Midland States Bancorp, Inc. (NASDAQ:MSBI) Q4 2022 Earnings Call Transcript

Midland States Bancorp, Inc. (NASDAQ:MSBI) Q4 2022 Earnings Call Transcript January 27, 2023

Operator: Good day, and thank you for standing by. Welcome to the Q4 2022 Midland States Bancorp Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there'll be a question-and-answer session. I would now like to turn the conference over to your host today, Tony Rossi of Financial Profiles. You may begin.

Tony Rossi: Thank you, Kevin. Good morning, everyone and thank you for joining us today for the Midland States Bancorp fourth quarter 2022 earnings call. Joining us from Midland's management team are Jeff Ludwig, President and Chief Executive Officer; and Eric Lemke, Chief Financial Officer. We will 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. 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.


Jeffrey Ludwig: Good morning, everyone. Welcome to the Midland States earnings call. I'm going to start on Slide 3. Our fourth quarter performance capped a very successful year in which we generated a record level of earnings for the company. One of our goals over the past few years was to bring our level of returns more in line with our peer group and we believe our performance this year reflects the strong progress we have made in this area. For the full year, we generated a return on average assets of 1.31%, up from 1.18% in 2021 and a return on average tangible equity of 20.8%, up from 17.9% in 2021. Our improved profitability represents our strong execution on our strategies to generate profitable growth and realize more operating leverage, while at the same time prudently managing our growth as reflected in our continued strong credit quality.

We have built a stronger, more diversified franchise with higher quality, more consistent sources of income, which has resulted in the steady improvement we have seen in our financial performance. Specific to the fourth quarter, we continued to generate strong financial performance despite moderating our level of loan growth given the likelihood of economic conditions weakening in 2023. We generated net income of $29.7 million, or $1.30 per share, which included $17.5 million gain we realized on the termination of forward starting FHLB interest rate swaps and $6.7 million in charges we took on commercial mortgage servicing rights and impairment on other real estate owned. On a core earnings basis, we continue to generate a higher level of profitability with adjusted pre-tax pre-provision earnings coming in at $33.2 million.

We were able to continue generating solid loan growth even while being more selective in our new loan production. Our total loans increased at a 7% annualized rate with most of the growth coming in our commercial portfolio. Our Equipment Finance business has had another strong quarter, which contributed to the growth in commercial loans as this portfolio has now surpassed $1.1 billion. Our Community Bank group continues to be highly productive and with the increased exposure to higher growth markets we are seeing a larger volume of attractive lending opportunities, which has enabled us to continue generating solid loan growth while being conservative in our underwriting and pricing. We are seeing good contributions across our footprint, but in particular, we are seeing increased production out of our Eastern Illinois markets, which includes the Chicago MSA and the St. Louis market, where we have made investments to increase our business development capabilities over the past couple of years.

For the full year, our Eastern Illinois loan portfolio increased 22%, while our St. Louis loan portfolio increased 40%. We also saw double-digit deposit growth in these markets as our teams are doing an excellent job of developing full banking relationships. As I indicated earlier, we have generated a higher level of earnings and loan growth over the past few years, while maintaining a conservative approach to risk management. As a result, we continue to see good asset quality trends. While we had a slight increase in non-performing loans in the fourth quarter, our net charge-offs were just 3 basis points of average loans. And importantly, at this point, we continue to see generally healthy trends across the portfolio with no meaningful change in delinquencies or watch list loans.

Our strong financial performance continues to enhance the value of our franchise. During the fourth quarter, our book value per share increased 2.4% while our tangible book value per share increased 4%. And with the exception of our total capital ratio, which decreased due to the payoff of $40 million in subordinated debt in the fourth quarter, all of our capital ratios increased from the end of the prior quarter, as we continue to make progress on one of the most important financial goals. At this point, I'm going to turn the call over to Eric to provide some additional details around our fourth quarter performance. Eric?

Eric Lemke: Thanks, Jeff and again, good morning, everyone. Before we move on, I would like to note that this is our first quarter reporting net income available to common shareholders following the capital we raised through the preferred stock offering in August. Our fourth quarter financials included the payment of the preferred stock dividend for the fourth quarter, as well as the portion of the third quarter after the stock was issued. Going forward, without the stub period included the impact to net income available to common shareholders will be $0.04 per share less per quarter. Now moving on to Slide 4, we'll take a look at our loan portfolio. Our total loans increased to $108 million from the end of the prior quarter.

