Old Second Bancorp, Inc. (OSBC) Q3 2017 Earnings Report, Transcript and Summary

Greetings and welcome to the Old Second Bancorp Third Quarter 2017 Earnings Conference Call. At this time all participants are in a listen-only-mode. A 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. Jim Eccher who's the CEO. Thank you Mr. Eccher, you may begin.

Thank you, and good morning everyone. Thank you for joining us today for our third quarter earnings call. With me on the call today is Gary Collins, Vice Chairman; along with our CFO, Brad Adams. I will start with the customary 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, and I'll give you my overview of the quarter and then turn it over to Brad for more detail on the third quarter performance. Let me first say there is a lot to like about our third quarter results. Net income was $8.1 million or $0.27 per diluted share, and core earnings were $0.22 per diluted share. It represents our strongest quarter of core earnings since the third quarter of 2008. On a core basis, these numbers represent an 83% increase over the third quarter of last year and a 29% increase over last quarter. Before we review third quarter highlights, just a couple of brief comments. We believe that over the last few quarters we have been building momentum in a number of key initiatives. That momentum continued in the third quarter in a meaningful way. Strong loan growth and net interest margin expansion highlighted the quarter as we continue to focus on improving operating leverage. Total loans increased 3.5% on a linked quarter basis and are up 7.8% year-to-date. Our recent pattern of strong asset generation in the second and third quarters continued this year. We traditionally have softer first and fourth quarters and we expect that trend to continue next quarter, as we anticipate a number of large loan pay offs. Competition for quality loans remains fierce in our primary markets, but we have remained disciplined in our loan pricing and credit discipline. Asset quality remains well controlled as well without significant changes during the quarter beyond the reasonable reduction in the OREO portfolio. OREO balance did decline about $2.7 million or 23% as we had a number of successful resolutions and disposing of these assets. A provision of $300,000 was recorded during the quarter, based on the strength of loan growth and the flow of ratings changes continues to be positive overall in the portfolio. Aside from solid loan growth, we were very encouraged about our results in a number of areas, that Brad will provide additional color, in his prepared comments. And with that I'll turn it over to Brad.

Thank you Jim, and good morning everybody. First on the revenue side, revenue increased by over a $1 million from second quarter levels, and non-interest expense decreased by $1.1 million as well. Net interest income pre-provision made up a little more than half of this, driven by modestly higher loan yields. On loans and securities the impacts of loan growth and modest mix shifts within the earnings space, specifically funding a little bit of loan growth out of the securities portfolio during the quarter due to some seasonal softness on the deposit side. I'd like to point out first off, that margin comparisons in 2017 are impacted by the adoption of ASU 2017-08 which accelerated upon amortization premiums in all periods in 2017. So that's been restated since the last time you guys looked at it. It was adopted on a modified retrospective basis. The impact on last quarter was approximately 10 basis points, which we discussed on the last earnings call. So it's been restated from 381 to 371. During the third quarter the taxable equivalent margin increased six basis points from this level and that was driven largely by loan growth with modestly higher yields. There continues to be very little pricing movement on the liability side of the sheet. On a GAAP basis the margin increased seven basis points. Overall, we continue to be very pleased with this level of performance and Old Second is well positioned in the near term. It continues to be all about deposits, I think that's true that our industry as a whole. The granularity and long-term nature of the deposit franchise here at Old Second is characterized by high concentration and low cost transaction accounts. Our third quarter is typically seasonally weak for us with the run-off of tax deposits, and we saw that with the modest decline from second quarter levels. I'm optimistic, as I sit here today that that we'll see a bit of a rebound in the fourth quarter. So far very early on in the quarter that looks to be the case. We continue to have very solid traction on the loan and lease side, as Jim mentioned. Linked quarter loan growth totaled $54.5 million during the quarter and the loan-to-deposit ratio is currently at 84%. Looking forward, Jim mentioned the seasonal challenges in loan growth for the fourth quarter and first quarter are typically are softest with the lot more strength in the second and third quarters. I think we'll see that, but I do maintain some optimism on trends based on the level of originations. I think the variable for us is going to be the degree of which we get pay offs on the loan portfolio. I think origination trends still look very solid. Core margin trends are currently stable, though they could expand further with the additional movements in interest rates. On the bid OCD [ph] I come in and check the probabilities based on that fund features basically every day, December obviously I think most of you know what that looks like. It certainly looks more than probable at this point. I think the degree of expansion from here will depend upon those rate moves, and also upon deposit pricing trends in our market. It still looks to me like margin and pressure that's out there for Banks like us is focused on high balance money market accounts. We haven't seen a lot of movements in a more granular side of things. That continues to be true, as we talked about last quarter. On the fee income side, wealth management and trust income continues to perform above both budgeted expectations for us, by the seasonal decline from second quarter. Mortgage banking margins had a slight decline during the quarter that was partially offset by a decrease in the magnitude of interest rate driven valuation impairment on MSRs. Commercial slot fee income continues to be a very strong performer and was responsible for the bulk of the growth during the quarter. Expenses overall remain very well controlled with positive comparisons to last quarter from the one-time HR expenses that we talked about previously. Operating leverage as Jim said, remains in focus for us obviously that's a pretty good story this quarter. Not much really to talk about in terms of trends within individual line items on the face of the income statement. But we are continuing to invest and continuing to look higher as Jim mentioned and we've made some progress there. We're also looking at infrastructure investments and risk management, we've increased headcount there, it's already in run rate. And we'll enhance our management reporting capabilities and compliance as well. The effective tax rate for the quarter was obviously below trend, it was $1.6 million benefit or $0.05 per diluted share recognized during the quarter related to the increase in Illinois tax rates. That's going forward, given the current make-up of the bond portfolio would be in the neighborhood of 30% to 31% from effective tax rate. That's really all I have, with that I'll turn the call back over to Jim.

