Greetings, and welcome to the QCR Holdings, Inc. Earnings Conference Call for the Third Quarter of 2020. Yesterday, after market close, the company distributed its third quarter earnings press release. If there is anyone on the call who has not received a copy, you may access it on the company’s website, www.qcrh.com.

In addition, the company has included a supplemental slide presentation with COVID-19-related disclosures that you can refer to during the call. You can also access these slides on the website. With us today from management are Larry Helling, CEO; and Todd Gipple, President, COO and CFO.

Management will provide a brief summary of the financial results, and then we will open up the call to questions from analysts. Before we begin, I would like to remind everyone that some of the information management will be providing today falls under the guidelines of forward-looking statements as defined by the Securities and Exchange Commission.

As part of these guidelines, any statements made during this call concerning the company’s hopes, beliefs, expectations and predictions of the future are forward-looking statements, and actual results could differ materially from those projected.

Additional information on these factors is included in the company’s SEC filings, which are available on the company’s website. Additionally, management may refer to non-GAAP measures, which are intended to supplement, but not substitute for the most directly comparable GAAP measures.

The press release available on the website contains the financial and other quantitative information to be discussed today as well as the reconciliation of the GAAP to non-GAAP measures.

As a reminder, this conference is being recorded and will be available for replay through November 11, 2020, starting this afternoon, approximately one hour after the completion of this call. It will also be accessible on the company’s website. At this time, I will now turn the call over to Mr. Larry Helling at QCR Holdings..

Thank you, operator. Welcome, ladies and gentlemen, and thank you for taking time to join us today. I will start the call with a brief discussion regarding our third quarter performance. Todd will follow with additional details on our financial results.

As the pandemic continues to impact our country and the economy, we hope that everyone is staying healthy and safe. Our top priority remains the health of our employees and clients, and I am proud of our entire team for continuing to do what it takes to support each other, our clients and our communities in times of need.

We are very pleased to report a record quarter of net income, preprovision, pre-tax adjusted net income and non-interest income driven by continued strong loan growth, record fee income and an expanded net interest margin.

Our net income and diluted EPS increased 26% from the second quarter, while our tangible book value grew 4% on a linked-quarter basis and 14% year-over-year.

We achieved these record results despite recording another quarter of elevated provision for loan losses and continuing to build our reserves due to the ongoing economic uncertainty created by the pandemic.

We delivered solid loan growth for the quarter, up 11.5% on an annualized basis, driven primarily by strong production in our Specialty Finance Group.

This group is having another banner year, generating record production volumes based on our strong client demand for our niche lending products, particularly in the area of municipal and tax credit finance. We also generated healthy production from our core commercial lending business during the quarter.

Overall, we feel good about the quality of our commercial lending portfolio. Generally, our clients are performing well as economic conditions are better in our local markets than in the rest of the country.

As a point of reference, our current unemployment rates in our primary markets of Iowa and Missouri are significantly lower than both the national average as well as the Midwest regional average. In addition, many of our clients have strong liquidity positions, which is a good indicator of their financial health.

Excluding our PPP loan production, loan and lease growth for the first nine months of 2020 was 7.2% on an annualized basis. Given our current pipeline, we now believe that we will be able to achieve organic loan growth of between 6% and 8% for the full year, higher than our previous guidance.

As we discussed on our last two earnings calls, we proactively implemented our loan relief program, offering 3-month loan payment deferrals to our impacted clients, helping them preserve cash and liquidity.

The total amount of loan and lease deferrals granted during the first round was $575 million, representing approximately 13.5% of our total loans and leases. Beginning in July, many of our clients started to roll off the program, and we continued to experience a significant reduction in loan deferrals throughout the quarter.

We are pleased to report that by quarter end, approximately 90% of our clients who requested payment relief early in the pandemic had resumed making payments, outperforming our guidance provided in July.

The total loan and lease balances participating in round two is now just 1.95% of loans, which we believe speaks to the high quality of our loan portfolio and the resiliency of our local markets. Additionally, this low level of loan balances remaining on deferrals is among the very best in our peer group.

Our core deposit growth was strong, again, this quarter. We posted annualized growth of 36.4%, and this was driven mainly by our correspondent bank clients who grew liquidity during the quarter.

