Midland States Bancorp, Inc. Q3 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by and welcome to the Third Quarter 2020 Midland States Bancorp, Inc. 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. Please be advised that today's call is being recorded. I would now like to hand the call over to Tony Rossi. Please go ahead.

Thank you, Michelle. Good morning, everyone, and thank you for joining us today for the Midland States Bancorp third quarter 2020 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 have not done so already, please visit the Webcast and Presentations page of Midland's Investor Relations website to download a copy of the presentation. 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 including those related to the impact of the COVID-19 pandemic. 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 would 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 third quarter. Our reported results reflected the one-time charges related to the branch and facilities optimization plan that we announced last month. And I will talk more about that plan a little later in the call. Excluding those charges, we delivered a strong performance this quarter, in light of the continuing challenges presented by the ongoing pandemic, with adjusted earnings of $12 million or $0.52 per diluted share. This performance was driven by solid balance sheet growth, significant contributions from many of our sources of non-interest income, and disciplined expense management. While overall economic activity remains muted due to the pandemic, we're effectively targeting those areas of the economy where we are seeing healthy loan demand. As a result, we were able to generate annualized loan growth of 8.4% during the quarter. And we continue to see positive trends in gathering core deposits, which resulted in 6.8% annualized growth in our total deposits this quarter. Looking at asset quality, in general, we were pleased with the trends that we saw during the quarter and the improvement we saw in the health of most of our borrowers. This was most notably in the decline we saw in deferred loans, as the vast majority of these loans returned to regular payment schedules during the third quarter. We did see an increase in non-performing assets, but this was largely driven by three commercial real estate relationships. These were three credits that were adversely graded prior to the pandemic. And with the downturn in the economy, their conditions deteriorated to an extent where they moved to non-accrual status. Outside of these loans, we didn't see other migration to non-performing during the third quarter. Given the uncertainty of the pace of the economic recovery, we continue to add to our loan loss reserves, resulting in our allowance for credit losses increasing to 1.07% of total loans. As we have throughout the year, we continue to benefit from the diversity of our business model and our ability to generate significant contributions from a variety of areas. Wealth management continues to provide a stable source of recurring revenue. Our equipment finance group had another outstanding quarter, generating the second highest level of originations in its history, just behind their performance last quarter, and our residential mortgage group continues to effectively capitalize on the demand for refinancing and produced a strong quarter of loan originations and gain on sale income. Aside from our financial performance, this was a very productive quarter for the company, as we made significant progress in our work to optimize our operating model and improve our ability to deliver consistent earnings growth in the future. This includes the sale of our commercial FHA loan origination platform and the announcement of a series of planned branch and corporate office reductions, which I will discuss in more detail on the next slide. Moving to Slide 4, I'll start with a review of our sale of the commercial FHA loan origination platform to Dwight Capital. We were able to structure this transaction in a way that will eliminate the volatility that this business had on our overall financial performance while maintaining some of the positive benefits for Midland. With the disposition of the origination platform, we have reduced the expenses associated with this business by $8 million to $9 million per year. At the same time, we maintain the servicing portion of the business that provides a meaningful source of low-cost servicing deposits and contributes approximately $300,000 in revenue for the quarter. As a nationwide mortgage banking firm and one of the largest originators of commercial FHA loans, Dwight Capital has significant funding needs and the relationship that we have formed as part of this transaction will provide Midland with the opportunity to provide warehouse lines of credit and bridge loans that will generate interest income for the company. In fact, the warehouse line of credit extended to Dwight was one of the contributors to loan growth in the quarter. So we will be able to offset some of the loss revenue from the origination platform and do it in a way that is more profitable for Midland. And with the size of our commercial FHA operation now much smaller, we will be able to focus our attention and resources on more profitable areas of the company. While there was no significant gain on the sale of this transaction, it did result in a $3 million tax charge recorded in the third quarter. Turning to the branch and facilities optimization plan that we announced, we felt that the pandemic presented an opportune time to make a comprehensive evaluation of all of our real estate holdings. Clearly, the pandemic has accelerated the shift towards digital banking, and we determined that there were a number of smaller branches that no longer made economic sense to continue operating. We identified 13 branches, which represented 20% of our network that could be consolidated. Four of these branches have been closed since March due to the pandemic. So customers have already made adjustments to use other branches. Most of the branches being consolidated are located within three miles of another Midland branch. So we expect a relatively smooth transition for our customers and only a modest amount of deposit attrition. We also identified five other branches that we will be renovating and upgrading to reduce their size and better utilize those facilities to serve retail and commercial customers. In addition to the branches, we are exiting three corporate locations, including facilities in St. Louis and Denver. We expect this plan to reduce operating expenses by approximately $6 million in 2021. Taken together with the sale of the commercial FHA loan origination platform, we believe the collective impact of these actions will help drive further improvement in our efficiency ratio and provide more operating leverage as we continue to grow our balance sheet in the future. Moving to Slide 5, we'll provide an update on our PPP efforts and the impact that these loans had on various line items in the third quarter. We had approximately $278 million of PPP loans on our balance sheet at the end of the quarter. We have now started the process of helping our clients apply for forgiveness. Through October 9th, we have submitted approximately $72 million in loans for forgiveness and have received approval from the SBA on a little more than $3 million. While it is difficult to predict how quickly the SBA will start approving more loans, at this point we are expecting 25% to 30% of our PPP loans to receive forgiveness during the fourth quarter with the remainder occurring sometime in 2021. Turning to Slide 6, we will provide an update on our loan deferrals. At September 30th, we had $279 million in loan deferrals which represented a decline of 69% from the end of the prior quarter. Our loan deferrals now represent just under 6% of our total loans. Approximately $238 million are full payment deferrals, with the remainder being interest-only deferrals. The largest contributor to our deferrals continue to be the hotel/motel sector.

