Midland States Bancorp, Inc. (MSBI) Q4 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen and welcome to the Q4 2017 Midland States Bancorp Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to introduce your host for today’s conference, Ms. Allyson Pooley from Financial Profile. Ms. Pooley, you may begin.

Thank you, Daniel. Good morning, everyone and thank you for joining us today for the Midland States Bancorp’s fourth quarter 2017 earnings call. Joining us from Midland’s management team are Leon Holschbach, President and Chief Executive Officer and Jeff Ludwig, Chief Financial Officer. We will be using a slide presentation as part of our discussion this morning. If you haven’t done so already, please visit the Webcasts & Presentations section of Midland’s Investor Relations website to download a copy of the presentation. Leon and Jeff will discuss the fourth quarter results and then we will open the call for questions. Before we begin, I would like to remind you that this conference call contains forward-looking statements with respect to the future performance and financial condition of Midland States Bancorp that involve risks and uncertainties. Various factors could cause actual results to be materially different from any future results expressed or implied by such forward-looking statements. These factors are discussed in the company’s SEC filings, which are available on the company’s website. The company disclaims any obligation to update any forward-looking statements made during the call. 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 that will be discussed today as well as the reconciliation of the GAAP to non-GAAP measures. And with that, I will turn the call over to Leon.

Yes, Allyson, thank you. Good morning everyone. Welcome to Midland’s earnings call. Slide 3 summarizes the highlights of the fourth quarter and we will start there. As with many banks, it was a noisy quarter for us due to the impact of tax reform on our deferred tax asset. We also had a couple of charge-offs that drove our provision expense higher in the quarter. Relative to the third quarter, the higher provision expense impacted our EPS this quarter by $0.14. But if we strip away the noise including the acquisition and integration-related expenses, we are pleased with the trends that we are seeing in our core operating performance. Most notably, our efficiency ratio has improved to 64.6% from 69% last quarter. This improvement was primarily due to expense reductions resulting from the continued realization of the synergies of the Centrue acquisition. We also had a strong quarter of balance sheet growth with solid increases in both loan and core deposits. As we mentioned last quarter, we were still seeing good loan demand but we are being more selective in our loan production in order to manage our loan to deposit ratio. With the pending acquisition of Alpine getting closer to completion, we felt comfortable taking our loan to deposit ratio a bit higher and booking more of the attractive lending opportunities we received. Essentially, we have pre-deployed some of the liquidity that we will be adding. We are very pleased with the broad-based loan production that we saw in the quarter. We had increases across all our major lending areas with the exception of commercial real estate. The strongest growth came in our commercial, construction and consumer loan portfolios. The commercial loan growth was driven by increased line usage, among existing customers as well as some new commercial relationships established during the quarter. Much of the growth of our consumer portfolio this quarter was attributable to the program we have with Green Sky Credit, which we have discussed in the past. While most trends we saw in the quarter were positive, we had softer quarters from both our commercial, FHA and residential mortgage banking businesses as well as another small write-down to value of the residential mortgage servicing rights, which we had moved to held-for-sale. The performance in these areas provided more evidence to us that we made the right decision to focus Midland around our core community banking and wealth management businesses. These are more stable businesses with consistent growth trajectories that we believe will reduce the volatility that we have seen in our recent financial performance. Ultimately, we believe we are on the right path to business mix that will enhance the value of the company for our shareholders in the years ahead. Admittedly, we have had a lot of noise since we came public that has obscured the true performance of the company. We always operated with a long-term perspective in mind and that that means taking some near-term pain to make the company stronger in the future. We don’t hesitate to take whatever actions we believe are in the best long-term interest of our shareholders. Since we had come public we have incurred cost to optimize our branch network and to reduce our exposure to the volatility of mortgage servicing lines. We have also had significantly increased the size of the company through the transactions that also resulted in near-term acquisition and integration charges. Although the noise has significantly impacted our reported results, we have steadily seen improvement in the core performance of the company; our revenues are up, our operating efficiency is improving and our level of returns are increasing. And all of those trends should continue in a positive direction after we realize the synergies that we are projecting from the Alpine acquisition. Over time we feel confident that the steps we have taken to strengthen the company and increase our earnings power, we will become more apparent in our reported results. Now I am going to turn the call over to Jeff and he will walk through some of the details of the fourth quarter performance.