Okay, thanks Brad. In closing we're obviously very encouraged about the quarter and although we anticipate a seasonal slowdown in 4Q as it relates to loan growth, we are nonetheless pleased with where the company is heading. Operating leverage remains very strong, we continue to remix the balance sheet, solid growth of most of our business units and as Brad mentioned expense control is very strong. Efficiency ratio for the quarter was well below 60% and has improved dramatically in recent quarters. And perhaps most encouraged by the traction we're getting and meeting with new potential relationship managers, we have added a few lenders on the commercial side here recently, and continue to look to hire talented bankers. You'll probably see additional impact here from those efforts as we believe our story is becoming more aligned with the increased Chicago [indiscernible]. That covers it for us and this concludes our prepared comments, so I'll turn it over to moderator and open up for questions.

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

Hey good morning guys. Mike, I'm pinching in for Chris today. Thanks for taking the questions. I want to maybe start on just the near term expense outlook, you had a nice rebound back down this quarter but it just sounds like there were maybe a couple adds on the commercial side in Q3, just kind of curious if there is any kind of near term outlook you can help us with on the expense line item maybe for the next couple of quarters here?

Yeah I will comment on the new hires, we have had a couple, they are really more in the second and third quarter, but as it relates to headcount it was net neutral as we added a couple of lenders also exit, so I wouldn't expect the run rate and salaries to really change materially. As far as the other expense line items we're not anticipating any meaningful changes.

Okay, that's helpful. And then on the commercial swap income, I think the fees were pretty much about $7.7 million, and securities gains in the last couple of quarters, here I mean, it sounds like you guys are little feeling good about some of the opportunities are in the swap side, and within trust, I mean is there an expectation to kind of see some continued modest growth in non-interest income, as we move into 2018?

Obviously, the swap fee income is something we'd certainly like to see that trend continue that's obviously contingent on loan origination and closings, as I mentioned we do expect more bit of a slowdown here in the fourth quarter but we certainly expect to see consistent results on the swap side in 2018. As far as other non-interest income line items, and we continue to see pretty steady progress in our wealth management group, mortgage, residential mortgage side of the shop is heading for a seasonal slowdown in 4Q but, we've been delivering pretty consistent results there, so we expect 2018 to be similar 2017.

