Hello everyone, and welcome to the Alerus Financial Corporation Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions]. After today's presentation, there will be an opportunity to ask questions. Please also remember that this call is being recorded. This call may include forward-looking statements and the company's actual results may differ materially from those indicated in the forward-looking statements. Important factors that could cause actual results to differ materially from those indicated in the forward-looking statements are listed in the earnings release and the company's SEC filings. I would now like to turn the conference call over to Alerus Financial Corporation President and CEO, Katie Lorenson. Please go ahead.

Good morning. Thank you, Bruno and thank you to everyone joining our call today. We appreciate your interest and investment in Alerus. Joining me today is Alerus' CFO, Al Villalon who will discuss our financial performance and results for the quarter. Also on the call is Karin Taylor, our Chief Risk and Operating Officer; and Jim Collins, our Chief Banking and Revenue Officer. This morning I will provide some commentary on the continued execution of our strategic initiatives and ongoing momentum in building a highly valued franchise. During the quarter, we continue to feel the impacts of the challenging interest rate environment and intense deposit competition. However, the NIM improved during the quarter and overall the deposit balances held steady. As our team members constant focus on clients and our relationship banking model was evident as commercial consumer and synergistic deposit categories all grew in the quarter and new accounts open again surpassed closed accounts. Notably, non-interest-bearing balances remained steady at 25% of our overall deposit portfolio and highly selective disciplined modest loan growth also continued during the quarter, as we added high-quality franchise building clients to our portfolio. The loan-to-deposit ratio remained manageable at just over 90% and I'd emphasize again that this is with no broker deposits at this time. Our uniquely diversified revenue mix of 58% fee income helped to stabilize the revenue headwinds caused by the net interest margin compression. As a reminder within this fee income mix, approximately 90% is highly annuitized recurring and non-cyclical revenue with minimal capital allocation and balance sheet risk. Specifically, Alerus' top 25 ranked national retirement services business delivers the majority of this fee income. The business is highly valuable and we remain committed to extracting this value by growing our scaled and highly profitable product lines of the business.…

Thanks, Katie. I'll start my commentary on page 14 of our investor deck that is posted on the Investor Relations part of our website. Let's start with our key revenue drivers. On a reported basis net interest income declined 8.3% on a linked quarter basis. The decline was driven primarily by continued increase in funding costs. Net interest income represented 41.8% of revenues. Switching to fee income; non-interest income increased 10.2% on a linked-quarter basis primarily driven by the impact of the divestiture of our ESOP trustee business within our Retirement and Benefit Services division. Excluding the ESOP trustee business, non-interest income grew 1.6% on a linked-quarter basis. I'll go into detail about each of our fee income segments in later slides. Turning to page 15. Net interest income was $20.4 million in the third quarter. Net interest margin was 2.27% a decrease of 25 basis points from the prior quarter. Impacting the net interest margin was about three basis points of accretion from the Metro Phoenix deal. During the third quarter, we saw improvement in our net interest margin after our index liabilities repriced in July. On a monthly basis July was the low point for net interest margin during the quarter. As the quarter progressed, we saw our net interest margin gradually improve. We ended the quarter with a net interest margin of 2.3% for the month of September which is higher than the 2.27% that we reported for the quarter. Based on the Fed hike last July, we do expect our net interest margin to compress another seven basis points to 10 basis points from the 2.27% since our indexed deposits will reprice in October. Should the Fed be done with raising rates, we do anticipate our net interest margin to continue to improve gradually as our…

[Operator Instructions] We do have our first question. It comes from Jeff Rulis from D.A. Davidson. Jeff, your line is now open. Please proceed.

Thank you. Good morning. Just a quick question – on the – Al on the margins, I just want to make sure I got this right. You talked about kind of another leg down 7 basis points to 10 basis points given the index deposits. So I'm trying to meet that with kind of the commentary about if the Fed pauses – is that kind of more of an idea well into 2024? If you could just guide me through Q4 and 2024 expectations on the margin?