Thanks Leon. Starting with Slide 4, I will review our net interest income and net interest margin. Our net interest income decreased by 2% during the third quarter, this was primarily the result of a decline in our net interest margin. On a reported basis our net interest margin decreased 5 basis points to 7.3% – 3.73% which was entirely attributable to the $40 million of some debt that that we added in preparation for the Alpine acquisition. Looking ahead excluding accretion income, we expect our net interest margin to be relatively flat. Once we add Alpine’s balance sheet and complete the purchase accounting adjustments we will provide an update on our margin expectations. Moving to our non-interest income beginning on Slide 5, total non-interest income decreased $1.4 million or 9% from the prior quarter. The decrease was primarily due to lower revenue from our commercial FHA and residential mortgage banking businesses. Residential mortgage had $1.6 million in revenue this quarter, which reflects the typical decline we see in the fourth quarter due to seasonally slower period for home buying. As we have indicated, we are in the process of rebuilding our residential mortgage production team by adding originators that focus on our core markets of Illinois and Missouri. We made several additions to the team during the fourth quarter and our goal is to have our staffing back up to its prior level, heading into the seasonally strong period for home buying in the second quarter. Turning to Slide 6, I am going to review wealth management. With a strong quarter as we added approximately $50 million in assets under administration reflecting market appreciation as well as net new business. As a result of the growth in assets our wealth management revenue increased 3.2% from the prior quarter. Measuring the organic growth on a year-over-year basis, excluding the assets added from CedarPoint, our total assets under administration increased by 12% as of 12/31. When the Alpine acquisition is closed, our wealth management revenue will substantially increase as our assets under administration will increase by approximately 50%. Turning to Slide 7 and looking at Love Funding, we originated $99 million and rate lock commitments during the quarter and had total commercial FHA revenue of $3.1 million. Our average servicing deposits were $295 million in the fourth quarter, up 9% from the same quarter last year. Our weighted average cost on servicing deposits was just 10 basis points. As we mentioned on our call last quarter due to the size of the loans originated by Love Funding, which can cause large swings in originations and revenue on a quarterly basis, we evaluate the performance of this business on an annual basis. Overall, for 2017, Love Funding was at the low end of the $18 million to $20 million in annual revenue that we projected for this business, while exceeding the high end of the 20% to 25% range of profit margin. Turning to Slide 8, we will take a look at our expenses and efficiency ratio. We incurred $2.7 million in integration and acquisition-related expenses in the quarter as well as $400,000 in losses and loss on the mortgage servicing rights that were moved to held-for-sale. Excluding these items, our non-interest expense decreased $3.4 million or 9% on a linked quarter basis. The decrease was primarily attributable to a couple of factors. First, we have lower salaries and benefits expense due to a 5.7% decrease in FTEs during the quarter resulting from the continued integration of Centrue. And second, we had lower variable compensation within the commercial FHA and residential mortgage businesses. In early January, we completed the sale of the mortgage servicing rights that we had moved to held-for-sale, which freed up $10 million of capital that will be used to support the Alpine acquisition. Moving to the balance sheet on Slide 9, we will take a look at our loan portfolio. Total loans increased at an annualized rate of 9% in the fourth quarter. Compared to the end of the prior quarter, commercial loans were up 8%, commercial loans were up 10% and consumer loans were up 8%. The growth in these areas offset a 2% decline in commercial real estate loans. Turning to Slide 10, we will take a look at our deposits. Total deposits were up approximately $17 million from the end of the prior quarter, although we saw much stronger growth in our core deposit categories. We utilized the sub debt we recently raised to decrease our holdings of brokered CDs by $43 million. When brokered CDs are excluded, our total deposits were up $60 million. The increase was driven by growth throughout our commercial, retail and servicing portfolios. Moving to Slide 11, we will look at our asset quality. We recorded $6.5 million in net charge-offs during the quarter, which were largely related to two commercial real estate loans. We charged off $5 million on a credit that we have modified to a TDR in the third quarter of 2016. As you may recall from our commentary at that time, the tenant in the underlying property was performing well and they continue to perform well. However, the building is part of a retail development that hasn’t progressed as expected. As a result, our borrower has had to service a larger share of the municipality-issued debt. The additional share of this debt, that the property is now burdened with, resulted in a lower valuation upon reappraisal, which triggered our charge-off. This loan is now being carried at approximately $5 million on our books. It’s a unique situation and unfortunately given that the cash flow generated by the tenant continues to be more than enough to serve as the original terms of the loan. The second significant charge-off in the quarter was $1 million related to a retail mall property in Central Illinois. The property was recently sold for a price lower than the amount outstanding on the loan. These were the two credits in the portfolio that we were most concerned about and now that we have taken these charge-offs we don’t see anything else in the portfolio that we think would drive an outsized level of provisioning in the foreseeable future. As a result of the charge-offs, our non-performing loans decreased by $6.6 million from the end of the prior quarter due to the growth we had in the portfolio this quarter as well as the higher level of charge-offs we recorded a provision for loan losses of $6.1 million. This provision brought our allowance to 51 basis points of total loans as of December 31. And our credit marks accounted for almost 51 basis points. With that I will turn the call back over to Leon.