Thanks, Jeff, and again, good morning, everyone. I'm starting on Slide 7, and we'll take a look at our loan portfolio. Our total loans increased by $102 million, or 2.1% from the end of the prior quarter. The increase was primarily driven by three areas. First, equipment finance, which continues to experience strong demand in both construction and manufacturing. Next, consumer loans increased coming through our partnership with GreenSky. And finally, we realized increases in warehouse lines of credit to commercial FHA originators, including the relationship with Dwight Capital that Jeff previously discussed. The growth in these areas has helped to offset a decline in our residential real estate portfolio, as we are not making an effort to retain loans that are looking to refinance to lower rates. At the end of the quarter, we moved some of our GreenSky loans to held-for-sale as part of our strategies to manage the concentration levels of consumer loans in the portfolio. On Slide 8, we've provided an update on our equipment finance portfolio. As of September 30th, we had $75 million of deferrals, which represents a decline of 68% since the end of the last quarter. The majority of the deferrals represent borrowers in the transit and ground transportation industry, many of which are operators of tour buses who have been temporarily impacted by the decline in travel. On Slide 9, we've provided an overview of our hotel/motel portfolio. At September 30th, we had $106 million of loan deferrals in this portfolio, which is down 28% from the end of the prior quarter. Over the past couple of months, more of these borrowers have had increases in occupancy rates that allow them to return to at least a breakeven level. With these improving trends, many of these borrowers are now moving back towards interest-only payments as we continue to work with them to find the right solution that will enable them to manage through this downturn. As of September 30th, approximately 40% of the deferred loans at June 30th were either back to making their original contractual payments or making interest-only payments. Looking at Slide 10, we’ve provided an update on the consumer loan portfolio that we have through our relationship with GreenSky. We had $8 million of deferred loans in this portfolio at September 30th, which represents a decline of 77% from the end of the prior quarter. This portfolio continues to perform well over the past four months and the delinquency rate has stayed in the 30 basis point to 40 basis point range. Turning to Slide 11, we'll take a look at our deposits. Total deposits increased by $86 million, or 1.7% from the prior quarter. The growth was largely driven by increases in servicing deposits related to commercial FHA originators. Our growth in core deposits and the runoff of higher cost time deposits continues to result in a favorable mix shift and a reduction in our overall cost of deposits. Looking now at Slide 12, we'll walk through the trends in our net interest income and margin. Our net interest income increased 2% from the prior quarter, primarily due to higher average loan balances. As we anticipated, we saw more stability in our net interest margin as it was essentially unchanged from the prior quarter with the decline in earning asset yields being offset by a reduction in our cost of deposits. The 11 basis point reduction in our cost of deposits was driven by our improved mix of deposits and overall reductions in deposit rates, particularly on rates paid on time deposits, as well as the run-off of certain money markets special rates during the quarter. Looking ahead, we have $91 million in time deposits with a weighted average rate of 1.11%, scheduled to mature in the fourth quarter. We also expect to redeploy some of our excess liquidity into higher yielding assets. The combination of these two factors should help us keep our net interest margin relatively stable. Turning to Slide 13, we'll take a look at the trends in our wealth management business. Our total assets under administration increased $7 million from the end of the prior quarter, primarily due to improved market performance. Our total revenue continues to range in the mid $5 million range, with quarter-to-quarter variations primarily driven by seasonal impacts related to tax preparation. On Slide 14, we'll take a look at non-interest income. We had a decrease of 2.5% this quarter, primarily due to lower commercial FHA revenue, as we only had the origination platform for two months in the third quarter. We also recorded a $1.4 million impairment of commercial mortgage servicing rights that reduced our non-interest income this quarter. Excluding the impairment, our non-interest income increased due to higher residential mortgage banking revenue and higher community banking fees, as we've seen an increase in transaction volume and business activity as the economy continues to reopen in our markets. Turning to Slide 15, we'll review our non-interest expense. Our total expenses were impacted by the one-time charges related to the branch and facilities optimization plan. Excluding these charges and a small loss on residential mortgage servicing rights held-for-sale, our non-interest expense was relatively unchanged from the prior quarter. This resulted in an efficiency ratio of 58.8% for the quarter. Looking ahead, we expect to complete the branch and corporate facilities consolidation by the end of the year. With the cost savings realized from the consolidations as well as the sale of the commercial FHA origination platform, we believe we will start out 2021 with a quarterly operating expense run rate of approximately $39 million to $40 million. Turning to Slide 16, we'll take a look at our asset quality trends. As Jeff mentioned, our non-performing loans increased primarily due to three commercial real estate relationships. We had $5.3 million of net charge-offs or 44 basis points of average loans in the quarter, which included charge-offs taken against those three commercial real estate loans. We recorded a provision for loan losses of $11 million which reflects a higher level of net charge-offs in the quarter, as well as a continued build in our level of reserves in light of the pandemic. At September 30th, approximately 96% of our allowance for credit losses or ACL was allocated to general reserves. We are seeing quite a bit of interest in the market for troubled debt and it's possible we might have some near-term opportunities to dispose of some of our non-performing loans with no additional losses. On Slide 17, we'll show the components of the change in our ACL from the end of the prior quarter. Our ACL increased by $5.7 million and strengthened our reserve to 107 basis points of total loans from 97 basis points at the end of the prior quarter. With economic forecasts stabilizing, this component of reserve drove a much smaller increase than it did in the prior quarter. The biggest contributor to reserve build was changes in our portfolio, largely resulting from new loans, downgrades to risk ratings and adjustments for loans on deferral and other payment plans. On Slide 18, we show our ACL broken out by portfolio. The increase in reserves was spread across the portfolio with most areas seeing a bump up in coverage. In addition to the ACL of the total loans, we also track the coverage ratio when excluding loan portfolios with certain credit enhancements or government guarantees, including the PPP portfolio, our GreenSky loans and commercial FHA warehouse lines. When these loans are excluded, our ACL coverage increased to 1.36% compared to 1.21% at the end of the prior quarter. And with that, I'll turn the call back over to Jeff.