Okay. Just a couple of more quick ones, maybe one for you Brad, just on the margin, you talked about how, obviously we are not 100% sure yet, which way if that's going to go in December, but can you maybe frame for us, what kind of positive impact you think you would see, if you do another hike in the shorter part of the curve here, as with your balance sheet hasn't sense to that?

Yeah, this is the conjecture part, and that always fun. But, with all the usual caveats, but certainly what's in there right now is, is the December rate hike and that leads the bulk of the quarter unchanged. I certainly don't feel worse than stable, and I have been pretty consistently long to the conservative side at this point, given the degree of expansion that we've seen over the last nine-months, so, it's hard enough to feel pretty going good. Say it is in December, I would think that would positively impacted by at least a few basis points. That being said, some of that depends on what we actually do with the balance sheet, I'm not particularly enamored with levering into this curve and I don't level lot of the spreads that are available from a fixed income side. So, I'm a little reverse to lever into it. We can certainly make more money if we did so, but that doesn't feel prudent at this point. So, modest to slightly higher if that rate, rate hike occur, I think is that all I can say.

Yeah, I know, that's helpful. And that kind leads me into my last question, Jim mentioned that the Q4, 1Q seasonal slowness in the loan book, but it sounds like deposit growth might pick up in the fourth quarter, and you guys had some pretty strong fourth quarter deposit growth performance in the past, I mean, is it going to just kind of having in cash for a quarter to potentially or do you expect there could be some build backup in that investment portfolio in the fourth quarter?

No, I don't anticipate growing a bond portfolio given the spreads that are out there right now, that just doesn't feel like a smart play to me. So, I think we'll ride with that where it is, I think that to the three deposit growth returns the magnitude with the such will determine the level of borrowings like I said I'm not anxious to lever and then what look a not all that enticing from a fixed income investment standpoint to me. On the loan growth side originations remain very strong and variable for absolute level, the loan growth for us is going to be a degree of payoffs. We've had substantial payoffs this year and still manage to produce some growth, so, I'm cautiously optimistic but origination trends remain very solid that obviously boards well for swap fee income, but the level of net balance sheet growth will, as I said, be a function more payoffs than anything else.

Okay, great. Well thanks a lot guys, I appreciate it.

Thanks Michael.

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

Good morning guys.

Good morning Andrew.

Just curious, was there, was there any the loan growth this quarter purchased some out of that last quarter?

No, there was some participation activity club deal but, the bulk of that was organic.

Got you, and then now, we built up the capital ratios pretty strong, TC is over 8%, what's the thought on more acquisitions anything like the Talmer branch deal or Old Bank deal, what's your thoughts there?

Well, banks are sold and not bought, so certainly our phone lines are open. We will remain disciplined. Can't foresee when those things will happen but we're certainly open to evaluating it, discipline is the name of the game, and what is important to us is we've said now for the last six months is the integrity of the deposit base in a rate environment like this and the outlook for rates in the future deposits of the name of the game.

And Andrew obviously our strategic focus continues to be organic loan growth one, hiring or lift outs would be our second strategy, and then M&A obviously would be our third option and we certainly would be willing look at that if it is a strategic move for us.

Very good, you've covered all of my questions. Thanks so much.

Thanks.

Our next question comes from the line of Kevin Reevey of D.A. Davidson. Please proceed with your question.

Good morning guys.

Hey Kevin.

Good morning.

Brad could you talk a little bit about the yields on the new loans that you're putting on relative to over the last couple of quarters in the trend?

Yeah so the weighted average yield for new originations in the third quarter was down a little bit, due to the nature of originations and the magnitude of the swap fee income. So we were kind of in the 4.15, 4.10, 4.15 range in terms of what was originated given the swap activity that's associated with that. A little bit below second quarter levels, but so far in the third quarter that should bounce back a little bit and the fourth quarter should bounce a little bit.

