Executive Summary / Key Takeaways

• Old Second Bancorp (NASDAQ:OSBC) has successfully executed a balance sheet transformation, significantly strengthening capital and improving asset quality metrics after proactively addressing credit challenges.
• Recent strategic acquisitions, including the completed First Merchants (FRME) branch purchase and the pending Evergreen Bank Group (BFIN) merger, are enhancing the deposit base, lowering funding costs, and providing liquidity for future growth initiatives.
• The company demonstrates resilient profitability, maintaining a strong net interest margin and efficiency ratio despite market volatility, benefiting from its asset-sensitive positioning in the current rate environment.
• Management is focused on deploying excess capital through organic loan growth (targeting mid-single digits), potential strategic M&A, and shareholder returns (buyback, dividends) to enhance tangible book value and maintain high returns on equity.
• While facing competitive pressures and macroeconomic uncertainties, OSBC's disciplined approach to credit, expenses, and capital allocation positions it favorably for continued solid performance.

Setting the Scene: A Community Bank's Strategic Evolution

Old Second Bancorp, Inc., headquartered in Aurora, Illinois, operates as a bank holding company primarily through its wholly-owned subsidiary, Old Second National Bank. The bank serves the Chicagoland area across seven counties, offering a comprehensive suite of community banking services. This includes commercial and consumer lending, deposit services, treasury management, and a notable wealth management division encompassing investment advisory and trust services. OSBC's business model is built on fostering deep relationships with individual customers and small to medium-sized businesses within its local markets.

The company's recent history has been marked by a strategic evolution, particularly in response to the shifting interest rate environment and emerging credit challenges. Starting in late 2021 and accelerating through 2022, OSBC proactively identified and addressed potential weaknesses within its loan portfolio, notably in commercial real estate sectors like office and healthcare. This period saw a significant increase in criticized and substandard loans, peaking in early 2023. Management's deliberate approach during this time laid the groundwork for the substantial credit remediation efforts that have characterized the past year. Concurrently, OSBC has focused on optimizing its balance sheet mix, aiming to increase its loan-to-asset ratio and reduce reliance on securities for income generation, a strategy designed to enhance long-term profitability and shareholder returns.

Competitive Dynamics and Market Positioning

Operating in the competitive Chicagoland banking market, OSBC faces pressure from a diverse set of financial institutions, ranging from large national banks to regional peers and increasingly, non-traditional financial technology (FinTech) companies. Key publicly traded competitors in its operating region include Wintrust Financial Corporation (WTFC), Midland States Bancorp, Inc. (MSBI), Old National Bancorp (ONB), and Huntington Bancshares Incorporated (HBAN).

OSBC positions itself by leveraging its established branch network and deep-rooted community ties, which contribute to strong customer loyalty and retention, particularly in its core suburban and rural markets. This localized expertise provides a competitive edge in certain niche lending areas and deposit gathering, contributing to a granular and relatively stable deposit base.

However, OSBC faces challenges in areas where larger or more technologically advanced competitors excel. While OSBC has invested in technology and infrastructure over the past couple of years, some peers may possess more streamlined digital processes or faster digital tools, potentially impacting efficiency and the ability to attract digitally-savvy customers. The company's reliance on third-party IT vendors is also noted as a risk factor. Competitors with greater scale, like WTFC or ONB, may benefit from lower operating costs per unit, while FinTech firms offer low-cost digital alternatives that can pressure traditional banking fees and services.

OSBC's strategic response involves not only enhancing its organic lending capabilities but also pursuing targeted inorganic growth. The recent acquisition of First Merchants branches and the pending merger with Evergreen Bank Group are direct actions to gain scale, expand market presence, and acquire valuable, lower-cost deposits, thereby improving its funding structure and competitive positioning against rivals. Management's focus on disciplined pricing for new loans, prioritizing risk-adjusted returns over volume, is another key aspect of its competitive strategy, particularly in an environment where some competitors may be willing to book loans at less attractive yields.