Yes. Thanks, Jeff. So for Q4, we do expect about 7 basis points to 10 basis points of margin compression but we do expect our exit rate to improve from basically from October to December. So as we go into 2024, we do expect net interest margin improvement throughout 2024, even if there's another Fed hike in there.

Okay. And the pause…

And a Fed hike we're anticipating right now. Go ahead.

Sorry. If we do not have a hike that's net better for the margin.

Correct. Correct. And what I was going to clarify is that we are anticipating based on the Fed up plus another 25 basis points of Fed hike.

Got you. Okay. Thank you. On the credit side just wanted to kind of get where the type of loans that the non-accruals, where those came from kind of how the legacy relationship is? Just a little more detail on what was added.

Sure. Jeff, this is Karin. Yeah, that's a commercial credit. And it's in our Arizona market. It's – I would say, it's a part of what we expect in terms of just credit normalization. The issues this credit is experiencing are unique to the credit. It's not indicative of a broader issue.

Thanks. So it was really centered in one credit then was the increase?

Yes. The entire increase is in one credit.

Okay. Got it. I guess just one last one. Just the buyback appetite that seems like a little pickup this quarter, but as we look out and balancing sort of capital and the environment, where do you stand on that as we head into Q4?

So, Jeff, we have the buyback is in place but we are watching price because we want to make sure that the payback is within our -- within three years of what we typically look at.

Okay. I’ll step back in the queue.

Thank you, Jeff.

Our next question comes from David Feaster from Raymond James. David, your line is now open. Please go ahead.

Hey. Good morning, everybody.

Good morning.

Hey, David.

Hey. Maybe just starting out on the funding dynamics from your perspective and just some of the trends you're seeing, obviously, it's incredibly competitive. I'm just curious some of the deposit initiatives that you're putting in place to drive core deposit growth. And then how are core deposits and deposit costs trending across your footprint? I appreciate the balances are expected to be stable. But just I'm curious how the core deposit side is trending and whether you're able to see that mix improve or are CDs going to be the stop gap near term? And just how you think about cost?

Sure. I'll start. This is Katie. From an initiative standpoint, it is all about the talent that we're attracting into the organization. And so as I mentioned earlier, mid-market C&I bankers -- bankers focused in the deposit-rich verticals as well as continuing to invest and build on our treasury management team. And so that has been key to the wins as well as the retention. From a mix standpoint, we certainly are seeing an increase in the CD book. I will say the majority of that business is multiple relationships. And so continue to be core client business. We also are able to retain dollars. We're seeing increases in our wealth management money market fund but the dollars are staying with the company which we believe is a key positive.

Okay. Terrific.

Does that answer your question? Al, do you have?

Yes. David, just in terms of pricing, the way I would like to think about it is that our index deposits typically reprice in the first month of a new quarter if there's any hikes in the prior quarter. So you'll see a little bit of repricing in October from those. And those will hit on money market, specifically but we only have about 14% of our deposits are indexed, okay? We're not seeing much more pressure in terms of broad-based lift. That was kind of all front-end loaded at the beginning of the year. So we've seen our deposit beta stabilize at this point. So I think at this point, it would just be a little bit on the margin here and there outside of this index liabilities. But again to something we were focused on two from a strategy standpoint is constantly looking at where we can get new relationship/low-cost funding for us and that's why we highlighted in the prepared comments HSAs because those are really a great source for us, especially when they carry a cost of only about 10 basis points to 20 basis points.

Yes. That makes a ton of sense. And then maybe kind of just following up on -- maybe touching on the other side of the coin, right? I mean you guys have done a great job growing loans. Obviously new loan yields are much improved. I'm just curious, how do you think about the pace of remix in the earning asset and the repricing schedule there? And ultimately kind of how does that play into the pace of margin expansion? I appreciate the guidance on the next quarter but -- and then we're going to be expanding throughout 2024. I'm just curious, how do you think about the pace of expansion because you guys are doing a great job defending deposit costs and repricing higher. Just curious, how you think about that.