Our outsized deposit growth contributed to some excess liquidity on our balance sheet, but we were able to shed higher-cost noncore funds and reprice deposits. This helped lower our overall funding cost during the quarter, which enhanced our net interest margin. Todd will provide more detail on NIM in his remarks.

Our asset quality remains strong, and our banks continue to be well capitalized.

While we are not currently experiencing meaningful degradation of specific credits in our portfolio, we chose, once again, to be prudent and booked a provision for loan losses of $20 million this quarter in order to continue to build reserves against future potential credit issues related to COVID-19.

While it continues to be difficult to predict the ultimate impact that the pandemic will have on our clients, our banks are well positioned to help them navigate this environment. We continue to believe that our client focus, combined with local decision-making, is the best way to serve our markets as the economy adapts and recovers.

I would like to thank the entire QCR Holdings team for their hard work and dedication to excellent customer service and delivering record earnings performance during the quarter. We appreciate their flexibility and cooperation and are very proud of all that has been accomplished during this time.

In summary, we continue to believe that we will emerge from this pandemic as a stronger company and will be positioned to pursue our long-term goal of profitable growth and value creation, both organically and through strategic acquisitions. With that, I will turn the call over to Todd to provide further information about our third quarter results..

Thank you, Larry. As I review our third quarter financial results, I will focus on those items where some additional discussion is warranted. Larry already discussed our loan growth, so I’ll start with deposits. We generated very strong deposit growth again this quarter.

Total deposits increased by $322 million, or 7.4% on a linked-quarter basis, with increases particularly strong in an interest-bearing demand deposits, which were up $449 million. Our time deposits and broker deposits declined by $125 million as we continue to let higher-cost CDs run off the balance sheet.

Our strong core deposit gathering activities, which have significantly reduced our reliance on wholesale funding, also helped to enhance our net interest margin. The majority of our deposit growth was sourced primarily from our correspondent banking relationships and our commercial clients.

We believe these core deposit relationships are an indication of our true franchise value. This is a significant benefit as we don’t have to rely on wholesale funding to support our stronger-than-peer loan growth, which will allow us to continue to drive long-term shareholder value. Now turning to earnings.

With the strong growth in our average loans during the quarter, funded with core deposits, and combined with the increase in our net interest margin, our net interest income grew $3.6 million or 8.9% on a linked-quarter basis.

The yield on our average earning assets increased by 13 basis points from the second quarter, and our deposit cost decreased significantly as we gathered a higher mix of lower cost core deposits and reduced our higher cost wholesale funding. This resulted in a reduction in our total cost of interest-bearing funds of 14 basis points.

These strong results led to a 22-basis-point improvement in reported NIM, and a 23-basis-point improvement in adjusted NIM. Also positively impacting NIM this quarter was a larger-than-normal amount of interest recoveries on previously charged off loans that were repaid during the quarter, providing 11 basis points of the NIM improvement.

Therefore, after accounting for the positive impact of these recoveries, our true core margin improved by 12 basis points this quarter. While we continue to be well positioned to navigate a prolonged, low-interest rate environment, there will be some puts and takes impacting NIM in the fourth quarter.

First, we do not expect the same level of onetime interest recoveries that created 11 basis points of margin accretion in Q3 to reoccur in Q4. Additionally, we will experience some dilution from the full quarter impact of our opportunistic subordinated debt issuance in mid-September.

Finally, we expect some loan yield compression due to the mix and pricing of our new loans coming on to the balance sheet. Positive factors impacting the fourth quarter will be ongoing progress in reducing excess liquidity and a further decline in the cost of funds as we continue to improve mix and reprice our deposits lower.

Therefore, on a net basis, we expect fourth quarter adjusted NIM to modestly decline in the range of three to five basis points. Now turning to our noninterest income, which was $38 million, up significantly from the second quarter. We produced record swap fee income, which came in at $26.7 million for the quarter up 34% from the second quarter.

As Larry mentioned, we are seeing robust swap production created by the strong relationships our Specialty Finance Group have developed.

Demand for our lending products remain strong, particularly in the tax credit space, where we are making high-quality, long-term variable rate loans and are enabling our clients to lock in attractive fixed long-term rates through the use of swaps.

We are also experiencing better pricing execution on our swap transactions due to the low interest rate environment and the flat yield curve. The pipeline of swap loans at our banks and our specialty finance group remains healthy and we believe that this source of fee income is sustainable for the foreseeable future.

