MSBI (2019 - Q4)

Ladies and gentlemen, thank you for standing by and welcome to the Fourth Quarter 2019 Midland States Bancorp Incorporated Earnings Conference Call. At this time all participants’ lines are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded. [Operator Instructions] I would now like to hand the conference over to your speaker of today, Mr. Tony Rossi of Financial Profiles. Sir, you may begin. Tony Ros

Thank you, Crystal. Good morning everyone and thank you for joining us today for the Midland States Bancorp fourth quarter 2019 earnings call. Joining us from Midland's management team are Jeff Ludwig, President and Chief Executive Officer; and Eric Lemke, Chief Financial Officer. We'll be using a slide presentation as part of our discussion this morning. If you've not done so already, please visit the Webcasts and Presentations page of Midland's Investor Relations website to download a copy of the presentation. The management team will discuss the fourth quarter results, and then we will open up the call for questions. Before we begin, I'd 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 to be discussed today as well as the reconciliation of the GAAP to non-GAAP measures. And with that, I'd like to turn the call over to Jeff. Jeff?

Good morning everyone. Welcome to the Midland States earnings call. I'm going to start on Slide 3 with the highlights of the fourth quarter. We generated $0.51 in earnings per share, which included a $1.6 million valuation adjustment to mortgage servicing rights and our commercial FHA business, which impacted earnings per share by $0.05. During the fourth quarter, we also recorded integration and acquisition expense, a loss on the repurchase of subordinated debt and a net gain on security sales. On an adjusted basis, we had $0.64 in earnings per share. We ended the year with a strong quarter in business development. Our total loans increased at an annualized rate of 6.7%. We had another good quarter of commercial loan growth driven primarily by our equipment finance business, which continues to produce loans and leases with the more attractive risk adjusted yields that we are targeting. Over the course of 2019, we successfully executed on our balance sheet management strategies. Towards that end, this put us in a favorable position from a liquidity standpoint to be more active and growing our consumer loan portfolio, which contributed to the stronger loan growth in the fourth quarter. We also had a very successful quarter in deposit gathering with our total deposits increasing at an annualized rate of 8.8%. Once again, this deposit growth was entirely driven by core deposits. We have introduced some new depository products for commercial customers and we continue to be very active in our calling efforts. This has resulted in strong inflows of core deposits from new customers as well as getting more of the wallet share from existing customers. Improving our deposit mix was one of our top priorities in 2019 and we're very pleased with the success we have had in this area. The strong inflow of core deposits enabled us to steadily run off higher cost broker deposits. As a result, our net non-core funding dependency ratio declined to 7.8% at the end of 2019, down from 17.9% at the end of the prior year. We also continue to make good progress on another key initiative, improving our efficiency ratio. With the successful integration of Homestar Bank’s core system conversion in October, we were able to recognize additional cost saves from this acquisition. This resulted in our efficiency ratio further improving to 59.5% in the fourth quarter, down from 60.6% in the prior quarter. Finally, we continue to effectively manage our capital. Our earnings continue to rebuild our TCE ratio, another key priority for us in 2019. Compared to the end of the prior year, our TCE ratio increased 32 basis points despite the impact of the Homestar acquisition. We also continue making what we believe is an attractive investment for the company through our stock repurchase program, as we repurchased approximately 85,000 shares during the fourth quarter at an average price of $25.69 per share while also continuing to pay an attractive dividend to our shareholders. At this point, I want to introduce our new Chief Financial Officer, Eric Lemke. Eric joined Midland in 2018 as our Director of Assurance and Audit, and we have been very impressed with his business and financial acumen during his time here. Eric was previously the CFO of Metropolitan Capital Bancorp, in Chicago, and also served as a partner in the financial services practice at RSM. So we are very confident that he has the experience and skill set to effectively lead our finance team. Now, Eric is going to walk us through more details on the financial performance in the quarter. Eric?