Thank you, Jeff. I will wrap up on Slide 12 with some comments on our outlook. We expect to close the Alpine acquisition by the end of February. This will have a significant impact on our business mix. Within our fee income we are projecting our wealth management service charges on interchange will represent approximately 47% of fee income in 2018, while commercial FHA and residential mortgage banking will comprise just 41%. This is significantly lower than the 61% of fee income that commercial FHA and residential mortgage banking accounted for in 2016. Within our total revenue mix, net interest income, wealth management and service charge and interchange are projected to account for 82% of our total revenue in 2018, up from 65% in 2016. With a greater percentage of our revenue being derived from core community banking and wealth management, we believe we will have a higher quality of earnings and less volatility in our financial results. We will also gain valuable scale with the addition of Alpine’s operations and we will be highly focused on capturing all of the synergies that we are projecting for this transaction. We are currently targeting the system conversion from mid-July and that will lead to the bulk of the cost savings from the combination being seen in the fourth quarter. With the additional scale and cost savings from Alpine, we expect to see an improvement in our efficiency ratio as well. Another key focus for Midland in ‘18 was focusing on those lending areas that generate the most attractive risk adjusted returns. One of those areas is the equipment financing which is a business we got into the acquisition of Heartland Bank at the end of 2014. We have grown that portfolio by nearly 80% since then. We like this business a lot as this generates attractive yields and have strong credit quality. Recently we had unique opportunity to significantly expand this business through the addition of Fred Van Etten. Fred was the President of Scottrade Bank Equipment Finance prior to Scottrade sale to TD Ameritrade. Fred has brought over a group of equipment finance professionals that worked with him at Scottrade and in addition to increasing the size of the team that we have in this business. Fred and his group will provide the expertise to expand our offerings to include loans, leases and hybrid products that will enable – it will enable us to capitalize on more financing opportunities. The timing couldn’t be better for the expansion of this business with the recently passed tax reform companies will have an increased capacity to invest in new equipment while also being able to take advantage of accelerated depreciation on their taxes. The combination of these factors and the strong track record that Fred has leading highly productive teams makes us very bullish on the outlook for this business. Of course we will also benefit from the tax reform through a lower tax rate as well. For 2018, we expect our effective tax rate to be approximately 23%. With the additional earnings coming from our lower tax rate we expect to generate more capital. We have two priorities for the use of this capital. First, we will be using it to rebuild our capital base, following the closing of the Alpine acquisition. And the second we intend to continue our 15-year track record of increasing our dividend by at least 10% annually. In summary, we are very excited about our positioning as we start 2018. We believe that will be a year of strong organic growth as well as seeing the initial benefits of a highly accretive acquisition. And we believe will be a year that significantly enhances the value of our franchise. And with that we will be happy to answer any questions that you might have. Operator, would you please open up the lines for call please.

