Old Second Bancorp, Inc. (NASDAQ:OSBC) Q4 2022 Earnings Call Transcript January 26, 2023
Company Representatives: Jim Eccher – Chief Executive Officer Brad Adams – Chief Financial Officer Gary Collins – Vice Chairman of the Board
Operator: Good morning, everyone, and thank you for joining us today for Old Second Bancorp, Inc.’s Fourth Quarter 2022 Earnings Call. On the call today is Jim Eccher, the company’s CEO; Brad Adams, the Company’s CFO; and Gary Collins the Vice Chairman of our Board. I will start with a reminder that Old Second’s comments today may contain forward-looking statements about the company’s business, strategies and prospects, 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. Management would ask you to refer to the company’s SEC filings for a full discussion of the company’s risk factors.
On today’s call, we will be discussing certain non-GAAP financial measures. These non-GAAP measures are described and reconciled to their GAAP counterparts in our earnings release, which is available on our website at oldsecond.com on the homepage and under the Investor Relations tab. Now I will turn it over to Mr. Jim Eccher.
Jim Eccher: Good morning and thank you for joining us today. Same format as prior quarters. I have several prepared opening remarks. Give my overview of the quarter and then I’ll turn it over to Brad for more additional details. We’ll then conclude with some summary comments and thoughts about the future and then open up for some questions. Net income was $23.6 million or $0.52 per diluted share in the fourth quarter. Net income adjusted to exclude West Suburban acquisition related costs, less net gains for brand sales was $24.1 million or $0.53 per diluted share in the fourth quarter. On the same adjusted basis, return on assets was 1.61%. Return on tangible equity was 28.33% and the tax equivalent efficiency ratio was 51.29%.
Fourth quarter earnings were also negatively impacted by a combined $1.3 million in pre-tax security losses and fair value adjustments for mortgage servicing rights. In aggregate, obviously an exceptionally strong quarter with more than 20% earnings growth linked quarter on annualized. Our financials continue to be favorably impacted by the increase in market interest rates with a 15% increase in the net interest income or $8.5 million over the third quarter of 2022 due to relatively stable funding costs and increasing asset yields across the balance sheet. The fourth quarter marks a full year since our acquisition of West Suburban Bank and I believe both, our execution and the positive impacts of the acquisition are apparent in our financials.
We have outperformed our own internal expectations on cost saves, loan growth in revenue that we had set out for ourselves. These internal targets became more aggressive as we move from deal announcement to the months following the closing of the transaction. We have been more successful than we had hoped in bringing on new sales teams along with experienced, back office managerial talent. We are a better company today than we were at the close of the acquisition. Plenty of work remains and this will be the full extent of our self-congratulations, but it seems appropriate to close the loop on this with a full year behind us. Overall, we cannot be more pleased with where things stand today from both a balance sheet positioning and operational standpoint.
The fourth quarter of 2022 reflected minimal loan growth due to both the usual seasonal slowdowns and reduced demand with an increased cost of borrowing. Exclusive of PPP loan run off, we had $1.1 million of loan growth quarter-over-quarter. Prepayments continue at a lesser rate than prior years, but origination activity slowed considerably in the fourth quarter. However, activity within loan committee remains better than expected for this time of the year and our confidence in loan growth in 2023 has not changed. January pipelines are building nicely and we believe originations will be strong in 2023. The net interest margin continued to expand this quarter with loan yields reflecting recent increases in market interest rates. Overall, the tax equivalent net interest margin was 4.63% for the fourth quarter compared to 3.96% in the third quarter.
The margin benefit resulted from balance sheet mix improvement, the impact of rising rates on the variable portion of the loan portfolio and strong loan growth for both the second and third quarter, which are now represented in the growth in net interest income. Loan to deposit ratio is now 76% compared to 73% last quarter. As we said last quarter, the focus for us now has shifted to balance sheet optimization and Brad will talk about that more in a minute. Turning to credit, we recorded net charge offs of 940,000 in the fourth quarter 2022, compared to 68,000 of net charge offs in the third quarter. Total classified loans decreased $4.8 million to $108.9 million from $113.7 million last quarter. Other real estate owned reflected no change in the fourth quarter and remains deminimis at $1.6 million.
We remain confident in the strengths of our loan portfolios. The allowance for credit losses on loans increased to $49.5 million at the end of the year, from $48.8 million at the previous quarter, which is 1.28% of total loans and just a few basis points more than the total ACL to gross loans at September 30, 2022. At quarter end $1.6 million of provision for credit losses on loans was recorded, partially offset by a reduction of 74,000 up for provision for unfunded commitments. The increase in the ACL on loans was primarily driven by a slightly higher loss rate in the fourth quarter compared to the prior few quarters, primarily due to the sale and related charge-offs resulting from one larger non-performing credit, which we have spoken about on this call for over a year now.
