Alerus(ALRS) - 2019 Q4 - Annual Report

PART I Business Overview Alerus Financial Corporation is a diversified financial services company with $2.4 billion in assets and $35.0 billion managed/administered as of December 31, 2019, primarily generating noninterest income from its four core segments Key Financial Metrics | Metric | Value (as of Dec 31, 2019) | | :--- | :--- | | Total Assets | $2.4 billion | | Total Loans | $1.7 billion | | Total Deposits | $2.0 billion | | Stockholders' Equity | $285.7 million | | Assets Under Administration (AUA) | $28.9 billion | | Assets Under Management (AUM) | $6.1 billion | | Mortgage Originations (FY 2019) | $946.4 million | - The company generates a majority of its revenue from noninterest income, primarily driven by its retirement and benefit services, wealth management, and mortgage business segments[13] - Alerus operates under a "One Alerus" initiative, a high-tech, high-touch approach that integrates all product offerings through a primary advisor and a unified client portal called "My Alerus"[16][19] Company Overview and Products - The company's business is structured into four distinct segments: banking, retirement and benefit services, wealth management, and mortgage[9] - The banking segment offers a broad range of lending products and sources funds primarily through core deposits, which represented 97.7% of total deposits as of December 31, 2019[20][22] - The retirement and benefit services business is a national operation offering plan administration, ESOP fiduciary services, payroll, and HSA administration[24][25] - The mortgage segment originated $946.4 million in loans in 2019, primarily in the Minneapolis-St. Paul MSA, for its own portfolio and secondary market sales[27][28] Market Areas and Competition - Primary banking markets include North Dakota, the Twin Cities MSA in Minnesota, and the Phoenix MSA in Arizona, strategically expanded for geographic diversification[29] - A "National Market" manages retirement and benefit services clients outside core banking areas, accounting for $23.6 billion in AUA and $463.5 million in deposits at year-end 2019[35] - Alerus faces intense competition from a wide range of financial institutions, including large national and regional banks, non-bank companies, and online providers[36] Supervision and Regulation - The company and its bank subsidiary are extensively regulated by federal and state agencies, primarily the Federal Reserve and the Office of the Comptroller of the Currency (OCC)[37] - Subject to Basel III capital framework, the Bank was considered "well-capitalized" under OCC regulations as of December 31, 2019[47][55] - As a bank holding company with financial holding company status, Alerus is regulated by the Federal Reserve under the Bank Holding Company Act of 1956 (BHCA)[58] - The Bank's ability to pay dividends to the parent company, a primary source of funds, is subject to limitations under the National Bank Act and OCC oversight[77] Risk Factors The company faces significant credit, operational, liquidity, legal, and market risks, including loan portfolio concentration, reliance on noninterest income, cybersecurity threats, regulatory compliance burdens, and interest rate fluctuations Credit Risks - Diligent management of credit risk is crucial, as failure to maintain prudent underwriting standards could lead to loan defaults and increased allowance for loan losses[100][101] - A significant portion of the loan portfolio (67.1% at year-end 2019) consists of real estate loans, exposing the company to risks from declines in real estate values and liquidity[111] - The upcoming Current Expected Credit Loss (CECL) accounting standard, effective January 1, 2023, is expected to increase the allowance for loan losses and may introduce more volatility[106][107] - The loan portfolio is geographically concentrated, with 95.7% of loans made to borrowers in North Dakota, Minnesota, and Arizona, making the company susceptible to regional economic downturns[109] Operational, Strategic and Reputational Risks - Noninterest income represented 60.5% of total revenue in 2019, making the company vulnerable to market conditions that could reduce assets under administration/management and associated fee income[131] - The retirement and benefit services business experiences significant annual outflows ($5.4 billion in 2019) due to client turnover and M&A activity, requiring active acquisitions to maintain and grow AUA/AUM[131][144] - The company is susceptible to fraudulent activity and cybersecurity incidents, and