Thank you. [Operator Instructions] And our first question comes from Michael Perito with KBW. Your line is now open.

Thanks Jeff and Leon. Good morning.

Good morning Michael.

Good morning Michael.

A few questions for me, I wanted to start with the credit in the quarter, you maybe give us a little bit more color definitely on about additional kind of retail strip center, mall type exposure either direct or indirect in the portfolio?

Yes. So, right total portfolio on that retail commercial real estate sides roughly just little over $200 million. We don’t have properties like these properties, so retail mall this was like that’s the only property we had in the portfolio as well as this retail development property that we have. We don’t have those types of loans in that portfolio. So we feel pretty good that that portfolio will outperform well as we move forward.

Has there been any other instances in that portfolio of even like modest charge-off or move to classifieds that is anything else worth noting?

No, I think we have actually – I think in that portfolio we have risk ratings actually a little lower than the total portfolio. So, we don’t see any issues going forward.

Okay. And then how are you guys thinking about the – I guess taking into consideration, what seems like decent organic loan growth aspirations next year, how are you guys thinking about kind of provisioning rate for 2018?

I think with the acquisition of Alpine that will drive a little more forward provisioning as well. So I think anywhere in that $1.5 million probably to $2 million range is the – a reasonable place to start.

Okay. And then maybe just sticking with you Jeff for a second just moving on I know the Alpine deal is closing a little sooner into February, it sounds like, which is good, but curious if you could just talk about the expense starting point for ‘18 maybe excluding Alpine, where you kind of see the Midland expense rates starting in the first quarter of ‘18, excluding any merger charges in the Alpine expenses just to kind of give us a better sense of what’s the starting point is moving forward?

Yes. So we saw a nice decrease in the fourth quarter and on the expenses excluding integration acquisition. In the first quarter we will see an uptick, I mean a couple of those, a big part of that decrease was related that what we will call permanent items with the Centrue synergies with some of that was more variable related to the mortgage business variable competition plan. So I would – I would expect the expenses to move out from that $33 million number. We have brought larger leasing team on and right at the end of the fourth quarter. So that will drive a little bit of additional expenses. I think something more in that $36 million range more like where the GAAP number was would be a reasonable starting point.

Got it. Thanks. And then, I guess Leon just any thoughts on you made that the general comment about strong organic loan growth, can you maybe give us a sense of some team that you brought from Scottrade with type of booking production levels they we are doing and than any other more specific thoughts I guess overall and what you kind of think are real estate expectations on the organic growth side, I mean it seems like the Alpine deal will give you a little liquidity to deploy, so just curious what you guys think you could do with it?

Yes. I will give you a couple of comments Mike and then Jeff jump in on this if you want to. But looking at – looking backward at Alpine’s recent growth, the last few years they have had a good solid loan growth in their own portfolio. They are positioned in one of the larger MSAs in the state and there are a lead – one lead bank in that market. So my expectation is that – and then bringing the sales force with them, my expectation is that they will continue a good trajectory of growth in that state line market. The leasing company and I will let Jeff to add some flavor to what we are thinking about for numbers, but we expect the leasing team to produce a nice lift itself, the combination of those two and good growth across the company. But Jeff what are we looking for ballpark from the leasing companies, in terms of new production?

Yes. So that was a good team that brought on with the number of sales people. So I think we are looking at $125 million to $150 million worth of production on to that team this year, so pretty good production.

Got it. And then just one last quick one from me just you have the closing number on the resi platform I think it was $53 million last quarter and what percentage of that was purchased?

You are talking about mortgage servicing rights.

No, no, just the residential mortgage sale like the closings you had in the quarter and what percent of that was purchased, I didn’t see it in the slide there.

Yes, we will get it for you.

Alright, perfect. Thanks, guys. Appreciate it.

We are looking for it.

No problem. Thanks.

Thanks Mike.

Thank you. And our next question comes from Terry McEvoy with Stephens. Your line is now open.

Good morning, guys.

Good morning, Terry.

Maybe let’s just start with credit, could you talk about watchlist delinquency trends within the CRE portfolio ex the retail segment that call it $1.2 billion portfolio?