While we don’t anticipate achieving the same record level of swap fees that we did in the third quarter, we have averaged nearly $18 million in swap fees per quarter this year and expect swap fees will approximate that level in the fourth quarter. We will provide swap fee guidance for 2021 on our year-end conference call. Now turning to our expenses.

Non-interest expense for the third quarter totaled $40.8 million compared to $33.1 million for the second quarter and higher than our guidance of $31 million to $33 million. There were a number of significant items that impacted expenses.

First, we incurred increased salary and benefits expense of $4.7 million, with increased commission and incentive compensation expense in the quarter, driven by the strong financial results and higher-than-anticipated swap fee income.

Second, we recorded a $1.9 million loss on debt extinguishment as we paid off high-cost wholesale funds to benefit future earnings. Third, we incurred disposition costs and a final loss on sale of $497,000 as a result of closing the Bates companies disposition.

And finally, we had $393,000 in higher FDIC insurance and fees due to our higher cash balances. Adjusting for these items, our non-interest expense came in at $33 million, at the upper end of the guidance range we provided on last quarter’s earnings call.

Looking ahead to the fourth quarter, we anticipate that our level of non-interest expense will be similar to third quarter levels in the $38 million to $40 million range.

This range is higher than our long-term run rate expectations, primarily due to higher year-end incentive compensation driven by our outlook for strong full year preprovision, pre-tax earnings and spot fee income. Our overall asset quality continues to be solid.

While we did experience some modest linked quarter increase in non-performing assets in the quarter, it was primarily due to a few isolated relationships that experienced degradation not directly related to COVID-19.

The ratio of NPAs to total assets increased to 32 basis points at September 30 compared to 24 basis points at June 30 and returned to Q1 levels.

While our local economies are doing better than much of the rest of the nation, we are still providing heavily for potential losses in the future, and therefore, we again recorded $20 million of provision for loan losses this quarter.

I would note that the majority of this significant provision was the result of increasing qualitative factors due to the pandemic. The level of our reserves, excluding the impact of the $358 million in PPP loans, was 2.05% to total loans and leases, up 44 basis points from the end of June.

This allowance now represents over four times our nonperforming assets. With respect to capital, we continue to maintain strong capital levels and have abundant liquidity to meet our clients’ needs.

Our opportunistic subordinated debt issuance at the end of the third quarter further strengthened our total risk-based capital ratio to nearly 15% at quarter end. Our tangible common equity to tangible assets ratio at quarter end is roughly 9% if you exclude the dilutive impact of the PPP loans.

Our overall earnings power remains significant as we generated a pre-provision, pre-tax ROAA of 2.9% in the third quarter. As a result, we are well positioned to continue to fund reserves, grow capital and tangible book value per share and provide solid earnings per share.

Additionally, with the aforementioned subordinated debt offering, we were able to further build our capital base to support the organic growth of our subsidiary banks and be well positioned for future M&A opportunities. Our effective tax rate for the quarter came in at 18.8%.

The rate was higher on a linked-quarter basis due to a higher ratio of taxable earnings to tax-exempt revenue. With that added color on our third quarter financial results, let’s open up the call for your questions. Operator, we’re ready for our first question..

[Operator Instructions] The first question will be from Nathan Race with Piper Sandler..

Maybe just start on credit. The reserve build was pretty substantial, and it sounds like it was just driven by qualitative factors and not a function of any downgrades or so forth, internally. Just kind of curious how we should kind of think about the reserve looking ahead and overall credit costs into the fourth quarter.

I imagine it will be just to support organic growth, which it sounds like the pipeline is pretty strong just based on the guidance for 6% to 8% loan growth for 2020..

Yes, Todd, I’ll start and then let you finish if there’s any additional comments you’d like to make. Yes. We’ve all along said that we wanted to get our reserve to over 2%. So we’re kind of at that level now. Given what we know today, we feel like we’re in a, approximately, the right territory.

So I think we would still expect elevated reserving to some level in the fourth quarter, maybe not at the same levels as the last two quarters, but we certainly still want to maintain the reserve at these kind of relative levels until there’s a lot more clarity on the credit metrics going forward..