Our outlook is cautiously optimistic as the underlying economy appears strong, albeit with significant uncertainties. We believe that we are more than adequately reserved under base case scenarios, but continue to overweight more pessimistic scenarios given that a higher degree of uncertainty. Recession probabilities increased relative to last quarter in our estimation. Credit remains very well behaved that we remain mindful and diligent in monitoring trends, both within the portfolio and more broadly. Non-interest income continues to perform well with growth noted in the fourth quarter of 2022, compared to the third quarter of 2022 in wealth management fees, bowling income and card related income. Pre-tax losses of $910,000 on security sales were incurred related to strategic repositioning within certain security types in our portfolio.
Expense discipline continues to be strong and we are far ahead of schedule on cost save targets announced with the acquisition. Total merger related costs of $645,000 were recorded in the fourth quarter. In addition, we recorded net gains on branch sales of 28,000, all pre-tax. The branch sale gains are recorded within occupancy expense. The sum total of these non-recurring, non-interest expense items discussed total of net $457,000 expense after tax, which resulted in adjusted earnings per fully diluted share of $0.53 for the fourth quarter. As we look forward, we are focused on doing more of the same, managing liquidity, building commercial loan origination capability for the long term and making prudent investments in the securities portfolio in the short term that did not carry excess spread or credit risk.
The goal remains to continue to build back towards an 80% plus loan-to-deposit ratio in order to drive the returns on equity, commensurate with our recent historical performance. With that, I will turn it over to Brad for more color.
Brad Adams: Thank you Jim. Net interest income increased $8.5 million relative to last quarter and $35.5 million from the year-ago quarter. Margin trends increased due to a loan portfolio growth, as well as due to the increases in security and loan yields from market interest rate increases. Total yield on interest earning assets increased 76 basis points to 489 basis points over the linked quarter, partially offset by an 8 basis point increase in the cost of interest bearing deposits and a15 basis point increase in interest-bearing liabilities aggregate. Obviously, exceptional margin performance. The fourth quarter continued to see a significant movement in rate, albeit this time in the opposite direction, with inversion across the entirety of the curve that leads many to read this or that from the tea leaves.
Obviously the short end of the curve remains high and this is where Old Second largely lives. I won’t bore you with my take on macro things, other than to briefly mention that I don’t believe that a Fed focused on inflation is going to whipsaw short rates absent a significant shock of some sort. The once popular belief that zero interest rate policy had no risk has proven shockingly misguided and any expectation and a reversion to that mean is foolish in my opinion. Obviously I’m biased as a decade-long sufferer of the belief that core deposits matter. So take that opinion for what it’s worth and feel free to unsubscribe from my newsletter going forward. The implications for investors in Old Second is that we aren’t in a hurry to place a large bets on the path of interest rates.
Photo by Towfiqu barbhuiya on Unsplash
Duration is being added to reduce asset sensitivity in numerous ways, including remixing out of the variable securities that has served us so well, and the addition of received fixed swaps. Few saw this coming and fewer still will nail attempted inflection point trades. Old Second is a very good Bank in my opinion and should not attempt to be a hedge fund. Our positioning over the last 18 months was undertaken to provide us with flexibility to fund in an environment where deposits become expensive. The success of that strategy is somewhat on display this quarter with $76 million in liquidity provided from the securities portfolio, with only a small loss realized. The loan-to-deposit ratio remains very low and our ability to source liquidity from the portfolio has increased relative to the color we gave you last quarter.
I would like to remind you that longer duration portfolios with longer duration than Old Second’s would have seen relative outperformance to ours given the sharp end version from the short end. The mark on the securities portfolio remains high, but will be recaptured relatively quickly. The net result is that Old Second should build capital quickly as evidenced by the 57 basis point improvement in the TCE ratio linked quarter. At 12/31 the portfolio duration was approximately three years. The weighted average life was approximately 4.5 years, and a little less than a third of the entire portfolio was still variable. I would also remind that Old Second has not moved anything that held the maturity, so what you’re saying is not maybe directly comparable to others.