No, but the breakout – but the global delinquency trend has been real solidly stable and in that 45 basis point range with real good stability for actually many quarters. We will see if we can get you CRE breakout number while we talk, Terry.

Okay. And then I guess on the commercial FHA mortgage, have you made adjustments to the expense base at all to reflect the decline in revenue. I know you said you are adding to that the mortgage production site through new lenders, but what about just that core expense run-rate?

Yes. So, in both platforms little tweaks in expenses, but on commercial FHA and Love Funding a little bit here a little bit there, but we believe that we have the operating platform to operate and generate pre-tax profit margins in that 25% range if the revenues in that $18 to $20 million. So, I think we feel good about that expense base in that business. On the residential side, we have kind of – we held – I will say we held the back office last year with the anticipation that we are going to be getting all times coming in we have and we are going to begin to rebuild that business, so we didn’t make – last year, we didn’t make adjustments to the back office with the anticipation that we are going to kind of get back to where we were. So, it’s you let people go for two quarters, I think are hiring back that gets a little tricky. So, if we thought that long-term that business wasn’t going to rebound, we would have taken the expenses out.

And just last question….

We think the expenses that we have in the mortgage business today supports our growth in next year without adding new back office expense.

Okay. And just my last question on Love Funding tax reform, did that change the growth outlook, the profitability dynamics at all of Love Funding and if so to what extent?

Yes. So, Terry, this is Leon. So, no, not in particular and I have appreciated that there has been lots of focus on the impact on the tax credit aspect of that business. So, two of the points there, one is that within Love Funding, the tax credit driven deals are not a big proportion in the business, but more importantly and appreciating that most of the deals structure are partnerships and LLCs, the beneficial impact of the tax return for the accelerated depreciation. So for example, of every piece of equipment that would be in an assisted living center, for example, there is a benefit there, not a penalty. And to the extent that these are other than C-Corp entities and most of them are that with the actual borrower that capping and I think I am not a tax expert, here is my tax disclaimer. I think the cap is at now 25% for pass-through from the individual investor in a multifamily or an assisted living deals, it’s actually likely a net improvement in the tax law changes. So, the high level answer to your question is no, not impacting projections, getting down in the granularity could very well be that it’s a net benefit.

Got it. Thank you.

Thank you. And our next question comes from Kevin Reevey with D.A. Davidson. Your line is now open.

Good morning, gentlemen.

Good morning Kevin.

So, Leon, you mentioned earlier that line utilization was up, can you provide us with kind of what the percentage was this quarter and what was it last quarter?

No, but you are welcome to call the CFO back later and grill him on that, I am sorry, Kevin I don’t have that at my fingertips.

We can try to find it here in next couple of minutes.

Okay. And then what was this bullet in the growth between new and existing customers on the commercial side on the growth side?

Yes, just that increased line usage and winning new customers just that.

Yes, probably half and half type of rough percentages.

And then as far as the mortgage lenders that you have been hiring, how many would you add in the fourth quarter and how many more do you think you need to bring on board in 2018 to kind of get to where you need to be?

Yes. So, I think we brought on 4, 5 in the fourth quarter and we are looking to bring on roughly 10, maybe 10 to 15 in the first quarter to get us to about where we were kind of pre-loosing that Colorado mortgage team in the second quarter of last year.

Okay, great. Thanks.

Yes.

Thank you. [Operator Instructions] And our next question comes from Andrew Liesch with Sandler O’Neill. Your line is now open.

Good morning, guys.

Good morning Andrew.

Question on the loan growth here just related to geography, is there any part of your footprint that’s stronger than any other or is there – or is it just broad-based across everywhere?

Yes, I think it’s pretty broad-based. We have kind of cut our business into like four different regions and we see it coming from all areas, so we think that’s a good sign.

Okay. And then the consumer loans, the Green Sky loans, they can be lumpy from quarter-to-quarter, does that something you turned on and off depending on your appetite for it or how do those loans come into the balance sheet, is there a way to easily model that?

