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 note, this event is being recorded. This call may include forward-looking statements and the company’s actual results may differ materially from those indicated in any 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 feelings. I would now like to turn the conference call over to the Alerus Financial Corporation President and CEO, Katie Lorenson, to begin. Katie, please go ahead.

Thank you. Good morning, everyone. Thank you for joining us today for our quarterly earnings call. Here in the Twin City today with me is Al Villalon, our CFO; Karin Taylor, our Chief Operating and Risk Officer; and Jim Collins, our Chief Revenue Officer and Head of our Commercial Wealth Bank. Forrest Wilson, our Chief Retirement Services Officer is also joining us on the call. I’ll start the call with some prepared remarks and strategic highlights for the quarter. Al will spend a few minutes hitting on the key financial highlights, and then we will address your questions. There is no question that this was a tough quarter for Alerus. We are not and will not be satisfied with our results until we are delivering superior returns. That being said, we also firmly believe success is not measured by a single quarter, and while the third quarter came up short, it was also a period of continued progress and execution of our key long-term strategic initiatives for our company. While the path to returning to top performance is not linear, the substantial strides we’ve made demonstrate our commitment to achieving our consistent top-tier performance. Our focus remains on driving shareholder value through steady growth, diversified revenue positive operating leverage and maintaining conservative efforts. Let me begin with the transformational changes we’ve been making over the past year and a half as we build a premier Commercial Wealth Bank. Over this period, we have added key talent, continue to diversify our loan portfolio and closed on our largest acquisition to-date. We’ve also managed through the challenging work of numerous restructurings, rightsizing and exiting of several business lines, which were not core to our focus. Regarding talent, we have worked with urgency on getting the right people in the right seats, and…

Thanks, Katie. I’ll start my commentary on Page 11 of our investor deck as posted on the Investor Relations part of our website. Let’s start on our key revenue drivers. On a reported basis, net income decreased 6.1% over the prior quarter, while fee income grew 3.6%. The decrease in net interest income was driven primarily by lower purchase accounting accretion for the Metro Phoenix Bank acquisition, an increase in non-accruals and higher interest expense due to mix shift from non-interest-bearing deposits to interest-bearing deposits. Growth in fee income was primarily driven by an increase in overall asset base fees within our Wealth and Retirement business line and from a gain recognized in the sale of one of our offices. Turning to Page 12 in the third quarter. We can dive into interest income a little more closely. Net interest income decreased to $22.5 million and our core net interest margin decreased partly due to three factors. The first one being lower purchase accounting accretion for Metro Phoenix as you can see above decrease from 10 basis points to 210 basis points, less net interest income due to higher non-accruals and higher interest expense from an increase in interest-bearing deposits. At the end of the quarter, we repaid our borrowings from the BTFP as the Fed recently reduced interest rates. So going forward, our reported net interest margin no longer reflect the drag from these low interest earning assets. We continue to see a path to our net interest margin reaching 3%. The path will not be linear as each quarter will have the different factors affecting net interest margin. For the migration of non-interest-bearing deposits to interest-bearing would drive our cost of funds higher. Turning to Page 13 to talk about earning assets. Since acquisition of Metro Phoenix Bank,…

Thank you. [Operator Instructions] And our first question comes from the line of Jeff Rulis from D.A. Davidson & Co.

Thanks. Good morning. A question on…

Good morning.

…on the larger credit, I guess, on non-accrual, as you extend more to potentially put yourself in a good position there. I guess, is that capped the extension of credit to that the construction item or is there more to come to kind of get it over to completion? And then I guess, secondarily, could you just remind us kind of where that is located and the time line on resolution?