While the company appears to lack specific, proprietary technological differentiators, OSBC acknowledges the importance of technology in meeting customer demands and creating operational efficiencies. Investments have been made in infrastructure, and the strategic intent is to leverage technology effectively. However, compared to peers who may highlight specific digital innovations or processing speed advantages, OSBC's competitive moat appears to be more heavily reliant on its relationship-based model, local market density, and strategic capital management rather than a distinct technological edge. The company's ability to enhance its digital offerings and operational efficiency through technology will be crucial for maintaining competitiveness against rivals with more advanced platforms.

Financial Performance: Strength in Margin and Efficiency

OSBC's financial performance reflects a story of resilience and strategic execution, particularly evident in its net interest income generation and efficiency. For the first quarter of 2025, net income stood at $19.8 million, or $0.43 per diluted share. While this represented a decrease from $21.3 million ($0.47 diluted EPS) in the first quarter of 2024, the linked-quarter performance showed an improvement from $19.1 million ($0.42 diluted EPS) in Q4 2024.

The core driver of profitability remains net interest income, which increased by $3.1 million year-over-year in Q1 2025 to $62.9 million. This growth was primarily fueled by a significant decrease in interest expense, largely due to the strategic paydown of higher-cost short-term borrowings (specifically FHLB advances) utilizing deposits acquired from the First Merchants branch transaction. The cost of interest-bearing deposits also saw a notable 13 basis point decrease linked-quarter in Q1 2025, driven by a reduction in time deposit costs and the integration of lower-cost acquired deposits. While the cost of deposits did increase year-over-year, the benefit from lower borrowing costs and higher asset yields (up 9 basis points year-over-year on earning assets) more than offset this.

This dynamic resulted in a robust net interest margin (GAAP) of 4.85% in Q1 2025, a significant increase of 19 basis points linked-quarter and 30 basis points year-over-year. Management attributes the linked-quarter improvement to the full impact of the FRME acquired deposits and favorable market interest rates, while the year-over-year gain highlights the benefit of reduced short-term funding costs and asset repricing.

Noninterest income saw a modest decrease year-over-year in Q1 2025, primarily impacted by mark-to-market losses on mortgage servicing rights and a decrease in the cash surrender value of BOLI, partially offset by solid growth in wealth management fees (up 20.6% year-over-year) and service charges on deposits (up 12.6% year-over-year), including commercial treasury management fees.

Noninterest expense increased by $6.3 million year-over-year in Q1 2025, driven by higher salaries and employee benefits (reflecting base salary increases, incentives, and restricted stock expense), increased occupancy costs, higher amortization of core deposit intangibles (from the FRME acquisition), increased legal fees (related to acquisitions), and elevated OREO-related expenses (due to operating and closing costs on property sales). Despite these increases, the company maintained a strong adjusted efficiency ratio (non-GAAP) of 55.48% in Q1 2025, reflecting effective cost control relative to revenue generation. Management expects OREO expenses to normalize in future quarters and aims to keep overall operating expense growth in the 4% range for 2025.

Overall, OSBC's financial performance demonstrates its ability to generate strong earnings, particularly net interest income, by effectively managing its balance sheet structure and funding costs, even as it absorbs acquisition-related expenses and navigates a dynamic rate environment.

Asset Quality: A Story of Remediation and Improvement

A key element of OSBC's recent narrative is the significant improvement in asset quality metrics, following a period of proactive credit identification and management. Management has consistently highlighted the peak in substandard and criticized loans in early 2023 and the subsequent progress in remediation.

As of March 31, 2025, nonperforming loans totaled $34.8 million, an increase of $4.5 million linked-quarter but a substantial decrease of $30.3 million year-over-year. The linked-quarter increase was primarily due to inflows from fifteen loans (mostly commercial), partially offset by charge-offs, paid-off loans, and principal reductions. The year-over-year decline reflects successful resolution efforts, including charge-offs and transfers of assets to OREO that were subsequently sold. Nonperforming loans as a percentage of total loans stood at 0.90% at March 31, 2025, down significantly from 1.60% a year prior.