Thanks, Jeff, and good morning again everyone. I'm going to start with our loan portfolio on Slide 4. Our total loans outstanding increased $72.6 million from the end of the prior quarter driven, as Jeff mentioned earlier, by growth in the commercial and the consumer loan portfolios. Our commercial loans and leases portfolio was up 7.4% on a linked quarter basis, largely due to the growth in our equipment finance business. The outstanding balances in our equipment finance business increased $66.8 million from the end of the prior quarter, or 11.8%. Our consumer portfolio increased $100 million from the end of the prior quarter, which represented all of the growth in this portfolio during 2019. As we've indicated in the past, we have a lot of flexibility in our consumer loan production and can increase production when it makes sense from a liquidity and a balance sheet management standpoint as it did during the fourth quarter. The growth in the commercial and consumer portfolios help to offset continued runoff in the commercial real estate portfolio, where we continue to see elevated payoffs being driven by aggressive pricing offered in our markets. In addition, the declining interest rate environment impacted our loan yields during the fourth quarter as yields, including accretion income, declined by 9 basis points to 5.22%. Turning to deposits on Slide 5. Total deposits were $4.54 billion at the end of the fourth quarter, an increase of approximately $99 million from the end of the prior quarter. Substantially, all the growth came in our checking and our money market balances, which is attributable to the success of the deposit gathering initiatives that Jeff previously discussed. Also during the fourth quarter, we intentionally reduced our balances of brokered time deposits by another $44 million. With this runoff, brokered time deposits represented just 1% of our total deposits at the end of 2019, down from 4% at the end of the prior year. Our overall cost of deposits dropped 4 basis points to 0.8% in the fourth quarter, but we’ll talk a little bit more about that in the next slide. And turning to that next slide, let’s talk a little bit about net interest income and our net interest margin. Our net interest income decreased 1.5% from the prior quarter. Excluding the impact of accretion income, our net interest margin declined 17 basis points from the prior quarter. As we expected, the increase in subordinated debt, following our $100 million issuance in September of 2019, put pressure on our margin. And in the fourth quarter, the additional sub debt negatively impacted our margin by 8 basis points. The strong deposit growth that we saw in the quarter increased our level of cash balances. Combined with lower rates earned on those cash balances, the excess liquidity negatively impacted our margin by 7 basis points. And then as a result of the 75 basis point reduction in Fed funds rates that occurred over a period of three months in mid to late 2019, lower average loan yields negatively impacted our margin by 4 basis points. All of these factors were partially offset by lower rates on deposits, resulting from a reduction in rates on certain deposit accounts and the improvement in our deposit mix. Now looking ahead, we see a number of factors that should have a positive impact on our net interest margin as we move throughout the year 2020. In particular, we’ll be redeeming our high cost – higher cost subordinated debt in June of 2020. We also have approximately $280 million of time deposits maturing from March through June that should renew at much lower rates. We expect to continue to see a positive shift in our deposit mix and pass through more of the recent rate cuts to our depositors, which should further lower our cost of deposits. And we expect that the higher yielding equipment finance portfolio will continue to comprise a larger percentage of our overall loan mix. So assuming no changes in the Fed funds rate going forward, we believe that these factors can help stabilize our net interest margin during the first half of 2020, excluding the impact of accretion income, and then help us move back towards the 3.5% range in the second half of the year. On a reported basis, we will still see some downward pressure on our net interest margin as our scheduled accretion trends lower throughout the year. Now turning to wealth management on Slide 7. At the end of the quarter, our assets under administration were $3.41 billion, an increase of $129 million from the end of the prior quarter. The increase was primarily attributable to improved market performance during the quarter. Our wealth management revenue decreased 10.4% from the prior quarter to $5.4 million, which was primarily attributable to a decline in our estate fees. Turning to Slide 8. Non-interest income, our total non-interest income decreased 3.0% from the prior quarter to $19.0 million. In the fourth quarter, our non-interest income included a $0.6 million or $600,000 in net gains on sales of investment securities. The decline in it from the prior quarter was primarily due to two factors: the decline in lower wealth management; and lower commercial FHA revenue. Our commercial FHA revenue was negatively impacted this quarter by a $1.6 million impairment to mortgage servicing rights in this business. Those declines were partially offset by an increase in bridge loan fees generated from referrals through Love Funding, which are recognized in other non-interest income. Looking ahead, over the long-term, we still expect commercial FHA revenue to range from $12 million to $20 million annually. However, given the operating environment for commercial FHA remains similar to the conditions that we saw in 2019, we expect revenue from this business to be fairly similar to what we saw during this past year. Turning to Slide 9 and our expenses and efficiency ratio. We incurred $3.3 million in integration and acquisition expense in the fourth quarter, a $1.8 million loss on the repurchase of subordinated debt and a loss on mortgage servicing rights held for sale of $95,000. Excluding these adjustments, our non-interest expense decreased 3.9% on a linked quarter basis. That decline was primarily due to additional cost savings realized after the HomeStar system conversion was completed in October. As a result of the decline in our expense levels, our efficiency ratio improved to 59.5% compared to 60.6% in the prior quarter. Moving to Slide 10, we’ll take a look at asset quality. We saw a general improvement in asset quality this quarter as reflected by the decline in our non-performing loans and net charge-offs compared to the prior quarter. We recorded a provision for loan losses of $5.3 million during the quarter. This reflected the stronger growth we had in the loan portfolio. The provision also included a $1.4 million specific reserve established for an existing non-performing loan when that property was put on the market at a lower price than our most recent appraisal data. This particular loan is unrelated to the non-performing loan that impacted our provision expense during the prior quarter. The fourth quarter provision brought our allowance for loan losses to 64 basis points of total loans at December 31, and our credit marks accounted for another 39 basis points. Now let me provide a few comments on our expectations for the implementation of CECL. Based on our loan portfolio balances and current economic forecasts at the end of 2019, our best estimate of the increase in the allowance for loan losses and reserve for unfunded commitments from the implementation of CECL is approximately $20 million to $25 million. This range reflects the uncertainty of economic forecast used to record those additional reserves. We are continuing to finalize these and certain other key assumptions used in our CECL model and methodologies. Looking ahead, at this point in the economic cycle while we continue to see generally healthy trends in the portfolio, we’ve seen a continuation of one-off credit events impacting our net charge-offs and provision expense. These one-off credit events have not been concentrated within any particular industry or property type, and we’re not seeing broad weakness in our portfolio in ag loans, retail loans, healthcare loans or any of the other industries where there is concern on a macro level. Our portfolio continues to be very well diversified and the one-off credit events we have seen have been in unique situations that haven’t been related to deterring fundamentals in any particular industry. For that reason, we’re expecting our quarterly provision expense to be in that $3 million to $4 million range during 2020, however that’d be under current economic conditions. Under CECL, provision expenses will be subject to more volatility, depending on changes in those economic forecasts and a variety of other factors. So with that, I’ll turn the call back over to Jeff. Jeff?