Yes. David, this is Al. I can take that one on. In terms of our expansion, I mean the way I kind of think about it there's kind of two parts of the net interest margin. The first part of it is that we do have a securities book with about a five-year duration, okay? So if you think about that now granted there was some investments of that came in -- those came in later in 2021, in 2020 -- early 2022 but that should roll off and provide us a source of liquidity. And that investment portfolio right now is yielding somewhere in like the 2.5% mid-2s range. So that's going to mature. We're remixing that into funding loans on a go-forward basis. Now also too when you look at our commercial book ex resident and quoting ex residential loans, our commercial book has about a five-year also life in there as well. So as those loans kind of some of those loans that were done pre-pandemic that were done at lower yields kind of come off, they'll be remixing as well until higher-yielding products loans for us as well. So those are two components. But then the third component also to be aware of is that about 40% of our loans are floating as well or adjustable.

Okay. Okay. Perfect. And then just last one for me. You guys have done a great job managing expenses. You talked about that in the prepared remarks. I guess first, I was hoping you could maybe elaborate on the decision to sell the ESOP business and maybe the plans to redirect that capital in those resources. Just how you think about additional investments going forward? Is now the right time to be maybe a bit more opportunistic with hiring and maybe segment or geographic expansion, while others are starting to pull back? Just curious how you think about that.

Yes. This is Katie. Absolutely now is the time. In regard specifically to the ESOP business, a very small piece of the overall business and again it was the ESOP trustee business. So we retained the recordkeeping and administration of that ESOP business, but the trustee business a very small portion. And so better suited served for the leaders that took that over and then their ability to grow it so that we are redirecting our resources all to those core product lines where the opportunity to scale and continue to grow in the business is very significant especially in with Secure Act 2.0 that we've talked about on previous calls. And our investments in that business line we invested in the consultant to come in. We are continuing to invest in talent. We are investing in our internal resources in terms of project prioritization into that business line again to streamline to improve processes, and at the end of the day of course make for a better client experience. In addition, we are investing in an executive 100% focused on the business. The last time that Alerus had an executive who's primary and total responsibility was on the retirement business was when we experienced tremendous growth from $2 million to $60 million in revenue. So that would be the other facet of the investments in this business line.

Terrific. That's great. Thank you.

[Operator Instructions] Our next question is from Nathan Race from Piper Sandler. Nathan, your line is now open. Please proceed.

Great. Thank you. I hope everyone is doing well. A question maybe for Al. It sounds like with the margin guidance is going to come down a little further here in the fourth quarter. And just curious to kind of get your thoughts on how you think about high growth next year and a higher for longer interest rate environment. Looks like NII is tracking down 12% 13% for this year. But just curious how you think about the growth potential of NII under that environment.

Yes. Thanks Nate. I mean, so for NII growth I mean we are looking at -- to be stable up some next year but a lot of it we're just looking right now what is the loan outlook to drive that. But from a NIM basis we do think that we are closer to a trough on our net interest margin too. So those are kind of things we're kind of thinking about as we head into 2024.

Got you. And in terms of funding future loan growth it sounds like you have some cash flow coming out just curious about how that can help that? And hopefully, there will be some deposit growth starting year after some stability this year. So do you see an opportunity to kind of reduce some funding levels to hopefully support greater NII growth next year or how you kind of just think about the level of wholesale funding that you could potentially unwind as hopefully deposit growth increases in 2024?

Yeah, we definitely would love to see more deposits coming to door deposits is king. And we'd love to -- deposits is what just -- its music to my years these days. So as we look into our 2024 planning we are very focused on bringing in deposits and deposit relationships. The question right now is given how much liquidity is coming on to the system what is out of our control is trying to figure that out as well. But we've brought in a tremendous amount of talent especially in the treasury management side to help us with those deposit gathering activities.

Got you. Makes sense. And then just kind of a bigger picture question on some of the fee income lines. Obviously, challenging equity markets was a headwind to wealth management and retirement revenue in the third quarter. But if we get kind of more stable market valuations going forward and with all the initiatives that you guys have put in place to increase the capture rate from the retirement platform into wealth how are you guys kind of thinking about the opportunity to grow those two lines in the next year particularly as you allocate more resources to the retirement unit led the ESOP trustee sale?

