Midland States Bancorp, Inc. (NASDAQ:MSBI) Q3 2019 Earnings Conference Call October 25, 2019 8:30 AM ET
Tony Rossi - Senior Vice President at Financial Profiles, Inc.
Jeffrey Ludwig - President and Chief Executive Officer
Donald Spring - Chief Accounting Officer
Conference Call Participants
Andrew Liesch - Sandler O'Neill
Terence McEvoy - Stephens Inc.
Michael Perito - KBW
Kevin Reevey - D.A. Davidson
Ladies and gentlemen, and thank you for standing by and welcome to the Q3 2019 Midland States Bancorp Earnings Conference Call. At this time, all participants 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, Tony Rossi of Financial Profiles. Please go ahead sir.
Thank you, Sidney. Good morning, everyone, and thank you for joining us today for the Midland States Bancorp third quarter 2019 earnings call. Joining us from Midland's management team are Jeff Ludwig, President and Chief Executive Officer; and Don Spring, Chief Accounting Officer.
We will be using a slide presentation as part of our discussion this morning. If you have not done so already, please visit the Webcasts & Presentations page of Midland's Investor Relations website to download a copy of the presentation. The management team will discuss the third 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 the 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 am going to start on Slide 3 with the highlights of the third quarter. We generated $0.51 in earnings per share, which includes integration and acquisition expense that impacted our net income by $0.15 per share. On an adjusted basis, we had $0.66 in earnings per share.
The highlight of the quarter was the closing of our acquisition of HomeStar Financial Group in mid-July with the systems conversion completed last weekend. Both teams worked very hard to complete this transaction in just a little over three months after the deal was announced and then completed the systems conversion 90 days after closing.
I would like to convey my thanks to the teams for their exceptional efforts in adding HomeStar to our franchise.
Our third quarter results reflected the initial benefits of this transaction, mainly the positive impact of adding an attractive low-cost deposit base that reduced our cost of deposits and provided excess liquidity that lowered our loan-to-deposit ratio.
We expect to see additional benefits as we fully realize the cost savings projected from this transaction and offer our new clients in Kankakee, the broader suite of products and services and larger lending capacity that Midland can provide.
From an organic standpoint, we had another quarter of solid execution on our strategic priorities. We continue to prudently manage our loan production and focus on areas that provide more attractive risk-adjusted yields.
Our equipment finance group continues to do an outstanding job of generating high-quality lending opportunities and grew our balances in this portfolio by another $57 million in the third quarter.
Over the past year, our equipment finance portfolio has increased 81% and has been a great asset generator for the company. This has been particular – particularly valuable during a time when we are seeing extremely aggressive pricing and term structures being offered by other banks for commercial and commercial real estate loans.
On the other side of the balance sheet, we had a very good quarter from a core deposit gathering perspective. On an organic basis, our core deposits were up $153 million from the end of the prior quarter, while we continue the intentional run-off of brokered time deposits. This resulted in total organic deposit growth of $112 million or 2.8% in the third quarter.
The addition of HomeStar improved our deposit mix and the success we had in gathering core deposits in the third quarter resulted an even more improvement. We also had another strong quarter of expense management and driving additional efficiencies throughout the organization. This helps drive our efficiency ratio down to 60.6% in the third quarter from 61.6% in the prior quarter.
During the third quarter, we also took some significant steps to enhance our capital management. We issued $100 million of subordinated notes that we used to repay our senior debt and put us in a position to refinance $40 million of existing subordinated debt with less expenses and longer-term funding.
In addition, as previously announced, our Board of Directors authorized the repurchase of up to $25 million of our common stock. Combined with our long track record of increasing our dividend by at least 10% annually, the stock repurchase program provides us with another tool for returning capital to shareholders.
Now I am going to turn the call over to Don to walk through more details on our financial performance in the quarter. Don?
Thanks, Jeff. I am going to start with our loan portfolio on Slide 4. Our total loans outstanding increased $255 million from the end of the prior quarter. $211 million of the increase was attributable to loans added through the HomeStar acquisition.