its dependence on third-party technology vendors for core systems presents operational risks[152][157] - The business is highly dependent on its executive management team and key personnel; the loss of these individuals could harm strategic implementation and client relationships[168][169] Liquidity and Funding Risks - Liquidity is essential, and an inability to raise funds through deposits, borrowings, or asset sales could negatively affect operations, with client deposits being the primary source[215][216] - A high concentration of large depositors exists, with the 10 largest relationships accounting for 9.2% of total deposits as of December 31, 2019, posing a liquidity risk if these funds are withdrawn[222] - The parent company's liquidity is largely dependent on dividends from the Bank, which are subject to regulatory limitations[223] Legal, Accounting and Compliance Risks - The extensively regulated banking industry means failure to comply with laws from agencies like the Federal Reserve and OCC could result in sanctions, fines, or reputational damage[252] - As a public company, Alerus is subject to Exchange Act and Sarbanes-Oxley reporting requirements, increasing legal and financial compliance costs[239] - As an "emerging growth company," Alerus uses an extended transition period for new accounting standards, potentially making its financial statements not directly comparable to other public companies[284][545] - The Federal Reserve's "source of strength" doctrine may require the parent company to commit capital resources to support the Bank, potentially when resources are limited[275] Market and Interest Rate Risks - The company's earnings are subject to interest rate risk, as net interest income depends on the spread between interest earned on assets and interest paid on liabilities[299] - The securities portfolio, valued at $313.2 million (13.3% of total assets) at year-end 2019, is subject to market value fluctuations, particularly with rising interest rates[301] - The company's common stock is relatively thinly traded, which could lead to price volatility and make it difficult for investors to buy or sell shares without impacting the market price[304] Unresolved Staff Comments The company reports no unresolved staff comments from the Securities and Exchange Commission - None[310] Properties The company's corporate headquarters are in Grand Forks, North Dakota, operating a network of owned and leased properties for banking and specialized retirement and benefit services across multiple states - The corporate headquarters is located at 401 Demers Avenue, Grand Forks, North Dakota 58201[311] - The company operates a mix of owned and leased properties across its market areas, including full-service banking offices and specialized offices for its retirement and benefit services segment[312][314] Legal Proceedings The company and its subsidiaries are not party to any material pending legal proceedings beyond routine litigation incidental to its business - The Company is not a party to any material pending legal proceedings, other than ordinary routine litigation incidental to its business[315] Mine Safety Disclosures This item is not applicable to the company - Not applicable[316] PART II Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The company's common stock began trading on Nasdaq (ALRS) on September 13, 2019, post-IPO, with a policy of quarterly dividends subject to discretion and regulation, and IPO proceeds used to reduce short-term borrowings - The company's common stock began trading on the Nasdaq Stock Market under the symbol "ALRS" on September 13, 2019, previously quoted on the OTCQX Marketplace[317] - The company intends to maintain or increase its quarterly dividend, subject to board discretion, financial condition, and regulatory restrictions from the DGCL and the Federal Reserve[322][323][325] - On September 17 and 25, 2019, the company sold a total of 3,289,000 shares of common stock in its initial public offering, with net proceeds held at the Bank to pay down short-term borrowings[327][329] Selected Financial Data Selected financial data for the five years ended December 31, 2019, shows consistent growth in assets, loans, and deposits, with net income reaching $29.5 million in 2019, driven by noninterest income, and key ratios like ROAA and ROAE demonstrating variability Consolidated Statements of Income Data (in thousands) | (in thousands) | 2019 | 2018 | 2017 | 2016 | 2015 | | :--- | :--- | :--- | :--- | :--- | :--- | | Net Income | $29,540 | $25,866 | $15,001 | $14,036 | $17,010 | | Total Assets | $2,356,878 | $2,179,070 | $2,136,081 | $2,050,045 | $1,744,324 | | Total Loans | $1,721,279 | $1,701,850 | $1,574,474 | $1,366,952 | $1,126,921 | | Total Deposits | $1,971,316 | $1,775,096 | $1,834,962 | $1,785,209 | $1,458,021 | | Total Stockholders' Equity | $285,728 | $196,954 | $179,594 | $168,251 | $182,282 | Key Performance Ratios | Ratio | 2019 | 2018 | 2017 | | :--- | :--- | :--- | :--- | | Return on average total assets (ROAA) | 1.34% | 1.21% | 0.75% | | Return on average common equity (ROAE) | 12.78% | 13.81% | 8.49% | | Noninterest income as a % of revenue | 60.50% | 57.73% | 60.36% | | Efficiency ratio | 73.22% | 73.80% | 75.36% | Management's Discussion and Analysis of Financial Condition and Results of Operations In 2019, net income increased 14.2% to $29.5 million, primarily driven by a surge in mortgage banking revenue and noninterest income, with total assets growing to $2.4 billion and the allowance for loan losses reaching $23.9 million Results of Operations Key Financial Performance (2019 vs 2018) | Metric | 2019 | 2018 | Change | | :--- | :--- | :--- | :--- | | Net Income | $29.5M | $25.9M | +14.2% | | Diluted EPS | $1.91 | $1.84 | +3.8% | | ROAA | 1.34% | 1.21% | +13 bps | | Net Interest Income | $74.6M | $75.2M | -0.9% | | Noninterest Income | $114.2M | $102.7M | +11.1% | | Noninterest Expense | $142.5M | $136.3M | +4.6% | - The increase in 2019 net income was primarily driven by an $8.2 million (46.4%) increase in mortgage banking revenue, resulting from higher mortgage originations ($946.4 million in 2019 vs. $779.7 million in 2018)[385][386] - Net interest margin decreased by 19 basis points to 3.65% in 2019 from 3.84% in 2018, primarily due to a 41 basis point increase in the average rate paid on interest-bearing liabilities[374] - The provision for loan losses decreased to $7.3 million in 2019 from $8.6 million in 2018, attributed to improved credit quality and a decrease in criticized loan balances[381] Segment Reporting Segment Income Before Taxes (in millions) | Segment (Income before taxes) | 2019 | 2018 | Change | | :--- | :--- | :--- | :--- | | Banking | $33.4M | $33.6M | -0.7% | | Retirement & Benefit Services | $28.4M | $26.9M | +5.6% | | Wealth Management | $8.3M | $8.1M | +2.1% | | Mortgage | $5.2M | $1.3M | +300% | - The Mortgage segment's income surged due to a 21.4% increase in originations and a transition to mandatory delivery of mortgages into the secondary market[418] - Retirement and Benefit Services AUA & AUM increased by $4.1 billion to $31.9 billion at year-end 2019, primarily driven by a $4.5 billion positive market impact[407] Financial Condition - Total assets increased by $177.8 million to $2.4 billion at year-end 2019, driven by increases in cash, investment securities, and loans[420] Key Balance Sheet Items (in billions/millions) | Balance Sheet Item | Dec 31, 2019 | Dec 31, 2018 | Change | | :--- | :--- | :--- | :--- | | Total Loans | $1.72B | $1.70B | +1.1% | | Allowance for Loan Losses | $23.9M | $22.2M | +7.7% | | Total Deposits | $1.97B | $1.78B | +11.1% | | Total Stockholders' Equity | $285.7M | $197.0M | +45.0% | - The allowance for loan losses to total loans ratio increased to 1.39% from 1.30% in the prior year, while nonperforming loans to total loans remained low at 0.45%[467] - Total stockholders' equity increased significantly by $88.7 million, primarily due to $62.8 million in net proceeds from the initial public offering and $29.5 million in net income[484] Quantitative and Qualitative Disclosures About Market Risk The company's primary market risk is interest rate risk, managed by ALCO, with the balance sheet being asset-sensitive as of December 31, 2019, projecting a 1.5% increase in net interest income for a 100 basis point rate hike - The company's primary market risk is interest rate risk, managed by the Asset and Liability Committee (ALCO) to control the exposure of net interest income to rate fluctuations[503][504] Estimated Impact on Net Interest Income from Interest Rate Changes | Interest Rate Change | Estimated Impact on Net Interest Income (Next 12 Months) | | :--- | :--- | | +200 basis points | +2.9% | | +100 basis points | +1.5% | | -100 basis points | -5.4% | - As of December 31, 2019, the company's balance sheet is considered asset sensitive, indicating that net interest income is expected to benefit from a rising interest rate environment[510] Financial Statements and Supplementary Data This section presents the audited consolidated financial statements for the three years