Thanks, Eric. We’ll wrap up on Slide 11 with some comments on outlook for 2020. Since our IPO in 2016, we have acquired three banks and two wealth management businesses. As a result, in a period of 3.5 years, we have doubled our total assets and had substantial growth in our wealth management business. As we start 2020, our focus will be squarely on organic earnings growth and improving our performance metrics, including our efficiency ratio, which we are targeting to be under 60% on a sustainable basis by the end of the year. If an attractive acquisition opportunity emerges, we certainly will consider it, but that is not our focus for 2020. We believe that our shareholders will be best served if we utilize 2020 to focus on optimizing the performance of the existing bank and continuing to build our tangible book value per share. From a balance sheet management perspective, we expect to have a continuation of the trends we experienced in 2019. We expect low single-digit organic loan growth, primarily driven by continued growth in our equipment finance portfolio. We also expect to have continued success in gathering core deposits and improving our deposit mix. We’d like to continue to keep our loan to deposit ratio in the mid-90%. Although we expect just modest balance sheet growth this year, we believe we are well positioned to generate a year of strong earnings growth for a number of reasons: first, we’ll have a full year of realizing the synergies from the HomeStar acquisition. Second, we will complete the consolidation of the previously announced six branches by the end of the first quarter, which will reduce the costs associated with our branch network. Third, earlier this week, we made adjustments in our staffing levels that reflect the shift in customer preferences towards digital and mobile banking, and our continued focus on efficiency. We eliminated approximately 50 full-time employee positions, with approximately 30% of those positions coming out of our retail branches, and the remainder are primarily coming from back office support and non-revenue generating positions. These staffing adjustments will result in approximately $3.9 million in annualized cost savings beginning in the second quarter. Following these staffing adjustments, we expect our quarterly run rate for non-interest expense to be in the range of $42 million to $43 million per quarter in 2020. Fourth, we will leverage the significant investments we have made in technology over the past few years to drive additional efficiencies, further streamline our operations and enhance our digital banking experience. And fifth, as Eric laid out earlier, we expect to see an expansion in our net interest margin later in the year, which should help drive an increase in our net interest income. We believe that solid execution on these initiatives will put us in a good position to deliver strong earnings growth in 2020 and further improve the level of returns that we generate for our shareholders. With that, we’ll be happy to answer any questions anyone has. Operator, please open the call.