The tax equivalent yield on the securities portfolio increased by approximately 55 basis points during the quarter and we are continuing to project a little less than $50 million per quarter in cash flow from the portfolio quarterly. If necessary, we can quickly sell several hundred million dollars at a loss of approximating 3% to 4% of net book value. That may not sound great at first blush, but I think it compares exceptionally well to others on a relative basis. The end result of that is that I don’t think it gets a whole lot worse with tangible book value increasing by more than 8% this quarter. I’m optimistic we have turned the corner. The trend should be very positive from here. The rest of the balance sheet looks fantastic. The deposit base as many of you know is extremely granular and insensitive to rates.
On the loan side Old Second is transitioning quickly to a higher rate world, with rapidly improving profitability. The coming quarters will likely see us pay down the notes payable with $9 million coming off in the first quarter and our attention turning from here to senior debt, perhaps later in the year. On the expenses front, a little bit elevated in the fourth quarter, in large part due to incentive compensation and Old Second’s performance this year on loan growth and bottom line performance relative to budget. There should be some relief in the first quarter of 2023. Wage pressure continues to be real in our markets, but has lessened considerably in recent months. The fourth quarter did represent the first full quarter impact of wholesale wage increases across the retail network.
That being said, I would expect quarterly wages and benefits to more closely approximate $22 million going forward. Given the revenue performance, investment has been running high, but we will maintain the ability to dial back as conditions warrant. I’m very pleased with the way the team has come together in identifying the improvements we need to make to transition into to a larger and more dynamic company. Deposits decline 3.2% from third quarter levels, primarily from tax payment seasonality as some parked funds exited. We also had a modest impact from a rate-sensitive acquired accounts. In aggregate though, trends were stable throughout the quarter. The resulting remix and improvement in the loan to deposit ratio clearly benefited the margin.
67 basis points of margin improvement is by any measure a lot. Margin trends from here will be more subdued. The trend remains positive and soon the fixed rate portion of the loan portfolio will begin to contribute as well. As Jim mentioned, we do feel good on the loan growth side, but I would expect slower growth until the second quarter of 2023. Deposits are a tougher game now, with a couple of local banks recently going very big on the time deposit and teaser rate front, but I still believe the Old Second will perform as well or better than it did during the last tightening cycle. The end result is that margin trends are expected to continue to trend in the right direction. Non-interest income decreased from last quarter by $2.6 million, driven by a $1.1 million net decrease in mortgage banking revenues, primarily stemming from a reduction in MSR income, as well as $910,000 net losses on security sales.
So reduction in other income due to pretext gains recorded in the third quarter of $743,000 from the sale of our Visa Credit Card portfolio and $180,000 due to the sale of the land trust business, both acquired with the West Suburban acquisition. Wealth management boldly and card related income, each reflected growth in the current quarter. Provision for credit losses of $1.6 million and our economic outlook remains largely unchanged from the third quarter, with an unemployment rate projection of approximately 4.5% to 5.75% through December 31 of this year and over the remaining life of the loans. I would expect loan growth to be roughly consistent with provision growth over the near term, though that could change with significant worsening in the macro environment.
We recorded a reversal of provision of credit loss of approximately 74 grand on unfunded commitments. Non-accrual loans declined a bit this quarter. 90 days past due declined considerably from the $20.8 million balance from the third quarter to $1.3 million at year-end. Classified loans decreased modestly as Jim noted and I would add that a larger credit we downgraded in a prior quarter was sold early in the first quarter 2023, resulting in an $800,000 charge off taken at year-end. Overall, we are pleased with how credit has performed and continue to consider credit metrics as both stable and excellent. Expenses were difficult to manage this year and into 2023 with mid-single digit increases in salary and double-digit increases in benefits, reflecting wage inflation and a difficult environment to hire.
We are managing through this and thankful for the flexibility and revenue strength that exists for us right now. Our efforts in the coming quarters will be continuing to bring additional talent on board, helping our customers and funding quality loan growth with the continuing trend of excellent overall core profitability. We expect loan growth to outpace earning asset growth for the bulk of 2023. We are continuing to look to build capital back a bit following our investment in West Suburban and think it will happen quickly. With that, I’d like to turn the call back over to Jim.
Jim Eccher: Okay. Thanks, Brad. In closing, we remain confident in our balance sheet and the opportunities that are ahead for Old Second. We’re paying close attention to both expenses and credit. We believe our underwriting has remained disciplined and our funding position is strong. Today, we have the balance sheet and liquidity flexibility to take advantage of a rising rate environment and will be aggressive in looking at new talent and new relationships. That concludes our prepared comments this morning. So I will turn it over to the moderator and open it up to any questions.
See also 15 Biggest Natural Gas Pipeline Companies in the World and 13 Biggest Eyewear Companies in the World.
To continue reading the Q&A session, please click here.