not had to pay up, relative to our peers. Having said that consumer behaviors is fickle, and we will protect our core deposit franchise if need be and we do need to move on rates, but right now, we're not seeing it in our markets.

I think the first place that we'll look to put some pricing is just on kind of loyalty bonuses within some CD pricing if we can lock in some funding on that side without a huge impact. I think that those people deserve our first move, and that's where we'll do it, with long-time loyal Old Second customers.

That's helpful. And just Jim, your comments about the pipeline, just kind of, where is at today versus where it was kind of last quarter. I mean, obviously the strong core growth in the second quarter, is the pipeline about the same level today as it was going into the second quarter? or is it up or down from there?

Yes, we feel it's pretty similar to -- it's early in the quarter, obviously, but we are expecting some payoffs too this quarter where we didn't last quarter, but we're feeling pretty good about it based on the deal flow we're seeing every [week].

And the lenders you hired, are they more Chicago or more suburbs? That may be -- if you said that, maybe I missed it. More focused at --

I'd say both. Some Chicago-based and some suburban-based.

Okay, a little bit -- okay. And then a couple other things. Just on the balance sheet, Jim, I think last quarter you talked about kind of a little bit of remix on where you'd like to see securities go. I guess, any update on that? I guess, is it kind of same thought as last quarter? Or has anything changed now that you've kind of done more with the -- or just kind of the whole bond repositioning is kind of completed?

I'll let -- I'll just add a couple of comments, I'll let Brad finish. We're at about 80% loan-to-deposit now. We think more leverage is important for us to maximize our returns. Having said that, we've -- I think 20% of our assets are still in the investment portfolio. It's probably a little more than we'd like long-term, but we like the gradual shifting that's happening and I think the returns are showing that. So Brad, if you've got any other comments?

Yeah, I'd say, just broadly in character within the securities portfolio, most of our efforts have been on floater side, and then also with an idea of minimizing, and we have a very little of it, exposure to MBS. I think there is the potential that, that market has some disruption over the next 6 to 12 months, and it's not an area where we want to be. So where we are feels pretty good. We may dabble at the edges of some CLO's and also some SBA floaters and that sort of thing. But it's going to be more of the same and just kind of dabbling at the edges and I don't think you'll see a meaningful shift, other than just a few MBS left at this point. We've largely exited those.

Okay. And then, your commentary on the change of the premium amortization. You said it's about a 10 basis point clip to the forward margin?

Correct.

Correct, okay, all right. And then, last two from me, you talked about the TruPS, I mean, the cash currently today -- do you have adequate cash to pay off that TruPS today? Or...

We have a significant cash position at the holdco today and we've got additional dividend capacity next year.

Okay. So you're just waiting at the moment to execute on that, if you choose to?

Yes, nothing's imminent at this point.

Just last thing from me, just on the credit side. Things look -- you talked about the one credit, but just your concentration, if any, on retail. Can you guys give any color on that? Or is it a smaller number of concentration-wise? Or any concerns at this point or kind of monitoring of that?

Brian, our exposure in concentration and retail has been actually declining over the last several quarters. It's not a focus for our production team. We don't have any meaningful concerns there.

There are no further questions. I would like to turn the floor back over to Jim for closing comments.

Okay. Thank you, everyone for joining us this morning, and we look forward to speaking with you again next quarter. Goodbye.