Sure, Jeff. This is Karin. Yeah. We continue to evaluate a number of options with regard to this particular credit. If you recall from last time, the borrower has been proactive in injecting equity into the project to cover overruns. It went to non-accrual because additional equity injections were delayed. They continue to try and source additional equity. That said, we will look at a range of options as we determine how to best resolve the credit. It is here in the Twin Cities market. It’s on the east side of Twin Cities, relatively close to both Downtown. St. Paul and Downtown Minneapolis. It’s well located to entertainment, to public transportation, it’s a Class A property in a preferable location. So we continue to feel good about the market dynamics and the market ability to support that property. It is about 87% complete at this point and we’re looking at early 2025 for completion. Obviously, we’re doing everything we can to resolve as quickly as possible, but I don’t have a firm time line for you.

Okay. I appreciate it. Thanks, Karin. On the expense side, Katie, I think you have, I guess, I’m interested in those areas that aren’t necessarily -- that were operational, but maybe not recurring. We can carve out the one-timers, but I guess of the areas that were elevated, trying to get a sense for the comp line, are those hires fully baked in and then maybe professional services, just some areas that you may see maybe tail off potentially that aren’t recurring, if you will.

Sure. Yeah. In regards to the professional fees. I would expect to see more normalization if you take the run rate for the past couple of quarters ex the M&A. There’s some lumpiness in between the second quarter and third quarter I would say for both the compensation line, as well as the professional fees line item.

Okay. I guess on a core basis to Al’s commentary, I mean, ex the added platform, you’re bringing on legacy expenses, can we expect flat to down? Trying to get a sense for what the trend is there?

So, Jeff, you’re going to see just on a reported basis, so our expenses, we are going to combine mergers. But on a layer standalone basis, if you were just to look at us, we are committed to getting that down. So that -- from a combined entity because we’re now two companies getting combined up, you will see reported expenses, of course, go up. We’re committed to the 30% cost saves -- 30% plus cost saves that we detailed out in our original performance for the deal.

Yeah. Al, I guess, I’m trying to get a sense for -- we could track the expenses on HMN side and what that potentially could add.

Yeah.

And we can carve out cost saves in 2025. But just the run rate for legacy is -- that’s the key I’m trying to nail down.

Yeah. Yeah. You would expect that to come down. Yes.

Got you. Maybe just one last one then on the loan growth. Really strong growth, and Katie. I appreciate the tilted towards the market share gains to the degree of, I guess, that -- does that suggest that the market overall, maybe the pie is not growing, you’re just taking a bigger piece of that or the question really is just on the underlying business trends and activity. Is that improving some, but you’re executing well on taking share. I just wanted to kind of wade into that discussion a little bit more.

Jeff, this is Jim. That is taking market share. We brought in a lot of talent over the last 18 months. Those non-solicits are up. So a lot of the relationships that are moving over and we’re seeing that in the growth. Our relationships that have been known to a lot of the employees here now that have come over for a long time. So it is market share in some of the other banks that are probably resting on the laurels a little bit.

Okay. And Jim, your pulse on the activity, generally speaking, of the market from demand, what would that be?

I think all the markets that we’re currently in are in pretty good economic shape. There’s not a ton of robust growth, I would say, but pretty average. So I don’t think there’s a lot of growth exponentially, but there’s enough growth for us as other banks are still not overly active in the marketplace. I think our activities are going to generate a lot as the market competition comes back. Our activities now are going to be more fruitful in the 2025 to 2026 just because they haven’t -- a lot of the banks haven’t been in the market as much as we have been.

Okay. Appreciate it. Thank you.

We will now take our next question that comes from David Feaster with Raymond James. David, your line is now open.

Hi. Good morning, everybody.

Hi, David.

I wanted to dig into the margin for a second. Look, there’s a lot of moving parts in here. I was hoping you could just help us think through maybe like a core margin, what’s a good starting point? Look, we’ve unwound the BTFP. You got HMNF in the fold. Just thinking through the trajectory, again, you got the non-accrual reversal in the last quarter. Just how do you think about a good core margin starting point, the trajectory going forward as your liability sensitivity had improved. And if you had any updated expectations for accretion just on rate marks now the deals closed?