ended December 31, 2019, with an unqualified opinion from CliftonLarsonAllen LLP, including detailed notes on accounting policies, segment information, regulatory matters, and the potential impact of COVID-19 - The independent registered public accounting firm, CliftonLarsonAllen LLP, issued an unqualified opinion on the consolidated financial statements[519] - The company adopted the new lease accounting standard (ASU 2016-02) on January 1, 2019, recognizing operating lease right-of-use assets of $8.3 million and operating lease liabilities of $8.9 million[598][524] - Subsequent to year-end, the company noted the COVID-19 pandemic and significant declines in equity markets, stating the full impact is unknown but may affect 2020 operations, including potential increases in loan loss reserves[771][772] Changes in and Disagreements with Accountants on Accounting and Financial Disclosure The company reports no changes in or disagreements with its accountants regarding accounting principles, financial disclosure, or auditing scope - None[774] Controls and Procedures Management, including the CEO and CFO, concluded that disclosure controls and procedures were effective as of December 31, 2019, with no material changes to internal controls reported, and no management assessment of internal control over financial reporting included as permitted for newly public companies - The CEO and CFO concluded that the company's disclosure controls and procedures were effective as of December 31, 2019[775] - The report does not include a management assessment of internal control over financial reporting, as allowed by a transition period for newly public companies[776] Other Information The company reports no other information for this item - None[778] PART III Directors, Executive Officers and Corporate Governance Information on directors, executive officers, and corporate governance is incorporated by reference from the company's definitive proxy statement for the 2020 annual meeting of shareholders - Information required by this item is incorporated by reference from the Company's Proxy Statement for the 2020 annual meeting of shareholders[779] Executive Compensation Information on executive compensation is incorporated by reference from the company's definitive proxy statement for the 2020 annual meeting of shareholders - Information required by this item is incorporated by reference from the Company's Proxy Statement for the 2020 annual meeting of shareholders[780] Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters This section details the company's equity compensation plans, showing 347,211 securities to be issued from outstanding awards and 1,100,000 available for future issuance under shareholder-approved plans as of December 31, 2019 Equity Compensation Plan Information (as of December 31, 2019) | Plan Category | Securities to be Issued | Securities Available for Future Issuance | | :--- | :--- | :--- | | Equity compensation plans approved by shareholders | 347,211 | 1,100,000 | | Equity compensation plans not approved by shareholders | 0 | 0 | | Total | 347,211 | 1,100,000 | Certain Relationships and Related Transactions, and Director Independence Information on certain relationships, related party transactions, and director independence is incorporated by reference from the company's definitive proxy statement for the 2020 annual meeting of shareholders - Information required by this item is incorporated by reference from the Company's Proxy Statement for the 2020 annual meeting of shareholders[783] Principal Accounting Fees and Services Information on principal accounting fees and services is incorporated by reference from the company's definitive proxy statement for the 2020 annual meeting of shareholders - Information required by this item is incorporated by reference from the Company's Proxy Statement for the 2020 annual meeting of shareholders[784] PART IV Exhibits and Financial Statement Schedules This section lists financial statements from Item 8 and exhibits filed with the Form 10-K, including corporate governance documents, capital stock descriptions, executive compensation agreements, and CEO/CFO certifications, with all financial statement schedules omitted - The consolidated financial statements are located in Item 8 of the report[786] - All financial statement schedules have been omitted because they are not applicable or the required information is included in the financial statements or notes[786] Form 10-K Summary The company reports no Form 10-K summary for this item - None[789]