Old Second Bancorp, Inc. (OSBC) Q4 2017 Earnings Report, Transcript and Summary

Greetings and welcome to Old Second Bancorp's Fourth Quarter 2017 Earnings Call. At this time, all participants are in a listen-only-mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] I would now like to turn the conference over to your host, James Eccher, President and CEO of Old Second Bancorp. You may begin.

Okay. Thank you. Good morning everyone and thank you for joining us today for our fourth quarter earnings call. With me on the call today is Gary Collins, Vice Chairman; along with our CFO, Brad Adams. I will start with our 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 quarter. Results overall continue to be very strong, despite some noise this quarter. We're reporting a net loss of 2.5 million or $0.08 per diluted share in the fourth quarter. Core earnings were $0.23 per diluted share, excluding a $9.5 million valuation allowance on the deferred tax asset related to tax reform legislation. On a core basis, these numbers represent a 35% increase over the fourth quarter last year and a 5% increase over last quarter. For the full year, excluding the implications of tax legislations at both the state and federal level, earnings per diluted share increased by 45%, ROA was approximately 1% and ROE was approximately 12%. Results in the last half of the year related to core operations were significantly stronger than the first half and speak to the momentum that is built in our business model. All told, we feel it was a solid quarter and close to a very productive year for the company. In regards to the fourth quarter specifically, loan growth was a little stronger than we expected, with balances up by about 23.4 million during the quarter and 9.4% for the year. Yield on the portfolio was modestly lower, largely due to a reduction of loan fees related to origination activity and accretable yield associated with purchase loans. 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 this trend to continue next quarter, as we anticipate a number of large loan payoffs. Deposit trends improved with core deposits increasing 40.6 million from last quarter and fully funding asset growth for the quarter. Operating leverage remains very positive with the core efficiency ratio improving to 56.5% for the quarter. Asset quality remains well controlled without any significant changes during the quarter beyond a reasonable reduction in the OREO portfolio. A loan loss provision of 750,000 was reported during the quarter based on the strength of loan growth and the adjustment of model factors. Loan rating changes continue to trend positively, along with continued declines in the level of non-performing assets. We feel good about the credit trends at this point. We remain very encouraged by the results in a number of areas and I'll turn it over to Brad for additional color.