Thanks, David. So with September on a legacy portfolio with an interest margin of around 2.41%. When you think about the acquired portfolio, HMN portfolio, their net interest margin is around 2.8% for the third quarter, okay? So those are both quarter-to-quarter, no deal marks, of course. Now on a going forward basis, we did indicate about a $54.2 million mark on the loan book. We’re still waiting back on the final valuation there, but we do expect that $54.2 million on original deal assumptions to be a little bit less given where the rates have moved since our announcement in May. So we’ll have less income accretion -- purchase account accretion to net interest income for next year in terms of deal accretion, but we also will have less goodwill because of the marks.

Okay. Okay. And then just how do you think about deposit betas on the way down? You talked a lot about the competitive landscape in your market for deposits. That’s obviously way on the margin.

Yeah.

How do you think about the competitive landscape maybe impacting your ability to reprice deposits on the way down? I mean is that going to make it may be a bit more difficult to do that and just curious how you think about that and some of the assumptions in your outlook?

Yeah. We’ve been pretty conservative in our assumptions in terms of deposit betas. We do expect deposit betas -- I mean our deposit pricing to lag a little bit on the way down because given how many banks are still north of 100% loan-to-deposit ratio and still continued. Again, in this quarter, we saw migration from non-interest-bearing to interest-bearing too, which increased our cost of funds. So in terms of the betas, now we are being -- we are seeing some rationalization though, because we did see in all our markets CD rates pull back some. So that is encouraging to see some of that now. We’re not seeing stuff in the high 5s or 6s anymore. We’re now seeing things come back, especially with the Fed cut. But I do think deposit betas on the way down will be a little bit slower to realize than probably take another 50 basis points to 100 basis points before we start seeing meaningful shift in deposit costs.

So that just kind of putting that all together, your margin trajectory is probably going to be more back half weighted for the expansion side. Is that a fair characterization?

Yeah. That’s correct. That’s correct. I think we -- when we still look at our ALM modeling, based on what we’re seeing still though, and I’m not talking about any deal marks, we’re looking on a legacy book right now, because we’re still importing a lot of stuff in understanding the HMN portfolio. When we look at our legacy Alerus book, we still see a path to 3% with even that lag effect coming in. So depend -- nothing has changed right with no rate cuts, we still get to 3% in 2026. And on a down -- the last thing I’ll add there too, that -- David, just the last thing I’ll add to is on a down 100-basis-point scenario, we still see our NII increasing in the legacy book about mid-single digits.

Okay.

Ex…

And maybe just last…

We have that locked in.

Okay. Good point. That’s a good point. Okay. And then just last one. You’ve had a lot of success in the Retirement and Wealth businesses. I appreciate some of the commentary that you had. You talked about some success with some national partners. I’m just curious where you’re seeing success in those lines of business? And then just following up on the commentary about improving efficiency. I mean profitability has come down pretty much in those businesses. I’m just kind of curious when do you start -- when do you think that that’s going to start manifesting itself and how do you think about the profitability profile of those businesses?

Yeah. I can take that. This is Forrest. I can take that for the Retirement business. One of the other benefits to this business is its very steady business, but we do anticipate margins to improve really in response to the groundwork that we’re laying in three areas, in efficiency, increased revenue and reduced client turnover. And Katie mentioned some of that in her opening comments, but we’re moving forward with multiple efforts in each of these areas, including upgrading some technology that we’re very excited about working on process improvement and forming new partnerships, which you specifically mentioned, I think there’s about 10-plus states now that have state-mandated Retirement plans and a lot of private companies do not want to go with the state plan and it’s definitely -- there’s a groundswell of startup plans, which with our PEP, our pooled employer plan model, we’re taking advantage of and that’s leading to some significant partnerships, one that we could highlight is our partnership with Mass Mutual Financial Advisors that has yielded north of 150 new Retirement plan clients in the last 14 months or so. So as far as margins go, we anticipate expanding margins through these various efforts, but it’s going to be steady over time.