Total classified assets also showed marked improvement, decreasing by $25.7 million linked-quarter and $52.2 million year-over-year to $88.4 million at March 31, 2025. This reduction was driven by both loan outflows (payoffs, upgrades, charge-offs, principal reductions) and significant OREO sales. Special mention loans, an early indicator of potential weakness, decreased by a notable 51% year-over-year, reaching their lowest levels in three years.

Net charge-offs in Q1 2025 were $4.4 million, primarily attributable to a single charge-off on two commercial loans ($3.4 million) and one construction loan ($821,000). Management noted that the large commercial charge-off related to a previously downgraded credit where bankruptcy proceedings led to an unfavorable outcome, but they believe the entire balance of this specific relationship has now been addressed.

The Allowance for Credit Losses (ACL) on loans totaled $41.6 million at March 31, 2025, representing 1.05% of total loans. This was a decrease from 1.10% at year-end 2024 and 1.11% a year prior. The provision for credit losses in Q1 2025 was $2.4 million, influenced by net charge-offs, a slight adjustment to the economic forecast, and specific credit downgrades, partially offset by upgrades and payoffs on higher-loss-rate credits. The ACL coverage ratio to nonperforming loans was 119.40% at March 31, 2025, a decrease from 144.00% linked-quarter but a significant increase from 67.80% a year ago, reflecting the improved nonperforming loan picture.

OREO balances decreased substantially by $18.7 million linked-quarter to $2.9 million, primarily due to the sale of two properties totaling $18.3 million. Management expects OREO-related expenses to decrease and normalize in future quarters following these sales.

Management expresses confidence in the current credit outlook, stating that their credit outlook is significantly better than it has been in two years. They believe they have been aggressive and proactive in addressing weak credits and do not foresee a "second wave" of broad credit problems based on current portfolio performance and stress testing. While acknowledging that isolated issues may arise, they anticipate more modest charge-offs in future quarters compared to recent periods and expect continued incremental improvement in asset quality metrics.

Liquidity and Capital Strength: Pillars for Future Growth

OSBC's liquidity and capital positions are significant strengths, providing a solid foundation for future growth and resilience against market shocks. Total assets increased to $5.73 billion at March 31, 2025, driven primarily by a substantial $156.8 million increase in cash, largely a result of the deposits acquired through the First Merchants branch transaction.

Total deposits reached $4.85 billion at March 31, 2025, an increase of $84.1 million linked-quarter and $244.5 million year-over-year. The linked-quarter growth was attributed to new deposits, including seasonal tax receipts, and product migration. The year-over-year increase was significantly boosted by the FRME acquisition, which added approximately $268 million in deposits. This influx of lower-cost funding allowed the company to reduce its reliance on higher-cost borrowings, notably paying down $20.0 million in short-term FHLB advances in Q1 2025, resulting in no outstanding short-term FHLB borrowings at quarter-end, down from $220.0 million a year prior. The loan-to-deposit ratio stands at an excellent 81.2% at March 31, 2025, providing ample liquidity and flexibility.

Beyond deposits, OSBC maintains other funding sources, including securities sold under repurchase agreements ($38.7 million) and longer-term junior subordinated ($25.8 million) and subordinated ($59.5 million) debentures. The company also has an undrawn $30.0 million line of credit with a correspondent bank and significant excess collateral ($928.6 million) available to secure FHLBC borrowings, further bolstering its liquidity position.

Capital levels are robust and growing. Total stockholders equity increased by $23.5 million linked-quarter to $694.5 million at March 31, 2025. This was driven by net income and a $6.4 million reduction in accumulated other comprehensive loss, reflecting an improvement in the unrealized position of the securities portfolio and swaps due to market interest rate changes. Year-over-year, total equity increased by $98.3 million.