On an organic basis, our total loans were up $44 billion or 1.1% driven primarily by growth in the commercial loans and leases portfolio. The primary driver of the growth in this portfolio came from our equipment finance business, which increased total outstanding balances by $57 million or 11.2% from the end of the prior quarter.
Turning to deposits on Slide 5. Total deposits were $4.45 billion at the end of the third quarter, an increase of approximately $434 million from the end of the prior quarter. The majority of the increase was due to the HomeStar acquisition, although as Jeff mentioned, we also had strong organic deposit growth in the quarter of $112 million or 2.8% driven by the $153 million increase we had in core deposits.
Our success in core deposit gathering enabled us to continue to implement our strategy to reposition our deposit portfolio to improve our liquidity management and reduce our non-core funding. During the third quarter, we intentionally reduced our balances of brokered time deposits by another $46 million. With this run-off, and the addition of HomeStar’s deposits, brokered time deposits represented just 2% of total deposits at September 30.
Turning to Wealth Management on Slide 6. At the end of quarter, our assets under administration were $3.28 billion with an increase of $155 million from the end of the prior quarter. The increase was primarily due to the addition of HomeStar’s assets under administration.
Our Wealth Management revenue increased 9% from the prior quarter to $6 million, which was attributable to an increase in the state fees, and the contribution from HomeStar.
Turning to our net interest income and net interest margin on Slide 7. Our net interest income increased 7.3% from the prior quarter primarily due to the contribution from HomeStar. Excluding the impact of accretion income, our net interest margin was relatively unchanged from the prior quarter as lower deposit costs were essentially offset by a decline in earning asset yields.
The decline in deposit costs was primarily due to the impact of HomeStar’s lower cost deposits. Exclusive of the impact of HomeStar, we started to see our deposit cost plateau during the third quarter and we believe it’s likely that we will be able to continue to move rates down as a result of the recent rate cuts.
Moving to loans, while we have seen some declines in the average rate on our new and renewed loans as a result of the lower rate environment, our focus on more attractive risk-adjusted yields enabled us to continue to add loans that exceed the average yield on our overall portfolio excluding accretion income.
During the third quarter, the average rate on our new and renewed loans was 5.39% or 32 basis points higher than the average loan yields excluding accretion income on our overall loan portfolio. Looking ahead, we continue to be relatively neutral through a balance sheet sensitivity standpoint.
However, the new subordinated debt we issued will temporarily raise our average borrowing cost by seven basis points until we resume our higher cost subordinated debt in June of 2020.
We continue to expect our net interest margin excluding the impact of accretion income to remain relatively stable going forward, although the temporary increase in our average borrowing cost will apply some modest pressure to the downside.
In terms of our scheduled accretion income, which does not include the impact of prepayments on acquired loans, we are expecting $2.4 million in the fourth quarter of 2019.
Moving to our non-interest income on Slide 8, our total non-interest income was relatively unchanged from the prior quarter at $19.6 million. The $6 million of wealth management revenue remains our single largest contributor to our non-interest income and continues to generate the large recurring source to fee income that we target for this business.
We had a strong quarter of loan production in our commercial FHA business this quarter with $113 million in rate loss commitments, our highest level in two years. However, we had $1.1 million impairment to mortgage servicing rights in this business and as we indicated after last quarter’s unusually low cost, and unusually high gain premium, both of these items returned to more normalized levels. As a result, our commercial FHA revenue came in at $2.9 million for the quarter and excluding the impairment we are within the range of $3 million to $5 million in revenue per quarter.
Turning to our expenses and efficiency ratio on Slide 9. We incurred $5.3 million in integration and acquisition expense in the third quarter, and also recognized a gain on MSR's held-for-sale of $70,000. Excluding these adjustments, our non-interest expense increased by 5.9% on a linked-quarter basis which was primarily due to the addition of HomeStar’s operations.
The strong expense management that Jeff previously discussed in combination with higher revenues lowered our efficiency ratio to 60.6% from 61.6% last quarter.