Okay. Okay. Thanks, everybody.

Thanks, David.

And the next question comes from Brendan Nosal from Hovde. Your line is now open, Brendan.

Hey, everybody. Thanks for taking the question.

Hi, Brendan.

How you are doing well? Maybe just to unpack like this quarter’s margin before we get into the outlook here, could you help us understand some of the drivers of the loan and earning asset yield pressure? I guess, one, how much of a drag came to non-accrual piece? And is that recurring as long as those loans may not accrual, and then two, was there any impact from the swap maturity in this quarter? Thanks,

Yeah. Thanks, Brendan. So nothing on the swap maturity when it comes to the non-accruals, you could see that about roughly around 7 basis points to 8 basis points was from the non-accruals.

And does that drag stick around as long as those bonds are on non-accrual or is that more of an interest reversal?

There will be a reversal.

So that 8-basis-point drag will not be present in the fourth quarter, just to make sure I understand completely clearly.

Yeah. That should not be there. Correct.

Okay. Got it. Okay. Thank you. And then as the rest of the swap book rolls off, as it is pertaining to timing versus where the terms of those stats are versus where Fed funds is? Is there any kind of intermediate impact one way or the other as those fall off the sheet?

No. I mean what we’re anticipating in this quarter is a slight decrease in our -- on the legacy interest expense. But we -- there is -- we should start seeing margin improvement going forward because the swaps, we had $200 million rolling off here in January. So then we will only have another $200 million left from January 2026. So there will be a very minor impact left from the remaining swap.

Okay. Perfect. And then maybe last one on Mortgage. I know you’ve kind of offered the guidance for the fourth quarter there. I mean, for this quarter, it seemed like things were better than I was thinking, even though originations were down kind of the core gain on sale was quite a bit stronger quarter-over-quarter. Just wondering if there’s anything that was kind of worth calling out for the third quarter performance?

No. We did disciplined pricing in that area is what really helped in the Mortgage area. Hence why you saw the better gain on sale.

Okay. Yeah. Yeah. All right. Thank you for taking questions.

Thanks, Brendan.

[Operator Instructions] And our next question comes from Nathan Race with Piper Sandler.

Hi, everyone. Good morning.

Your line is now open.

Thanks for taking the questions.

Hi, Nathan.

Hi, everyone. Good morning. Thanks for taking the questions. Just put all the pieces together around the margin outlook and just the impact from Home Federal. Al, can you just help us with kind of a 4Q NII starting point, both on a core and reported basis?

Yeah. Yeah. So I would look at it, it’s like Home Federal at 2.8% take 20% of that and then 80% as around 2.4%, you’re going to get to somewhere in the mid-2s like 2.5-ish.

So you’re talking margin, I was referring to NII.

Oh! I’m sorry, for NII, my bad. Sorry. When we talk about NII, we’re looking at right now, let me just get that number up for you. Because we’re doing about, I’m going to say, around $32 million to $33 million in total for NII.

That’s kind of the starting 4Q with Home Federal?

Yeah. Yes. Without any deal marks.

Right. Right. And just thinking about the opportunity to maybe deleverage the balance sheet at Home Federal. Any other balance sheet optimization initiatives that could come to fruition with that deal? Just curious to hear any thoughts as it relates to your loan sales or just securities portfolio restructuring that could help that margin outlook as we get through the integration into early 2025?

Yeah. So we already looked at doing some loan sales for that, we’re contemplating laying off options on the loan front. On the securities front, you can expect that we’re going to make -- we’ve done some stuff on that front to help with NII. But the lift from the securities book because they only had about $190 million worth of securities is going to be very small.

Okay. Perfect. Very helpful. And then just -- in terms of just the rate sensitivity of the combined franchise going forward. I think we talked about the liabilities since the position of the balance sheet previously. You have some swaps going off next year. So just curious how you are kind of thinking about just the static margin or NII impact from each 25 basis points…

Yeah. We are…

… going forward?