Most of the growth came in our commercial and construction portfolios, which more than offset a small decline in our commercial real estate portfolio. Equipment Finance was the largest contributor to the commercial loan growth as the fourth quarter is typically a seasonally strong period in this business. We also had a small increase in our consumer loan portfolio, which was attributable to an increase in loans generated through our new partnership with LendingPoint which more than offset a small decrease in our GreenSky portfolio. Jeff will talk more about our relationship with GreenSky later in the call. Now turning to Slide 5, we'll look at our deposits. We had a small decrease in total deposits from the prior quarter, largely due to declines in non-interest bearing and savings deposits.

The decline in non-interest bearing deposits was primarily due to lower period end balances of commercial FHA servicing deposits as well as more commercial depositors moving some of their excess liquidity to interest bearing accounts in order to capitalize on the higher rates now being offered. As we indicated on our last call. We have selectively raised rates on deposits in order to continue funding our loan growth. We continue to see the opportunity to add high quality lending relationships with new commercial clients that we believe we can expand over time and we believe it is in the best interest of the company and our shareholders to add these relationships, even if the results in near term upward pressure on our deposit costs in order to fund the initial loans.

Now looking at Slide 6, we'll walk through the trends in our net interest income and margin. The net interest income was down slightly from the prior quarter as a higher average balance of interest earning assets was offset by a decline in our net interest margin. Our net interest margin decreased 13 basis points from the prior quarter as the increase in our cost of deposits exceeded the increase we saw on earning asset yields. We've been able to generate our strong loan growth, without compromising on loan pricing and as a result, we continue to see positive trends in our average rate on new originations. In the month of December, the average rate on our new and renewed loans was 7.1%, an increase of 150 basis points from the month of September.

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In particular, we are seeing higher rates on commercial loans including equipment financing. As we indicated on our last call, we plan to take some steps to move the balance sheet into a more neutral position in terms of interest rate sensitivity and the termination of the forward-starting interest rate swaps has done that. Our goal this year is to try to keep our net interest margin relatively stable. The rapid increase in interest rates impacted our cost of funds significantly in the fourth quarter. However, if interest rate increases slow or moderate. It will allow our fixed rate assets to reprice and stabilize our margin going forward. Turning to Slide 7, we'll look at the trends in our Wealth Management business. Our assets under administration increased by $150 million from the end of the prior quarter, due to both market performance and inflows from new clients.

The increase in assets under administration resulted in a slight increase in our wealth management revenue compared to the prior quarter. On Slide 8, we will look at non-interest income. We had $33.8 million in non-interest income in the fourth quarter, which included the $17.5 million gain from the termination of the forward-starting interest rate swaps. Excluding this gain, most fee generating areas were relatively consistent with the prior quarter. As we indicated on our last call, we are currently in the process of selling the commercial mortgage servicing rights portfolio, which will eliminate a source of earnings volatility. We are working with a potential buyer and expect the transaction to close during the second half of the year. We expect to retain the servicing deposits related to the commercial mortgage servicing rights portfolio.

However, they will reprice to market rate upon completion of the sale. Now turning to Slide 9, we'll review our non-interest expense. Our non-interest expense was up from the prior quarter, primarily due to two non-recurring items. First, as part of the sale of the commercial MSR portfolio, we recorded a $3.3 million loss on MSRs held for sale to reflect the current valuation. And second, we recorded an other real estate owned impairment charges of $3.5 million. All the other areas of non-interest expense were relatively consistent with the prior quarter. For the near-term, we expect our operating expense to be in the range of $43 million to $44 million per quarter. Turning to Slide 10, we'll look at our asset quality trends. Our non-performing loans increased $2.5 million from the end of the prior quarter, which is entirely attributable to one commercial real estate loan.