Yes. Nate, I might just add that, give a little color around roughly $50 million in provision we’ve made thus far this year, around half of that, $26 million, is unallocated COVID-19 qualitative factor. And then around $10 million would be increasing our qualitative factors on national and local economies.

So roughly $36 million of the $48 million that we’ve provided thus far this year is really related to those qualitative factors. As you might guess, little of the provisioning thus far this year has been specific credit metrics. So kind of, to your point, it’s really been about build for the future.

And just echo Larry’s comments, we thought about this that we wanted to get around that 200 basis point level. We really wanted to get this provisioning behind this sooner rather than later. That’s really part of our credit culture here at QCR. We tend to get our arms around things quickly.

And one other comment I’d make, my guess is somebody might have the question, our incurred loss model and our CECL model are pretty much right on top of each other at this point at close to $80 million. So for all those reasons, we thought it was prudent to provide $20 million this quarter..

And then just maybe changing gears on capital. The sub that raised in the quarter, obviously, you guys are operating with very robust capital ratios at this point. I imagine, M&A is probably on the back front these days just given that most works are inwardly focused these days.

So just curious how you guys are thinking about the possibility for additional share repurchases in 4Q and into early ‘21 at this point?.

Yes. Right now, Nate, we’re not considering buybacks. We think it’s a bit early given the significant uncertainly that remains on the severity and duration of the pandemic. So we think it’s a bit early to pivot in that direction. We do feel very good about the ability to go out and raise that $50 million.

We view it as more opportunistic for organic growth, for potential M&A, for potential stock buybacks depending on the results here for the pandemic and credit and what really happens in the equity market. So it gives us more options. We felt really good about the pricing and the ability to do it on a private placement basis with one large investor.

And you’re right. Don’t really have anything on the table with respect to M&A, but we will remain vigilant on looking for opportunities and potential partners. And I think we’ve said several times, our focus would be on build-out in Springfield and Des Moines over additional new markets..

Nate, you’re right, there’s limited activity in the M&A space right now. But our belief would be that when the pandemic impacts become more clear, it will be a lot like when we came out of the Great Recession a decade ago, where there was some pent-up demand for buying and selling banks.

And I think that’s certainly very possible, again, as we get toward later 2021. So we’ve been in an effort to position ourselves to be ready for those opportunities when they present themselves..

The next question is from Damon DelMonte of KBW..

So first question on the margin. Todd, you kind of gave the puts and takes with the margin and the outlook. I think it’s like three to five basis points of compression in the fourth quarter. So if you guys had about $800,000 of purchase adjustments, you take that off the reported $351 million, that gets you at about $344 million.

Of that $344 million, how much of that was impacted from PPP?.

Really just a couple of basis points of compression from the yield on our PPP loans..

And with regards to PPP, what’s your outlook on the kind of the timing or the pace of forgiveness? Do you expect to see much here in the fourth quarter? Or do you expect it to be more heavily weighted torwards 2021 now?.

Yes. Great question, Damon. We believe right now that little of it will happen in terms of forgiveness in the fourth quarter. It just appears that SBA guidance has been slow to come, as I think you’re well aware. The SBA has, I think, 90 days to respond to the data once it’s submitted.

We put together a very nice portal for all of our clients to submit the documents, and we’re working with them to help them do that. But our expectation now is that it’s likely the first quarter..

And Damon, we might see some meaningful numbers of smaller loans, but the dollars are more likely, certainly, in the first quarter 2021..

Got it. Okay. That makes sense. And then I guess, lastly, with loans, the outlook for loan growth, you obviously raised your guidance for the full year.

But as we kind of look into 2021, how do you think you guys are shaping up for next year?.

Yes, Damon, we’ve grown loans at a consistent pace over many years. And I think that we would expect, as we look forward, still being able to continue to grow loans. As you know, we’ve got the specialty finance niche that is really being benefited right now because of the pandemic environment.

And so we expect that to continue at a strong pace clearly through 2021. And we’ve had good activity with our core commercial banking group, too. A lot of it was aided by the relationships that we built on during the PPP loan process. And so we’ve got some great new core relationships that should allow us to continue to go to our loan totals..

Okay. All right. That’s great. Congrats on the next quarter..

Thanks Damon..

The next question is from Jeff Rulis of D.A. Davidson..