Yeah. We’re still working through that right now as we get our two systems merged in place. But what we could see from the surface right now is that they’re liability sensitive, so that’s just going to add to liability sensitivity that we have.

Got it. Thanks for that. Switching gears, maybe a question for Karin. Curious if you could just touch on what you saw in terms of criticized classified loan trends in the quarter?

Sure. Good morning, Nate. We did see those increase again. What I would say about that is that while we’ve been experiencing increases, overall levels are fairly consistent with what we saw pre-pandemic. And so the non-performing obviously are higher and those are being driven over half of that by that one loan. So those are higher than what we’ve experienced in the past. But generally speaking, the criticized and classified levels are more consistent with pre-pandemic. And when you look past these few credits that Katie pointed out in her comments, there’s -- they’re really made up of all different segments, even the asset classes within the commercial real estate are different and then origination date kind of span all the way back actually to mid-2015. And so I think really what we’re seeing is we’re seeing some continued normalization, which isn’t unexpected, but then we’ve got these couple of big deals that are really bouncing those non-performing numbers.

Got it. That’s very helpful. Maybe one last question for me for Katie. Now that you got Home Federal closed in a pretty timely fashion here in the fourth quarter. I would just love to hear your updated perspective in terms of managing excess capital. Obviously, with the profitability improvement with Home Federal, you guys should be accreting excess capital at stronger clips going forward. So just curious how you’re thinking about weighing those options and deploying excess capital between additional acquisitions, whether it’s on the Retirement or Wealth side or in terms of whole big acquisitions or perhaps resuming share repurchases just given where the stock is trading.

Sure. Yeah. Thank you. In regards to capital, our priorities remain consistent with the previous quarters. Organic growth is certainly a key priority to maintain our fortress balance sheet is always number one in our priority books. Our commitment to our dividend remains consistent with our long history. And as I mentioned in my opening comments, we understand the value embedded in this company and so having the share repurchase out there from a defensive standpoint, I think, serves us all well. In regards to M&A, again, there’s a couple of catalysts particularly in the Retirement space for some scale providers, and we are known and have proven that we are a partner of choice for many of those companies. We’ll be highly selective of course, because there’s a lot of work that we’re doing internally in that business, but we believe we will continue to see opportunities specifically in that Retirement, as well as in the Wealth space.

Got it. Very helpful. Thanks for all the color.

Thanks, Nate.

The next question comes from Damon DelMonte with KBW. Your line is now open, Damon.

Hi, everyone. Thanks for taking my questions. First one, just regards to expenses. Al, kind of just wondering what your thoughts are on the combined company here in the fourth quarter. I think you guys mentioned the Wealth plat -- Management platform upgrade you guys are going to be doing. So just trying to get a gauge on kind of what we could expect here in the fourth quarter?

Yeah. Damon, I’m going to say that fourth quarter is going to be a little messy here because we’re going to have a lot of the deal expenses flowing through especially contract terminations and onboarding of new stuff. So I don’t have a good guide for you at this moment in terms of the fourth quarter run rate. But what I could say for the 2025 run rate is that we are looking once you get pass all the deal costs and everything from a combined basis that we’re still on track to meeting all the goals we set for in 2025.

Okay. Yeah. And I understand there’ll be a lot of moving parts. But I mean is the simple way of looking at it is -- if you take out the merger this quarter, you’re around $40.8 million today, basically layer on the HMNF expense base and then start to take off some expenses, which would kind of put you in the upper $47 million, low $48 million range. Is that ballpark?

That’s the way to think about it, right, on a core basis. Correct.

Okay. Okay. Great. And then with regards to the two new loans that moved into non-accrual this quarter, could you just scale a little bit more color, one of them was a large residential relationship, like how big was it and what kind of reserves do you have against that?

Yeah. Damon, this is Karin. That relationship was about -- is about $8.5 million and it’s comprised of an owner-occupied property, as well as the previous property that’s listed for sale. The current reserve on is about 5% and we will be getting updated valuations on both of those properties.