Thanks, Jim. Net total revenue, pre-provision and excluding the impact of securities gains, was essentially unchanged from last quarter. Net interest income was up modestly due to averaging effects from the timing of the loan growth last quarter and fee income was a little softer on a core basis due to a smaller contribution from stocked fee income during the quarter, given lower origination levels. The taxable equivalent margin decreased by 1 basis point during the quarter with yield pickup in the variable portion of the securities portfolio mitigated by modestly lower effective yields on the loan portfolio. Given the timing of the most recent rate adjustment, it had very little impact on our numbers this quarter. Pricing movement on the liability side of the balance sheet remains well controlled with some pick up in time deposit competition during the quarter from a number of competitors. We expect this factor to moderate next quarter for us, given the timing of maturities in our portfolio. We have moved rates modestly higher in the money market and savings captions in response to December rate hike with the goal of remaining within reasonable proximity to the median pricing level in our markets. The strength of our deposit base is important to our continuing success and our customers will benefit as we have with rising rates. We expect betas to remain very well controlled. They are very well controlled however on an overall basis. We continue to be very pleased with this level of performance and the outlook for margin trends going forward. The loan to deposit ratio was unchanged at 84%. As Jim mentioned, we had success in fully funding asset growth this quarter. On the loans side, yields were largely stable with a slight decline in accretion income due to lower than expected prepay activity on the portfolio. The remaining accretable discount on the portfolio was 835,000 at year end compared to 1.05 million in the prior quarter. Looking forward, Jim mention the seasonal challenges on loan growth. We certainly did a little better than I expected this quarter. I believe the impact - the effect on gross should be moderated by stronger deposit trends and less of a need to remix earning assets. We make supplement loan growth in the first quarter with a modest consumer portfolio purchase, given this outlook and the complete lack of attractive spreads in the fixed income market. Core margin trends are currently biased higher and could expand further with additional movements in interest rates. The degree of that expansion will depend upon deposit pricing trends in our market and remains true that the bulk of deposit pricing pressure is isolated in larger balance deposit relationships to which our exposure is limited relative to competitors. A little bit of detail here. There are two items that will impact the taxable equivalent margin, beginning in the first quarter of 2018. The first is the change in the federal tax rate and its impact on effective yields for municipal securities. Reported taxable equivalent margin is estimated to be approximately 9 basis points lower in the first quarter. There will be no impact to the GAAP margin from this change. Again, simply, that's just the impact of the tax rate. The second item is an anticipated realignment on the income statement. Approximately 450,000 of quarterly noninterest expense, that's loan origination expense, that's located within the salaries and benefits caption will instead negatively impact loan yield going forward. So lower expenses by 450,000 and lower loan yield by 450,000. This has the effect of both improving the efficiency ratio by about 71 basis points and negatively impacting both the GAAP and taxable equivalent margin by approximately 8 basis points. There is no bottom line impact from either of these items beyond the lower effective tax rate, resulting from legislation. From a trend perspective, as I said, the bias for margin trends remains positive beyond these adjustments. On the fee income side, wealth management and trust income continues to perform above budgeted expectations for us. Mortgage banking experienced a decline in gain on sale margins during the quarter again. That was offset by a decrease in the magnitude of interest rate driven valuation impairment on MSRs. Commercial swap fee income declined in the first quarter, as I said previously, on seasonally weak originations. Securities gains contributed a $500,000 increase relative to last quarter, with a single holding within our portfolio receiving an unexpectedly high bid on our routine price check. Expenses remain very well controlled, not much really to talk about here though. Investments are underway in a number of areas, including risk management, management reporting and compliance. Effective tax rate for the current quarter, absent the impact of the DTA valuation adjustment Jim mentioned, was above the expectations that we communicated to you last quarter. Best guess going forward with the changes in both the Illinois and federal statutory rates fully implemented, and assuming the current makeup of the bond portfolio, would be in the neighborhood of 28% to 29% effective for 2018. With that, I'd like to turn the call back over to Jim.

Okay. Thanks, Brad. In closing, very encouraged about the quarter and although we anticipate continued seasonal softness through the slowdown in the first quarter, as it relates to loan growth, we are nonetheless pleased with where the company is heading. On an organic basis, operating leverage remains very strong with solid growth across business units and well controlled expenses. The efficiency ratio was solidly below 60% for the quarter and improved dramatically throughout 2017. Returns on equity are now in the teens on a core basis and the interest rate environment provides an opportunity for a bank like Old Second to demonstrate its strengths for the first time in a long time. We are perhaps most encouraged by the traction we are getting and meeting with potential sales hires. We are in a better position today and more competitive position today on the recruitment side of things. We're extremely excited about the opportunities inherent in the recently announced acquisition of Greater Chicago Financial Corp and its subsidiary ABC Bank. We believe the addition can meaningfully enhance our growth in 2018 at a relatively low risk fashion, while providing us additional opportunities to grow our franchise in the city of Chicago. We look forward to welcoming them to our team and are committing ample resources to ensure a smooth transition for customers. And that concludes our prepared comments this morning. So I will now turn it over to the moderator to open it up for questions.

[Operator Instructions] Our first question is from Chris McGratty with Keefe, Bruyette & Woods.

Brad, maybe just starting with you on the margin real quick, the remaining accretable discount of 835 that you talked about, is that inclusive of the credit market that's going to be the amount realized through the margin and also kind of interested in where that run rate goes post close. I think right, last couple of quarters, the accretion has been 200,000, 300,000.

Yes. So the 835 is inclusive of the credit mark, which is accretable in this case because these were not purchased credit impaired. So you accrete the credit just as you accrete the rate portion on that. The credit portion, just for your information, is around $535,000 I believe. The accretion this quarter was a little over 200 grand. I would expect a similar number, maybe a little bit higher, if we get a prepayment that I think we might be getting. And then it will run in the neighborhood of 200 grand for the next two quarters and then start to trickle towards 100 grand over the following two quarters would be my best guess.