Thanks. Good morning. .

Good morning, Jeff..

Wanted to look at the -- your thoughts on the expense strategy versus investments in maybe as we roll into ‘21 maybe knock out the variable comp from swap. But I -- and we got your comments on the Q4 expectations.

But just thinking a little longer term about investments versus expense, and what’s got the heavier hand in ‘21 as we still kind of climb out of the pandemic? Any thoughts on in-house what you’re talking to your folks about on costs?.

Sure. Larry, I might start with that and let you fill in..

Yes, go ahead..

We’re spending a fair amount of money on IT right now. And primarily some really significantly talented folks that we’re adding to our roster here. And we think that, over time, that will reduce our spend rate on IT, probably likely further into ‘22 and ‘23, a little longer term.

But in addition, we think it will improve our user experience both internally and our client user experience externally. The pandemic has really accelerated the need for the best technology. We feel like we’ve always had the best bankers in each of our markets. We have the best people. We are very focused on having the best technology alongside that.

So some of our increased spend here in ‘20 and maybe into ‘21 will be on some talented folks helping us navigate this. And ultimately, our spending will go down, and we’ll have better technology as a result. One thing I would point out, Jeff, the variable comp for us is pretty significant.

It’s about 36% of our comp year-to-date through the third quarter. So we like it that way. We think that’s good for shareholders and our staff. When we do better, compensation goes up, and when we have some challenges, it varies down.

But longer term, I think, the investments will continue to be in technology, and we expect some good payoff a little longer term..

Yes. Jeff, the other thing I’d add is one of the benefits of having a growth story like we have is that we can just slow the growth in expenses and, which we’d certainly intend to do in 2021.

With the growth we have, really get to the same place without having to do some of the drastic expense cuts that others are dealing with if they don’t have growth. So because we’ve shown that we can grow over a long period of time, we think that’s the way we’ll be able to get turn in 2021..

And Todd, just to follow up on that. On the variable side, I’m still trying to nail down the kind of the swap puts and takes. If your, say, swaps were up $7 million linked quarter, but I think you mentioned higher comp was something, 4.7% or something. And maybe that’s not all swaps, it’s total profitability.

Is that a good sort of exchange ratio if you think about the swap versus variable comp, if we had to pull out that piece? Or is that not the right way to look at it?.

Yes. It is a bit convoluted. So good question. I understand why you need a little more detail there. The 4.7% here in Q3 would be a combination of both the incentives around the swap production and also candidly ramping up our incentive comp around the company.

We’re certainly performing much better here on a full year basis pre-pre at the end of the third quarter than we expected to be at the end of March. I think we were all fairly concerned about bottom line profitability. And while we’re still not out of the woods, we’re certainly performing much better.

So as a result, we’ve ramped up our incentives and, the incentive comp around the company. And so that’s a chunk of that 4.7%. I would say, it’s roughly half and half would be related to swaps and then incentives around the rest of the company for improved profitability..

That’s helpful.

And maybe one last one on, just trying to get a sense for the loan growth and more particularly, color on, was any of that within the footprint? Was there some areas geographically that you’re doing better? Or was it fairly broad based?.

Yes. I’d say it was fairly consistent. If you look at the kind of markets we’re in, as evidenced by significantly lower unemployment rates that we talked about, the economies in our size markets, I think, are kind of uniquely positioned to perform better than in the major metropolitan areas.

And so, I think, we feel good about the broad-based nature of our marketplace and the opportunity to, in those midsized markets that are performing much better than in the big markets..

The next question is from Brian Martin of Janney Montgomery..

Just a couple of quick questions. Todd, back to that, the PPP for just a minute.

The remaining unearned loan fees to collect today, can you give us an idea of what we should still include in the forecast prospectively? What’s it down to today?.

Sure, Brian. It’s around $7 million left remaining out of the $11.3 million. That was being accreted, is being accreted straight line over the 24-month duration of those loans. That’s really how the loan system is calculating that. So it ended up being much more straight than deferred.

But there’s roughly $7 million of that left and probably a couple of million of that would be accretive in Q4, and then the balance would likely come in bigger chunks as forgiveness happens in Q1..

Got you. Okay. And just the, you guys talked about it in the strong credit quality. Are there any changes of note in the criticizing classes this quarter? I guess, it doesn’t sound like it would be. So I just want to kind of confirm that based on your comments about the provisioning and the strength of credit..