Okay. Great. Great. So both of those were to one borrower. One part of it was residential and one was owner-occupied?

Yeah. It’s a long-term Banking and Wealth client, as Kate mentioned, and he had a primary residence, constructed a new residents, which we financed. And so he -- both of those residents are single-family residences and he is in the new home now and the previous homes listed for sale.

Got it. Okay. And then with regard to the construction loan, this may have been asked before, so I apologize. But is there any additional funds to be released to this borrower to help complete the project or are you at full exposure right now?

We’re at full exposure on that deal.

Okay. And then that’s at about how much now 20, is it upper 20s?

Oh! Oh! I’m sorry, you’re talking about the original deal. I thought you were talking about the residential deal. No, no, I’m sorry.

I’m talking about the construction loan, yeah, sorry.

Okay. Yes. That one, we’re considering -- we still are considering a number of options on that one, Damon. The borrower is continuing to try to raise equity. They’ve demonstrated their willingness to inject equity and so we’re supporting that process. But certainly, additional fundings may be on the table as we look at how we can most quickly resolve this.

Got you. Okay. And have you quantified what the total exposure is to that one particular borrower?

Right now as of 9/30, the balance was $25 million and the approved or they’re approved up to just under $29 million.

Great. Okay. That’s helpful. Thank you. I think that covers everything. So, thank you very much.

Thanks, Damon.

The next question comes from David Feaster with Raymond James. David, your line is now open.

Hi. Thanks for let me hop back in. I just wanted to touch on…

Yeah.

… the hiring front. You guys have been really active. You’ve attracted a lot of new talent. I’m curious, I guess, A, what’s your appetite for new hires and how much of the production, like, how much of the growth that you’re seeing from those guys or is that kind of still on the come?

Hi, David. This is Jim. I will say we’re still active on hires, but I do want to note we are -- as we have some individuals leaving the organization, we are repurposing those FTEs for a lot of the new hires. The growth is coming from those new hires because they have capacity and relationships that are new, but we also have a lot of growth coming from our existing traditional portfolios as well.

Okay. Okay. And I guess, as you think about funding growth going forward, I know we kind of talked about a mid-90s loan-to-deposit ratio. Is that kind of still the target? And I just -- how do you think about funding growth with core deposits in light of the competition that you talked about?

Yeah. Thanks, David, thank for the question. I mean that is our target is 95%, but we understand too that will drift up above that in certain course due to seasonality. So you could see us get up to 97%, 98% and maybe some quarters below 95%. So the average will get to 95% through the cycle. But with that being said, too, though, as we continue to grow, we will probably be utilizing other areas -- the other means to fund those growths if we can get core deposits in the door.

Okay.

I do want to note, David, we do have some very specific deposit strategies around our homeowners’ associations around large non-profits and large specific mid-market clients generate a lot of cash and don’t need a lot of loans. So we are very focused on driving those core deposits and I think we’ve been fairly successful over the last year and we will continue to drive those.

Okay. That’s -- and just to be crystal clear, that 2.45% is a core margin that we talked about out, right? Accretion would be on top of that?

Correct. That is correct.

Okay. Okay. Appreciate it. Thanks, everybody.

Thanks, David.

Thanks.

So this does conclude our question-and-answer session. And I would like to turn the conference back over to Katie Lorenson for any closing remarks.

Thank you. Thank you all for joining our call and for your relationships, and of course, for your investments. We acknowledge and take full responsibility for a tough quarter. The path to superior returns is certainly not linear. It does take time for some of these investments we have made to result in top-tier performance. So the sum of the parts of this incredibly valuable company will be recognized with time, and we are transforming from within and we’re making progress every day. We have a best-in-class diversified business model and a company that will deliver superior profitability and tremendous value creation to our shareholders. I want to say thank you to all of our team members who are part of our journey to get better every day. Have a great day, everyone.

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.