Moving to Slide 10, we look at our asset quality. Our portfolio was generally stable this quarter with no significant new additions to non-performing loans. As we indicated on our last call, a number of existing non-performing loans that had specific reserves stood against them moved to charge-offs in the third quarter which resulted in elevated net charge-offs with a corresponding reduction in non-performing loans.
Our net charge-offs represented 49 basis points of average loans in the third quarter while our non-performing loans dropped to 1.04% of total loans from 1.24% at the end of last quarter. We recorded a provision for loan losses of $4.4 million; $2.3 million of the provision was related to an increase in the specific reserves established from an existing non-performing loan.
This additional $2.3 million was a result of recent appraisal data that we received on the underlying collateral. The third quarter provision brought our allowance to 58 basis points of total loans as of September 30, and our credit marks accounted for another 51 basis points.
With that, I'll turn the call back over to Jeff. Jeff?
Thanks, Don. We will wrap up on Slide 11 with some comments on our outlook. As we finish out 2019 our primary focus will be on integrating the HomeStar acquisition and fully capitalizing on all the synergies that we projected for this acquisition.
Now that we have completed the system conversion, we are on track to have all the costs faced in by the start of 2020. We continue to focus on driving greater efficiencies throughout the company. And as part of that process, we continually assess our branch network in light of changing customer needs.
In addition to two Midland branches that will be consolidated as part of the HomeStar integration, we have identified one branch from the HomeStar acquisition that can be closed and three other branches that can be consolidated in other areas of our footprint with minimally expected disruption to customer service. These branch consolidations will put us in position to realize additional efficiency improvements next year.
In terms of loan production, we don’t expect to see any meaningful change in the trends we have experienced over the past few quarters. We still expect loan growth to be in the low-single-digit range with the growth primarily coming from areas that generate more attractive risk-adjusted yields.
With the strong execution we have on our strategic priorities, we feel good about our ability to drive additional earnings growth in 2020 as we realize the earnings accretion from the HomeStar acquisition and continue to realize further improvement and efficiencies.
With that, we'll be happy to answer any questions you might have. Operator, open the call.
[Operator Instructions] Our first question comes from Andrew Liesch with Sandler O'Neill. Your line is open.
Good morning guys.
Good morning, Andrew.
A question here on the liquidity and loan growth. So, good deposit inflows and then the HomeStar deal added a good base to liquidity as well. So, with the loan-to-deposit ratio down 97%, it doesn’t sound like you have much interest in stepping on the loan growth too much, but what are your thoughts about driving that back up towards a 100%? Or are you comfortable operating more near this level?
Yes, so, I think I am more comfortable operating under 100%. When we are at a 100% and we were a little bit of above the 100% in prior quarters, probably, that’s on the higher end of probably where we would like to operate ideally under a 100% is probably where we want to be and again, that number will probably, again, it will fluctuate a little depending on what’s going on quarter-to-quarter.
That number could be lower. We’ve been paying broker deposits off over the last several quarters, which actually improves that ratio or lowers that ratio. So, I think the good thing is, we have a lot more flexibility on the balance sheet today than we did a year ago.
A lot more liquidity, a lower loan-to-deposit ratio and lower non-core funding on the balance sheet. So, I think, we are well positioned going forward and as we see loan growth that makes sense, we’ll be able to capitalize on that.
Okay. And then just on the core deposit inflows, I was curious just what was driving that? You had some pretty good success this quarter. Is there anything unique that generated that growth?
A couple things. We are running some deposit campaigns. Our bankers in the market are running calling campaigns with customers and I think we are getting – we are starting to get traction there. We’ve introduced some new products on the commercial side and we are seeing some good inflow on that front. And then, there is probably some seasonal money in there as municipalities are collecting taxes.
We had a little bit of an uptick in the servicing deposit area, which that money kind of comes and goes at times. But overall, we saw really good deposit flow as a company, very focused on gathering deposits and lowering that loan-to-deposit ratio. So, it was a really good quarter and it’s good to see that level of core deposit growth, so.
Certainly. Great. I’ll step back.
Thank you. And our next question comes from Terry McEvoy with Stephens. Your line is open.
Hi, thanks. Good morning everyone.