Yes. Brian, what I would say is, it will be what you expect in that there will be some elevation in classified mostly because of those sectors that we’ve identified, the hotel, entertainment, restaurants, the areas that have been disproportionately impacted. We will have a little degradation as we watch those credits more closely.

But certainly, not meaningful change in the NPAs as we discussed in the comments..

So some migration on both the special mention and the classified primarily due to the hotel book?.

Correct. But nothing. It’s performing exactly as we would have thought it would given the market conditions..

Yes. Brian, Todd. As Larry said, I’m looking at the table here for the queue that will be out sometime soon. And really, it’s just a pivot between special mention and substandard. The total number has moved very slightly like $5 million for total criticism. So it’s really just that downgrade related to primarily hotel space..

And maybe just one more for you, Larry.

Just the strong growth that you’ve seen in the specialty finance portfolio year-to-date, can you just give some numbers around or just some context around how much growth you’ve seen in that portfolio? And just, maybe just articulate what’s leading to the, this portfolio thriving so much today? And just trying to understand both on the swap side and the loan generation side how to think about that business as it’s becoming a greater piece of the franchise..

Right. First of all, I’d say there’s a couple things that have put wind at our back in that space. Certainly, in broad terms, the demand for our products in that space and the tax credit space have really both been strong.

The marketplace is wanting more low-income tax credit housing and in the historic tax credit space, strong demand for those kinds of products. Secondly, the interest rate environment has been particularly conducive to doing swap transactions for clients. Low interest rates with a flat yield curve really helps the pricing power in the swap environment.

And then the pandemic, while impacting our -- many of our customers in a not positive way, in this case, it’s probably a smaller company like us in the tax credit space and in the municipal space has been able to pivot and be responsive.

And the pandemic has really slowed down some of our competitors from being as responsive as they might have been historically. So just like other parts of our business, if we’re responsive and attentive, we’re able to grow the business more quickly than other people in this space.

So in total, the total tax credit business, for us, now is a little over 10% of our total assets. Would like the quality of the assets. We believe that it’s superior to any other of the lending niches that we’re in. And so it’s been a really positive focus for our company..

Got you. Okay. And maybe just one last one, if I can sneak it in. Just on the deposit side. I mean, you’ve talked about the significant growth you’ve seen in the last couple of quarters and just the improvement in the mix.

I mean, I guess, given where wholesale is at today and kind of this strong growth this quarter, I guess, do you feel like the deposits are pretty sustainable at this point? Do you expect some of those to leave the bank? Or just how are you thinking about that and maintaining a mix where the wholesale side has gotten so much better here the last couple of quarters?.

Yeah. Great question, Brian, and it has. It’s dramatically improved the mix of our funding. Our reliance on wholesale is down below 5%. And that may well be a floor for us.

I don’t know that it can get much better, but we will continue to see these deposits around, I believe, for the foreseeable future, with it being heavily weighted toward correspondent banks, certainly, all banks have a fair amount of liquidity right now. And when you’re in the correspondent business, you tend to be an aggregator of that liquidity.

So our challenge is really to continue to put it to work. It really helped our margin in the third quarter. If you look at the NIM table in the press release, you can see the average balance of real cash and Fed funds that we had was down a couple of hundred million quarter-over-quarter. So we were much more aggressive in putting it to work.

That really helped us with margin. It’s one of the remaining opportunities we have for Q4. We talked in the early comments about some of the headwinds we’ve got, but we will continue to work hard to put the liquidity to work. We do have a little bit of room left on deposit pricing, and we’ll try to squeeze that out here in the fourth quarter.

So I expect that liquidity to be here for some time, certainly into 2021, deep into 2021..

Okay. Thanks for taking the question, guys. Nice quarter. .

Thanks, Brian. .

[Operator Instructions] Seeing no further questions, I’d like to turn the conference back over to Larry Helling for any closing remarks..

Thanks, operator, and thanks to all of you for joining our call today. We hope everyone remains healthy and safe. Have a great day, and we look forward to speaking with you all again soon. Thanks so much..

Thank you. We, today’s presentation is now concluded. We want to thank you all for attending today’s presentation and you may now disconnect your lines. Have a great day..