And then can you also talk about the - Jim if you could talk about the competition for talent, I know everybody I talked when Chicago is looking at team left out?

Yeah it's our opportunities had improved significantly since we made the commitment to move into Chicago. We're having active dialog with more lenders in your rate cutter that it is very competitive, that our story is becoming more compelling and I think when you look at the Chicago landscape there is fewer banks in that $2 billion to $3 billion range and that is an attractive size for a lot of lenders.

And then my last question is for you Brad. Can you talk about it looks like your deposit service charges were up almost 7% linked quarter, did you change your deposit pricing, was that and if [indiscernible] or just the higher, can you kind of talk about the growth in that line item?

No real pricing changes. I think that we have seen the rate on overdraft fees has certainly slowed. That helps just opening new accounts. I mentioned it before. We are a net account borrower at Old Second, and have been for a long time, but those trends continue to remain positive, which is unusual, despite what people say in our industry. And I think it's just going to be a function of account growth driving those fees going forward and headwind certainly don't feel as substantial as they've been over the last two years.

That's exactly right Kevin, the other consistent pattern we're seeing is a seasonal uptick in debit [ph] card swipes and income in the third quarter typically with higher consumer spending, so that was a nice trend that's continued.

And so you expect to see that trend in the fourth quarter I guess with the holiday season as well?

We typically do yes.

Great, thank you, that's helpful.

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

Hey guys.

Good morning Brian.

Hey so I joined late, so I may have missed some of this Jim, but just can you talk about, Brad touched on to the pay-offs that you guys have seen. I mean were they high this quarter as well, I guess I need you to talk about in the year they've been high, but were they elevated this quarter. And just kind of can you give a little background on what the production was versus what the payoffs for this quarter?

Yes, this quarter, third quarter, we did not have as many payoffs, and these large loan payoffs really stand from sale of various real estate investments from a lot of our clients, they are not due to refinancing, in large part, - we did have one large credit that did exit, that was not the result of the loan sale. But I'd say the second quarter is little bit lower than the third quarter, the fourth quarter will have more due to properties that are under contract, that we expect to see close later in the quarter. So there is some lumpiness in that, it's hard to predict, but second and fourth quarter of this year look like larger payoff quarters.

Okay. In the loan pipeline today, did you give a little color on where that sits today, maybe I missed it or.

Yeah, in our prepared comments, we typically see a seasonal slowdown in 4Q and even lagging into the first quarter. And that appears to be the case, although it feels better this year than last year. Pipelines are certainly not as robust as the second and third quarter. So we we're hopeful that we see some moderate growth in the quarter, but it would not be surprising if we are flat.

I got you, okay. And then maybe just one last question for Brad. Just as it relates to the loan yield comment you just made maybe a little bit of a drop in that loan yield. It looks like the loan yields were actually up on a linked quarter basis. So I guess just kind of tying together your comments about maybe being a little bit lower, I guess the loan yields in the quarter I guess what was driving, if I miss that Brad.

So that's, well that comment was that answer that question was strictly around originations during the quarter. We still got the impact of originations last quarter, and certainly even that level of origination is still a margin pick up for us. When you see large loan payoffs to typically the larger loans are at lower yields than the smaller more granular types. So those trends still feel very positive to me. And we continue to watch the deposit side and that will drive the margin, but there is nothing to be upset about at this point in time.

And what we did generally in the quarter Brian, more than half of it was floating in nature. So that's obviously the swap income came from. So we're positioned well in the event that reached, continue to take higher.

Right. Okay so the outlook is more positively spreads, that more positive and negative on the margin. And then did you guys comment on the - I know you had the tax benefit in the quarter, but just what the outlook is for the tax rate, how we should think about that.

Yeah given the makeup with community concentration, somewhere around 30 to 31 feels kind a rate to me.

Okay. All right. I think that's all I have guys. Thanks.

Thanks Brian.

There are no further questions over the audio floor and at the conference. I would now like to turn the conference back over to management for closing remarks.

Okay, thank you everyone for joining us today. And we look forward to speaking with you again next quarter. Good bye.