Good morning, Terry.
The commentary about the margin being stable going forward, I was wondering if you were assuming another interest rate cut and that was behind your statement, and if not, what would you expect the margin to do with the FED cut, let’s say 25 basis points?
Yes, so we are beginning to move our deposit rates down with the first couple rate cuts and we’ll continue to do that going forward. The rate cuts initially put a little bit of pressure on the margin. But then we are able to react on the deposit side to begin to offset some of that impacts. Our balance sheet has some loans on the books that move when those rate cuts happen.
But it’s probably a smaller percentage than a lot of other companies. So, I think we will be able to work through on another rate cut and other than the impact of the sub debt being put on the books that’s going to for sure put some pressure on the margin. We should be able to work through these rate cuts over time, maybe a little pressure early. But little – a quarter or two out be able to work through it.
Okay. And then, just a follow-up question on the expenses, with the conversion happening, I guess, earlier this month and I would say just third quarter expense trends are at least better than I was expecting. What are your thoughts on the fourth quarter and then maybe the first quarter once you get the full benefits of the branch reductions as well as the HomeStar deal?
Yes, so I don’t have any specific targets, but what I will say is, expenses on an adjusted basis will continue to trend down in the current quarter as that conversion happened last weekend and the system cost and people cost will begin to go away this quarter and be fully impacted into the next quarter.
So, without giving you a specific number, that number will continue to trend down. And then the additional, the additional branch consolidations that we are doing will hit in the first quarter of next year as well and give us some more improvement on that expense line.
Understood. Thanks, Jeff.
Thank you. And our next question comes from Michael Perito with KBW. Your line is open.
Hey, good morning.
Good morning, Mike.
I have a couple things I want to hit on. I want to start on credit. Don, I appreciate the color in your prepared remarks and kind of drawing - mapping the dots together on why the provision was elevated. But if we kind of just take a step back in the last four quarters you guys have been provisioning at kind of a 30 to 40 basis point rate, which kind of really I mean, is probably about 2x where kind of the Midwestern peer group is.
And I am just - I guess two-part question, one, I mean, is that something you expect to continue going forward? Or two, do you have some insight into that moderating? Or any other general thoughts kind of about the provisioning credit environment you guys are seeing, I think would be helpful.
Yes, so, I’ll take this, Mike, a little challenging of a question. So, we knew we had additional provisioning to take, we would need to take at this quarter. So, I think, we are hopeful that we can start to move that provisioning back to where it was three or four quarters ago at that $2 million mark.
We are, in the last couple quarters been working through some of the non-performers and some appraisal issues that we received on some of those. So, we are hopeful that that can migrate down. But it’s sort of hard for us to sit here and predict.
The good thing is we didn’t see any non-performers come in this quarter. But we do have non-performers in there that appraisals are going to be ordered on the annual basis and as those appraisals come in, we will need to make adjustments to reserves.
So, I guess, I am not probably answering your question a real well, but as I looked at our current quarter, we had a more normal provision line. We would have had a really good quarter. But we are kind of in the credit business and there are quarters that come up where we got to put additional provisions out.
So, I guess, without answering your question specifically, I am hopeful that we can get back to that more normalized $2 million. But it could be $4 million again next quarter. I don’t have a good sense as I sit here today.
Okay. Yes, because I mean, that's kind of the thought behind the question. I mean, if you could appear provisioning rate in, I mean, you guys are – we're doing 1.20%, 1.25% ROAs in the third quarter. Trying to extrapolate, if that's kind of a range that you guys think is achievable, if credit – it normalizes a bit from kind of the highly elevated level of the past year or so.
That is our expectation and that’s through our efficiency work to get the low 60%. That work should help us drive to a more 120% type ROA which are internally are some targets that we’ve set for ourselves of efficiency to get under 60% and an ROA to get over 1120%. And those work in tandem.
Now does the provision hurts your ROA and doesn't come out of your efficiency ratio and now it’s part of what happened this quarter where the quarter really showed up on the efficiency ratio, because the provision and impairments are taken out of those efficiency ratios, but not taken out of our ROA calculations.