Regulatory capital ratios remain well above minimum requirements. The Bank's Tier 1 leverage ratio increased to 11.27%, and its total capital ratio reached 14.58% at March 31, 2025. On a consolidated basis, OSBC exceeded all minimum capital ratios to be deemed well capitalized. Tangible capital metrics also show strong improvement, with the GAAP tangible common equity to tangible assets ratio increasing to 10.34% at March 31, 2025, up from 10.04% at year-end 2024. Management highlighted the significant increase in tangible book value per share over the past year, underscoring the capital-building momentum.

Management views its strong capital position as a key asset and is focused on its strategic deployment to enhance shareholder value. This includes supporting organic loan growth, pursuing potential strategic M&A opportunities (targeting banks between $500 million and $3 billion in assets, with a preference for cash inclusion to manage accretion), and returning capital to shareholders through its existing share repurchase program (available post-merger closing) and future dividend considerations.

Outlook and Key Considerations

Management's outlook for OSBC is one of cautious optimism, grounded in the company's strengthened balance sheet and strategic initiatives. While acknowledging the softer current loan demand influenced by market volatility and customer uncertainty regarding interest rates and tariffs, the company targets achieving low-single-digit organic loan growth in the second half of 2025. They believe they have the internal capacity to be a mid-single-digit grower organically and are open to adding talent or considering loan purchases if attractive risk-adjusted opportunities arise.

Net interest margin is expected to remain stable to modestly trend down from its current high level. Management's view on inflation being stickier than market expectations suggests potential fewer rate cuts than the forward curve implies, which would be favorable for OSBC's asset-sensitive profile. The full integration of the lower-cost deposits acquired from the FRME transaction and the anticipated benefits from the Evergreen merger are expected to provide a more favorable funding structure, mitigating some potential margin compression. Management believes that in an environment where short rates are above 2.5%, OSBC should maintain a margin significantly north of 4%.

Expense growth is projected to be manageable, with a target of keeping overall operating expense growth in the 4% range for 2025. While employee benefit costs are anticipated to be a factor, management is confident in controlling other expense categories. OREO-related expenses are expected to decrease significantly and normalize in the second quarter of 2025 following recent property sales.

Credit quality is expected to continue its positive trend. Management anticipates more modest charge-offs in future quarters and further incremental improvement in nonperforming and classified asset levels. Future provisioning is expected to be in the $2 million range per quarter, aligning with ongoing portfolio management.

The pending merger with Bancorp Financial and Evergreen Bank Group is a significant catalyst, expected to close in the third quarter of 2025. Management is optimistic about the strategic and financial benefits of this combination, including enhanced profitability potential, particularly if sustained success in deposit gathering continues.

Key risks for investors to monitor include the impact of future interest rate movements on the margin (though mitigated by balance sheet positioning), potential credit deterioration if macroeconomic conditions worsen (especially in C&I, though currently well-behaved), competitive pressures on pricing and digital capabilities, and successful integration of the pending Evergreen acquisition. The effects of global tariffs and broader economic uncertainty also remain factors influencing loan demand and credit performance.

Conclusion

Old Second Bancorp has demonstrated a compelling transformation, moving from a period of credit challenges to one of significant balance sheet strength and strategic opportunity. The proactive management of problem assets has resulted in markedly improved asset quality metrics, while disciplined capital generation has built a robust equity base. Coupled with strategic deposit-gathering initiatives, including the recent FRME branch acquisition and the pending Evergreen Bank Group merger, OSBC is well-positioned with ample liquidity and a favorable funding structure.

While facing a competitive landscape and macroeconomic uncertainties that may temper near-term organic loan growth, OSBC's focus on risk-adjusted returns, expense control, and strategic capital deployment provides a clear path for future value creation. The investment thesis centers on OSBC's ability to leverage its strong capital and liquidity to pursue disciplined growth, both organically and through accretive M&A, while maintaining resilient profitability driven by its optimized balance sheet and improving asset quality. Investors should watch for progress on loan growth acceleration, successful integration of the Evergreen merger, and continued strong credit performance as key indicators of the company's trajectory.