And then the comments about the FTE gross up in the first quarter, is that relative to the reported 376 that you're talking about, so 376 plus modest bias because of the balance sheet?

So 376 plus 9 basis points for just the, hang on a second, 9 basis points for the tax rate adjustment and then an additional 8 basis points for the reclass on the income statement from salaries and benefit expense to loan yield. So 17 basis points lower and then add your bias higher just from core margin trends.

So roughly 360. And that's a reported basis. Okay. And then the offset on the expense, so this quarter's expenses were little over 16 million, we're taking off the 450 off of that and then what's the assumption on kind of flow through from taxes, kind of realization rate. Is there any big investments that you need to partake on or incur or is it kind of modest growth off of the 16 base?

I think it's pretty modest at this point. I think there's still a little bit of leverage there. We'll have an opportunity for investments that can really enhance the growth rate, namely sales hires, which can't be borne by the back of the relative costs change with the acquisition. So I don't expect a lot of growth and a lot of inflationary pressures even on that certainly low single digits in terms of what the core growth rate is, absent thinking about any acquisition.

And so it sounded like also the securities books mostly flat from here as well.

Yeah. I mean, deposit growth did better than we thought and that feels great, especially where it came in. If that continues to be the trend, then I would say securities would be flat. It's hard to do that, given my appetite for the issues that we're seeing. But, yeah, that's kind of my bias right now.

Okay. And then maybe the last one if I could sneak in on the reserve, you had recoveries, but you bumped the reserve a bit. Is that just kind of year end geography or kind of conservatism or anything to read into that the reserve bump?

Chris, I mean, we did have a little stronger growth than we expected. There's some timing issues relative to some payoffs we thought were coming in 4Q that are probably going to trickle in to the first quarter. That had some minor model changes and then some year-end adjustments. So that's really those three factors.

And the movements within credit, Chris, were all positive, even down to the level of flows were positive. Classifieds were positive. So, all the indicators on the portfolio still look positive and very good.

Our next question is from Andrew Liesch with Sandler O'Neill.

Just curious about, when you got the one deal announced, Jim, what are your thoughts on more deals, how many discussions - are you having more discussions, have they picked up a bit, just curious on the likelihood of more deals this year and any potential timing on them?

Right now, Andrew, our singular focus is on preparing for the closing and integration, which should happen in the second quarter. I will say, we continue to have active dialog, but right now, we see immediate opportunities in attracting additional talent, more so than we ever have probably in the last four quarters, four to eight quarters. There's - we're having very productive and constructive conversations with a lot of Chicago based talent.

Our next question is from Kevin Reevey with D. A. Davidson.

So, Jim, how should we think about modeling the provision expense in 2018, given the loan growth and also you bringing ABC into the fold as well?

Sure. We like our growth trends from 2017, high single digit growth. We would like to think that's a run rate we can sustain in 2018. So, the 750 a quarter or 250 a month and provision feels about right. I think that's our best guess at this point. I'll let Brad talk about the provisioning regarding how we're looking at with ABC Bank.

So ABC Bank, obviously, we won't have a provision for those loans that we bring on and there will be some portion of that that is credit impaired and a larger portion that is not. What you'll likely see there is provision back in line with what's accreted for those that are not purchase credit impaired, maintaining an overall reserve on the portfolio, given the character of the type of lending that we see there. And on a standalone basis, I certainly am a big believer in providing with loan growth, as Jim is and we do have challenges in that we've got some lost years of some significance that are rolling out of the model. I think that we've been in a net recovery position now for two quarters and it's quite possible that that will happen again next quarter. So there are some difficulties that come with provisioning with or above loan growth and there are some hard to call them, challenges, when it's all fun and good, but we certainly want to make sure that there is something for a rainy day there though, it's hard to get remotely pessimistic about what the trends are within the portfolios we're seeing here right now.