Right. Okay. And then, just can you talk about how you guys are feeling about capital today? And then, just I guess, secondly kind of the appetite for share repurchases that we should be thinking about as you guys move forward here?
Yes, and so, I think we are in a position now to try to build capital. We’ve – over the last three years, we’ve done two fairly large acquisitions. We just closed on a smaller acquisition and that put some pressure on our capital ratios or TCE ratio in particular.
And we need to begin to build those capital ratios up which we think we can as we get into next year. And that will be the goal is to get that TCE ratio back between 8%, 9%.
As it relates to the buyback, we did buy some shares back in the third quarter and I guess we are – what I will say about that is we’ll be selective on our buybacks when we think the stock price is in good value. In the third quarter, our average price was right around 25.50 and we think that’s a really good price to be buying our stock back. Today it’s not there.
So, I think we are going to use that as when we think that the stock is well priced, we are going to use that to buy some shares back. So, I don’t see us using the $23 million or so that we have left in the plan using that up in the next quarter, next two quarters, we would kind of look at that as probably using that over several quarters.
Helpful. Thank you. And then, just, actually one last one just on the commercial FHA business. I know the pipeline for that one, I think, typically extends out a little longer. So, just curious if you have any initial insights on 2020. How the pipelines kind of comparatively look and whether you think kind of the revenues and guidance that you guys have kind of provided previously will hold as we move into next year?
Yes, I mean, I think we feel that $12 million to $20 million and again I would encourage to the analyst to take the lower end of that range. It’s real hard for us to predict even quarter-to-quarter let alone into 2020 exactly what that number might be.
But, I think we still feel comfortable in that range and probably the lower end of the range and we work real hard to get the number more towards the top of the range. But I think that’s a reasonable spot to be in.
Great. Thanks guys for taking my questions. I appreciate.
Thank you. [Operator Instructions] Our next question comes from Kevin Reevey with D.A. Davidson. Your line is open.
Good morning, Kevin.
So, my first question is, besides the opportunities from HomeStar to use their deposits to tail off some higher cost funding, what are the strategies, and what are the levers can you pull to mitigate NIM compression going forward, especially when you have additional rate cuts?
Yes, so, we are looking at all product sets and as rates are coming down, we are beginning to trend those rates just like we move the rates up. As rates were going up, we are going to trim them as they come down. We have run some CD specials earlier this year that will get repriced in early part of next year.
So that will help on the CD front and other product sets we are beginning to move those rates down. We have the sub debt next year that will – a $40 million that we paid down that will help and I guess, that’s the strategy.
Okay. And are you – do you have any floors on your existing commercial loans. I know you are putting on new floors for new loans that are…
Yes, we’ve been pretty active in the last probably six months of trying to get floors in our loan agreements and we – and a lot of our loan agreements we have prepayments, penalties and floors. I think we have been more active in the last six months to try to get the floors although those can be challenging and negotiated with clients. But we are trying to do that. We do have some floors in our loans, which will help and a big part of our portfolio is fixed. So, it’s not moving quickly as rates are being cut.
And then, lastly, I know equipment finance is an area of focus for loan growth. What does the typical equipment borrower look like as far as the type of equipment that they are leading and their credit profile?
Yes, so, it’s kind of credit profile. There is probably smaller businesses, businesses that been in business for ten, ten plus years is probably a part of the profile. It’s – I’ll say, tangible equipment not soft equipment. So, trucks and bulldozers and one of our guys like to say yellow paint equipment.
So the caterpillar type equipment are a big part of what we do. But it’s tangible. It’s things that if it goes back we can go get. We work through vendors. So, our sales force is closer to vendors, probably than customers. So, it’s this point-of-sale type of business where I need a bulldozer, I go into the CAT dealer and financing there is through Midland, because we are providing kind of point-of-sale at the dealer, so.
Great. Thank you very much.
Okay. Thanks, Kevin.
Thank you. And I am not showing any further questions at this time. I would now like to turn the call back to management for closing remarks.
All right. Thanks, everyone. And we will see you next quarter.
Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may now disconnect.