Go ahead, Katie.

Okay. Thanks, Alan. So in regards to just top line revenue growth certainly stable improving markets will help both of those divisions. From a momentum standpoint in both business lines we continue to add new clients, core client business really within our sweet spot and within our target markets. The initiatives, I speak to are really about improving efficiencies and margins in the business as well as opening up additional capacity to continue to bring on that new business. So we have some initiatives where we're seeing early success. I think it's still a little bit too early to call but definitely putting the right processes in place to really grow this and are seeing some early indications of success. With that, I think, I'll turn it over to you Al in terms of guidance.

Yeah. So, just as we think about next year, I mean the $15.3 million for lease retirement is the launch point which we talked about. We'll see probably gradual improvement in there, because only about 35% of our revenues there are market sensitive. So the rest of it is really kind of growth and plans and participants which we would continue to see growth in that area. So we're pretty optimistic on that side.

Okay. Got it.

And then, Jim is there anything you want to add on there?

Nate, I was just going to -- this is Jim Collins. I was just going to add and reiterate really what Katie said is, our expectation of core new client growth from our existing staff due to the oncoming of the private banking team and the synergies that those teams are building. I think is really important that we will see that growth. In addition we've instituted a much more aggressive recruiting plan for those lower entry-level advisers that can help harvest out of the 401(k) rollovers. So I think that's what we'll see additional growth next year.

Got it. Very helpful and just maybe one last one for Katie, curious if you're kind of more or less optimistic today on potential acquisitions on the retirement side of things in light of what you're seeing from a pricing perspective in your discussions with potential partners and what you're seeing from a competitive perspective relative to other entities that are also maybe looking to expand in that space.

I think we sit very well-positioned from a competitive standpoint in all of our business lines. I think our company has got a really unique story to tell and a very strong reputation. And that in and of itself is having more volume of calls, coming our direction in terms of interest in looking to potentially partner with us. So we'll continue to be very prudent and disciplined as we look at those opportunities. But I would say the momentum is trending in the right direction for future talent lift-out strategic opportunistic acquisitions.

Got it. That's great to hear. I appreciate all the color and thank you guys for taking my questions.

Thanks Nate.

Thanks Nate.

Our next question comes from Damon DelMonte from KBW. Damon, your line is now open. Please go ahead.

This is Matt Renck from KBW, filling in for Damon DelMonte. I hope everybody is doing well. Most of my questions have been asked and answered,…

Hey Matt.

…but this is a follow-up. Hi. Just as a follow-up the IRA roller is $100 million just to put some context around that number where do you think you could grow that to in 2024 with the new initiatives?

Sure. Just for context that's about an 8% capture rate today and has been mostly on the reactive side and the initiatives are really around proactive reach out to these individuals at a very timely way and high-touch way. And then, as Jim referenced continuing to build our talent pool with the opportunity then we are a very -- we have a differentiator in attracting that talent to our company because of this opportunity. So we anticipate continuing to see that capture rate of 8% increasing.

Okay. So do you think it could potentially reach like 10% to 15% or is it more gradual than that?

I would say it takes time so it will be a little more gradual than that.

Okay. Got it. That's all for me. I'll step back. Thank you.

Thanks Matt.

We currently have no further questions. So I would like to hand back to Katie Lorenson, for closing remarks. Over to you.

Perfect. Thank you and thank you everyone for the questions. I will end with just a comment about the company and our unique strength of our diversified business model which again continues to differentiate our ability to attract and retain clients as well as talented professionals. We remain laser-focused on our strong and diversified balance sheet, talent investments fee income and investments in our key business lines while again, optimizing our infrastructure to return our company to our long history of delivering strong profitability, tangible book value growth and top-tier returns to our shareholders. Thank you to our investors, our analysts and to everyone joining the call today. Have a great day.

Ladies and gentlemen, this concludes today's call. Thank you for joining. You may now disconnect your lines.