Within the consumer portfolio, the delinquency rate remains exceptionally low and should any deterioration begin to occur, we have approximately $41 million in an escrow account that is available to cover any losses on the GreenSky portfolio. As Jeff mentioned earlier, we had an extremely low level of loss in the portfolio in the fourth quarter with net charge-offs of just 3 basis points of average loans. We recorded a provision for credit losses on loans of $3 million, which was largely related to growth in total loans, changes in the mix of the portfolio and the impact of negative economic forecasts. On Slide 11, we show the components of the change in our allowance for credit loss from the end of the prior quarter with the provision being well in excess of net charge-offs, in the fourth quarter, our ACL increased by approximately $2.4 million, and the ACL to total loans increased by 2 basis points to 97 basis points.

The increase in ACL was driven by growth in total loans, changes in the mix of the portfolio and changes in forecasts from weakening economic conditions. And finally, on Slide 12, we show our ACL broken out by portfolio. The most significant increases in coverage came in our commercial owner occupied CRE and construction and land portfolios. And with that, I'll turn the call back over to Jeff. Jeff?

Jeffrey Ludwig: All right. Thanks, Eric. We'll wrap up on Slide 13 with some comments on our outlook and priorities for 2023. It's clear that the possibility of a recession is going to make 2023 a challenging year, but with the stronger franchise and earnings quality that we have built, we believe that we could continue to generate strong financial performance and a higher level of profitability while we maintain our more conservative approach to new loan production until economic conditions improve. At this point, it is difficult to provide a forecast for our level of expected loan growth given the uncertain economic environment, but we believe that we will continue to grow our total loans as a result of a more productive commercial banking team we have built, the greater exposure we have to higher growth markets like Chicago and St. Louis and the continued growth of the Equipment Finance business.

Given the success we are having in generating commercial loan growth, and with the loan deposit ratio at 99%, we are now planning to accelerate our exit from the GreenSky partnership. On Tuesday of this week, we provided notice to GreenSky that we will exit the program in October of this year. Our required notice period under the contract. The contract includes certain minimum loan originations through the notice period and we have indicated the GreenSky that we will waive those minimums in order to lower our overall balances in the program. We believe that exiting the partnership will have a positive impact on our liquidity and capital, while having a relatively minimal impact on earnings. The average yield on this portfolio is currently 5%.

As loans in the program pay off, the cash flow can be profitably invested in either loan originations or within the securities portfolio or used to pay-off some of our higher cost funding sources. As we've talked about over the past few quarters, one of our newer initiatives is building our Banking-as-a-Service platform, which we believe can be an important contributor to the continued profitable long-term growth of the franchise. We are being very selective in our approach to adding new partnerships in this initiative. So that we can ensure that any partners we add meet our high standards of risk management. During 2023, our primary focus will be adding partners that can contribute to deposit gathering. We are going to maintain disciplined expense management, while we focus on getting more leverage from our significant investments we have made in both banking talent and technology over the past few years.

As we do this, we believe that we can keep our expense growth rate below our revenue growth rate which should help support our continued strong profitability. We have significantly strengthened our commercial banking team over the past few years and we are very happy with the group. We currently have and don't anticipate making any meaningful additions in the near term as we focus on keeping our expense levels relatively stable. However, we are making investments in the wealth management business in terms of adding some new personnel and enhancing our platform, which we believe will enable us to improve our business development efforts, increase our client base and grow the fee income that this business generates. In terms of the outlook for credit, we believe that our loan portfolio will continue to perform well given that we have a well-diversified portfolio with limited exposure to those areas that are most likely to be impacted by a recession.

Most notably, office and retail commercial real estate, small business loans and subprime consumer loans. At the beginning of last year, we indicated that we are open to considering small strategic M&A opportunities that could further improve our deposit base, increase our exposure in higher growth markets or build the wealth management business. Our branch acquisition in Northern Illinois in June fit this criteria perfectly and enabled us to add low cost deposits and increase our exposure to the Chicago MSA without disrupting the organization's focus on the execution of strategies that have generated a strong improvement we have seen in our financial performance. In 2023, we will continue to be open to the same type of opportunities. And as we have mentioned in the past few earnings calls, we are focused on strengthening our capital ratios to better support the continued growth of our franchise.

With the higher level of profitability that we are now generating and the lower level of balance sheet growth that we expect this year, we believe that we can continue to increase our capital ratios as we move through the year. While we expect the operating environment to be a challenging year with the strong execution we are seeing throughout the organization, we believe that we will continue to enhance the long-term value of our franchise in 2023. With that, we'll be happy to answer any questions you might have. Operator, please open the call.

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