Yes. So, this is the former part. So, we kind of give them a target balance that we would like them to hit and they bring it to that balance and they are maintaining and then the next quarter goes by if we want to raise it, we raise it, they bring the balance up to that number. So, we moved the number in the fourth quarter with the Alpine kind of this pre-funding some of the Alpine liquidity we moved the target up and it brought more balance in it.

Got it. Alright, thank you.

Yes.

Thank you. And we do have a follow-up question from Michael Perito with KBW. Your line is now open.

Hi, guys. Thanks. Jeff, you weren’t just repeating your margin guidance comment that you made in your prepared remarks I just want to make sure I have it down correctly?

Let me look, real quick on the mortgage side where I am getting back to that, Mike, about $60 million in secondary loan production and 72% of that production was purchased.

Thank you.

Yes. So, we said excluding accretion, we see margin near relatively flat. We will see if there will be a little pressure on the margin with the tax change, because our margins on a tax equivalent basis. So, there is a little bit of pressure there. So, that’s kind of one reason to say it’s going to be relatively flat on an ex accretion. Alpine has got a roll in at the end of February as we assess the credit mark and see how that’s going to roll through the income statement moving forward. It might be – it would be fairly like the first quarter, because it would only be in here for a month, and then the next quarter it will start to kick in. Centrue was going to begin to roll down, that one is going to come in and then roll down, but got it.

And just future movement in the short end of the curve, fed fund hikes, any thoughts on what the impact is at this point, my guess is that benefits becoming less and less, but is there still some benefiting I think you would achieve if the short end keeps moving?

Yes. I mean we see the benefit of – as we have adjustable rate loans that are adjusting based on short-term rate movements. And we are seeing, we continue to see that, but we are also seeing the creep on the deposit side as well. So we are not seeing big benefits in the margin. And where we are at today, we are out there generating core deposits. We have different rates, promotions going on to bring those deposits and so we are seeing a little bit of deposit rate pressure.

Got it. Thanks for taking my follow-up.

Yes.

Thank you. And our next question comes from Eric Rubin [ph] with Bank Investor. Your line is now open.

Yes. Hi, good morning, could you refresh my memory on something, your mortgage servicing rights say the little bit of the market took in the quarter, was that purely rate related or was there something else and given the fact that tenure is up about I don’t know 20 basis points or so from year end, would expect the existing portfolio that you have on balance sheet to be marked up?

Yes. So what we would tell for sale it was sold early January, so the true up if you will between the negotiated price and what was there when it was actually sold is the difference…

Loan balance…

Balances were down a little bit, that was a true up in the sale price on January 3.

Some payoffs or amortization related to what one it was actually, so those are gone now that we won’t see from next quarter?

Yes. We still have a small piece of resident tied flow growth roughly $4 million of mortgage servicing rights. I mean rates are moving up, I wouldn’t think anything there material on and up rate movement, because there is a lot of balance there.

Okay, that’s fine. And then just one other question I have for you on those the credits that you mentioned that you charged-off in the quarter, I didn’t – I don’t know if you had mention this or not, I got sort of temporarily disconnected or distracted at the beginning of the call, were those your own home grown loans or did they come from acquisitions of other banks?

Eric, this is Leon. So, the one in Central Illinois in fact came, these are both credits have been on the banks a longtime. The smaller one, the Central Illinois one was acquired in the Amcor acquisition, which was 8 years ago and that’s what we acquired it, but it’s been on their books for a long time. It was a sort of 1980s vintage retail mall between about halfway between two Central Illinois towns. So that’s been on the book longtime. The second one where as Jeff was characterizing, the underlying tenant is strong, national franchise continues to perform well. And that was booked by us about 8 years ago as part of the larger commercial development at the state capital and just a classic stalled commercial real estate development and rolled out at the beginning of what we have become to characterize as the great recession. So, but yes both of those have been on the books for a longtime, one originated by us, one in inherited in the deal.

Okay, thanks. Thanks for that. Thanks for going over that again. Appreciate it. Thank you.

Yes.

Thank you. And I am not showing any further questions at this time. I would now like to turn the call back over to management for any further remarks.

Alright. So, thank you all for joining us and we will look forward to talking to you again in the quarter.

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude today’s program and you may all disconnect. Everyone have a wonderful day.