And then Jim, you talked about transactional hires in and around the Chicago area and I know a lot of the other banks that we talk to were doing the same thing. Can you talk about the competitive environment for talent in the Chicago region?

Well it's certainly around the C&I segment, remains ultracompetitive. I will say that our increased presence in the city, the talent that we've acquired was with the [indiscernible] in the fourth quarter of '16. It is driving a lot of new relationships and having an additional four locations with the ABC acquisition will only help us further recruit talent in 2018. So, as our story becomes more and more compelling, our size gives us an advantage I think for those looking for maybe a little smaller institution that has a lot of upside.

I think also there's a - Chicago is an interesting market right. You've got a few very big banks that are headquartered here and then you've got a ton of very small banks and they're not much in the middle. I think Old Second is certainly in the middle. I think that that size lender of that that fits in an institution our size maybe wouldn't be quite as valued as some of the larger institutions around town and maybe can't be supported by some of the small. So I think that there is a niche there that we do benefit from just what market conditions in Chicago have come to. And I think that's what we're trying to take advantage of.

And then my last question is centered around the core efficiency ratio, which you've done an excellent job improving. Do you have any goals in 2018 as far as further improvement in that metric?

Yes. Revenues faster than expenses. I don't know whether expenses will, I don't know - I don't believe that revenues will continue to go or expenses will continue to go down. But I am quite confident that revenues will go up.

Obviously, mid-50s would be a great target, Kevin. We're going to have some noise in the second and third quarters obviously with the acquisition, but our run rate is only going to improve as margin expands and our fee income generation improves. So we're optimistic as to where that's heading.

[Operator Instructions] Our next question is from Brian Martin with FIG Partners.

Hey, Jim, can you talk about, I think - I don't know, because you or Brad that mentioned that if, just the seasonality in the first quarter as you may look at purchasing some loans, just kind of how you're thinking about that and just how that may play out or I guess what needs to happen for you think about that?

I already spent some time thinking about it would be in the magnitude of $15 million to $20 million and they'd be variable.

And what type of loans are you interested in Brad? I guess if you -

Consumer.

Okay. And that can be a one-time thing just for the seasonality first quarter and then the organic growth kicks in as you look at the balance of the year?

Yes. It's a function of a couple of things, most notably, where fixed income spreads are. Two concentrations within the balance sheet overall where we are heavily biased commercial in terms of what our capabilities are. I think longer term, we would like to develop some sort of consumer lending vertical that makes sense. The problem is, there aren't a lot of them that make sense. And want to stay variables. So those are kind of the three thought processes that go into it. That's about the seasonality than it is just the dynamics of what's in the marketplace right now.

And just to be clear, Jim, you talked about just the hiring. These are folks, I guess, you haven't added anyone as of yet, these are people you're looking and the discussions, at least are escalating. Is that fair?

I can't say, Brian, we have hired one in the first quarter and we expect to bring on two to four more in the next two quarters.

And those folks at least hope to hire, Jim, I guess, when you talk about the growth guidance for '18 at this point, kind of the mid to high single digits, is that inclusive of the folks you're hiring. I guess, these folks would be additive to your current forecast?

No. I would say, it would be inclusive. I mean, there's generally a ramp-up period, Brian before these new hires really start getting any tractions. So, I think 6% to 9% growth is what we're targeting and if we can do better and we obviously will.

It's also inclusive, Brian of what we talked about with Greater Chicago deal where that deal was modeled on a flat acquired balance sheet over time. And so whereas normally, I don't think that normally, I would model something like that to be a run off portfolio just in terms of the granularity of the portfolio. We can't go that far downstream consistently. So, holding that flat plus a core organic growth of 6% to 9% is inclusive of the sales hires that we have planned.

And then maybe Brad, just on the, just the outlook on the guidance you gave on the margin kind of that 360 was kind of an upward bias. Can you talk about this quarter? I guess you said the December rate hike obviously was nothing much in the fourth quarter margin, just kind of the puts and takes of that bias going forward on the margin and just the rate increases, how much of an impact the rate increase will have? I guess you're thinking about it at least in December 1 and the first quarter numbers.