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

Hey, good morning. Happy New Year.

Yes. Good morning, Mike.

I want to start – so obviously, appreciate all the forward-looking commentary, but I want to start maybe just on the credit side. I mean, you provided a pretty much a 40 basis point rate last year. And clearly, pretty high above where most of your peers are, but it sounds like the portfolio – you guys still remain confident in kind of the makeup and underwriting of the portfolio. And then – so I’m just trying to pull all the pieces together here. I mean, what type of loss content does the $3 million to $4 million provision for next year assume? Does it assume that charge-offs remain slightly higher than peers like you experienced in 2019, and then the low single-digit growth? Or are there other assumptions that kind of make up that provision expectation?

Yes. So I think we’re looking – if you look back in 2019, we probably averaged at about $4 million a quarter. We think that will come down slightly in the range that we gave of $3 million to $4 million kind of puts us in that range. And I think charge-offs, we probably think are probably going to look a little bit like 2019. We do have, as we disclosed more detail around our allowance, we do have a fair amount of specific reserves that are sitting in the allowance today. So as those get resolved, we could see some charge-offs come through on those specific reserves, but those are already provided for. So kind of excluding maybe that group of loans, we don’t – we probably expect under 20 basis points kind of charge-off level as we look at the portfolio today, and the diversification that we have.

Okay. Helpful, thanks. And switching over to the margin. Can you guys – I guess, two-part question: one, can you remind me if there is another cut in Fed funds? What kind of the negative sensitivity to the margin would be in that scenario? And then secondly, can you just provide a little bit more color on the kind of time deposit repricing opportunity as you see it today? Maybe where the kind of the yields on the book are, and where the new yields are coming in and what the potential pickup could be there that seems to be a big driver of the potential margin pickup in the back half of the year.

Yes, that’s a good question. So I guess, I’ll start with the time deposits. So we’ve got – we did quite a few CD specials during the first and second quarter last year at this time. And so we’ve got about $280 million that are going to be maturing between March and June. And so the way we’re kind of modeling it is we think there’s potentially an 80 basis point pickup. However, we’re also modeling that we won’t be able to retain necessarily all of those funds. But that’s a pretty significant pickup to that during the course of the next year.

Okay. And then the sensitivities on the potential for another cut in the Fed funds?

Yes. So maybe I’ll take that one. Well, I think what we’ll see is what we saw in the fourth quarter. We’ll see initial pressure on the asset side. And then it will take us a quarter or two to continue to adjust deposit rates across the board. So there’ll be somewhat of a lag. So I think we would see some initial pressure and then be able to work it back.

But the initial pressure – I mean, the fourth quarter compression in the core margin. I mean, there – that was partly debt, partly liquidity-driven? I mean, wouldn't beat to that magnitude, right? It would probably be something in like the 2 basis point to 5 basis point range and then work back over time. Is that a fair way to think about it? Or just in a kind of isolated?

Yes, I think so. I mean, 8 basis points was sub debt, 7 basis point was additional liquidity. So yes, it would be more in that mid-single-digit basis point range.

Okay. And then just as I think about capital here, Jeff, 2019 was – saw your capital levels build, and based on the efficiency and recent profitability kind of production, I would think that will continue next year. It seems like it's still another kind of internally focused year of kind of sustaining the improvements you guys have made in returns. And then kind of expanding on that, if you can. Does that lend to maybe kind of behind the scenes utilizing share repurchases and deploying some capital that way? Or any updated thoughts, I guess, just in general about capital deployment outside of M&A and organic growth?