I am thinking solely of the December 1 in the first quarter numbers. If there was one in March, I don't think that would have a whole lot of benefit, just given the timing of it. So we see, the prime stuff obviously, reprices instantaneously, but then a larger component is the LIBOR based stuff and the one month LIBOR based stuff that reprices on anniversary days on a one month lag. So, our loan yields just in January should be up around 10 to 12 basis points relative to what we saw on December on a full month basis and they should pick up a bit further in February. We are raising deposit rates a little bit on the money market and savings side and we are largely all the way through the kind of negotiated rate one-offs on swaps and that sort of thing in terms of getting that priced into the balance sheet. So I don't feel a lot of deposit pricing pressure at all right now. And we have moved to within spitting distance of the median and almost across every deposit caption at this point as we sit here today. So it's hard not to feel pretty good about where we sit there.

So I mean it could be, if you get 10 basis points on loans and not much on funding, I mean, you can be mid - 5 basis point type of pick up for the rate increase at least for the December 1 in the first quarter, just big picture?

Well, you get paid the big bucks, Brian.

And then I guess just the biased, if the deposit beta stayed as you expect Brad, I guess, would the thought be that the - any other increases throughout the year would have still a positive, but maybe incrementally lower benefit to the margin.

You tell me what betas are going to do, Brian. I think - the deposit base here is very, very good and that's the name of the game, right. So, it's hard enough to see forward three months in terms of what the pricing dynamics are going to be in Chicago, given how competitive the market is. But I wouldn't trade our balance sheet for anybody else's.

The other thing, Brian is, we obviously have to get our arms around it, the deposit betas at ABC Bank, their cost of funding structure is significantly higher than Old Second. Obviously, we'll then try to work to get then more aligned with how we operate in the retail arena. So, we think there's opportunities for improvement there over time.

And just - maybe just one on ABC, just kind of when you look at the portfolio, I guess maybe Brad, you talked about it, and maybe I missed it, but just as far as how you're thinking about that balance sheet when you bring it over, kind of with the changes you expect to have to make I guess a run-off, you would look for whether on the funding side or on the securities on the asset side. Can you just talk big picture about what things look like as you bring them into the mix? How you're thinking about that folding them in?

Sure, with the caveat that it's all hypothetical at this point, because the deal is not closed. A balance sheet such as that, the typical thought process would be that we would move to eliminate basically volatile funding, in this case, brokered funds and move down out of some of the securities portfolio, primarily because they're low dollar issues, small in size and relatively illiquid. Not something that you really want to mess with too much, so I would anticipate a shrink in the order of magnitude in the balance sheet of some $30 million. The loan yield on that portfolio is fantastic. I would anticipate that bleeding down by about 15 basis points a year over a three year run and replaced with loan originations from sales hires in order to hold the overall balance sheet flat. The net effect of those two movements would be a relatively stable margin on the acquired balance sheet and we'll track it independently for a while, just to make sure that that's how it flows and track it against the model. But flat balance sheet, remix at a volatile funding, test the betas on the deposit base in terms of looking to see where it's over priced, where it's under price and make sure that it fits with what we're trying to do there. And what we're trying to do is encourage loyalty from good solid core deposit customers by paying them a fair rate and get the volatile funding out of the mix.

And you said the effective tax rate for you guys, the way you're thinking about it today is somewhere in the 28% range?

Yeah. 28% to 29%. And that's, I remind everybody that the state of Illinois raised their tax rate to 10% on corporate in July.

And you said the effective rate this quarter was higher then you kind of had guided to last quarter, but where was the effective rate adjusted for the tax reform this quarter?

So excluding the impact of tax reforms, it was in the neighborhood of 30, a little over 34 I believe.

So it dropped from 34 to 28, 29 is kind of how you're thinking about the benefit from tax reform?

Yeah. The 28 and 29. Yeah. That's correct.

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

Okay. Thanks, everyone for joining us this morning. We look forward to talking to you again next quarter. Have a great day. Good bye.