Yes. So maybe I'll start with dividends. We have a long track record, I think, probably a 15 year track record of increasing dividends by 10%. So we're going to continue to pay a good dividend. We do have a share repurchase program. We've used it, I'll say, defensively, to this point, as our stock price, as you saw in the fourth quarter, when we bought, we bought in the $25 range. And I think, at least in the short term, we're going to continue to use it defensively. Our TCE ratio is still not to 8%. We'd like to ideally get to above 8%. So we need to continue to work the TCE ratio up. We need to continue to work book value up. And as you know, as you buy your stock back, that works against you. So I think we'll continue to use it defensively continue to build tangible book value, continue to build TCE. And then as the TCE ratio begins to get back over 8%, maybe we'll use that share buyback in a different way, but I think we have to get there first.

Okay. Helpful. Thank you guys, appreciate you taking all my questions.

Yes. Thanks, Mike.

Thank you. Our next question comes from Terry McEvoy from Stephens. Your line is open.

Good morning, everyone.

Good morning, Terry.

First off, thanks for all the disclosure around Day 1 and Day 2 CECL. Very helpful. And I also understand the drivers of the margin upside from 4Q through, I guess, the second half of next year. I believe in the past, you have provided some thoughts on accretion. I know you said accretion would come down, which would impact the reported NIM, but any thoughts on accretion over the next two to four quarters or for full year 2020?

Yes. The challenge we're having right now as some of that accretion kind of goes out of accretion and goes into, I'll say, normalized – or normalized margin number, and we're still trying to get our hands around what that looks like. So in pure dollars, it's probably $4 million, $5 million decrease year-over-year, something like that. Now whether that as we get into 2020, it shows up in that line item or not. That's where it gets a little confusing with the adoption of CECL. So there's $4 million, $5 million of headwind there.

Okay. And then moving over to fee income, the wealth management, I've got in my notes here, seasonality in the state fees put pressure on wealth management fees. So what are your thoughts on that line of business in 2020? And then on the FHA, just so I'm clear if 2020 looks pretty similar to 2019, does that include the MSR impairment? Or should we adjust for any MSR volatility that was experienced in 2019?

So regarding FHA, if rates stay the same, we don't expect more impairment in that portfolio. So I would say it excludes the impairment part of the revenue. And I think you were even looking at maybe from a disclosure point of view, pulling that out of the revenue line and disclosing that separately on the income statement, but that's for another day. On the wealth business, we've changed our revenue recognition late in the year around the estate fees. So that should, as we get into 2020, begin to be more normalized through each of the quarters. So we'll begin to recognize the state fees as we earn them instead of when the state closes. So that was providing some, if you will, lumpiness in the revenue line, that should start to smooth out a little. I mean, we continue to have a fair amount of states that we're working on. So that revenue line should start to smooth out a little bit and I think we're positioned well with the increase in assets in the back part of the year to begin to drive revenue increases from that fourth quarter revenue line or that revenue number in the fourth quarter.

And the just one last follow-up. The $42 million to $43 million of expenses in 2020 on a quarterly basis. Do you feel good about that number for Q1, given the comments earlier about the FTE reductions and the benefit not showing up until the second quarter?

I think it will probably be on the higher end of that range in the first quarter. And now that includes, yes, I think the higher end of that range in the first quarter.

Great. Thanks everyone. Have a good day.

Yes, thanks.

Thank you. [Operator Instructions] And our next question comes from Andrew Liesch from Piper Sandler. Your line is open.

Good morning, everyone.

Good morning, Andrew.

Just a follow-up question here on the margin just with the excess liquidity that's been sitting on the balance sheet. Just kind of thoughts on what's the plan with that? Is that going to be – how is that going to be deployed? And what sort of timing do you anticipate with that?

Yes. So we’ve been working hard to address our excess liquidity. And I think with some modest loan growth. We do have some additional non-core liabilities that we'll continue to pay down as Eric said earlier, those – that $280 million of CDs reprice, we'll– there'll be some attrition associated with that. And we've made some additional investments in the investment portfolio itself. So in the short term, that's what we're doing to address that liquidity.

Okay. Great. You’ve covered all my other questions.

All right. Thanks.

Thank you. And I am showing no further questions from our phone line. I'd like to turn the call over to management for any closing remarks.

Yes, thanks for joining today, and we will see you next quarter. Thanks.

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