Thanks, Eric. I’ll wrap up with a few comments on our near-term outlook and priorities. First and foremost, we will continue to focus on maintaining strong capital and liquidity positions. We will also continue to capitalize on those areas where we see loan demand in the current environment. The equipment finance continues to have a strong pipeline, and we have additional opportunities to expand our commercial lending relationship with Dwight Capital. As a result, we believe that we'll see another quarter of growth in average loan balances although our end of period loan growth might be impacted by volatility that we see in warehouse line utilization and forgiveness of our PPP loan portfolio. We also continue to see strong demand in residential mortgage lending and should see another good quarter of revenue from this group. From an operations perspective, we will be focused on implementing our branch network and corporate facilities reduction plan, ensuring that we provide a smooth transition for customers using new locations. As we approach the end of 2020, while this has been an extremely challenging year due to the pandemic, it's also been one that has been extremely productive for the company in terms of repositioning and refocusing our franchise on areas of the business that we believe present the best opportunities for future growth and deliver the most attractive returns. With the changes we have made and the improved operating leverage that has resulted, we feel that we have made important progress in positioning Midland to deliver more consistent financial performance and earnings growth as the economy strengthens. With that, we'll be happy to answer any questions you might have. Operator, please open the call.

Our first question comes from Michael Schiavone of KBW. Your line is open.

You experienced solid loan growth this quarter across three different areas. Could you elaborate on the key drivers behind this growth and discuss the pipelines? Also, how stable do you anticipate this growth to be moving forward?

We experienced significant growth in consumer loans through our partnership with GreenSky, where we have set and increased some limits this quarter. I anticipate there will be some additional growth in that area, which we manage closely. Eric mentioned that we sold some portfolios in that division. While the volume has decreased more than we hoped, we can cooperate with GreenSky to sell some of those loans at their original value, which supports the low credit loss in that portfolio. There are also opportunities in the commercial FHA warehouse lines, which are currently seeing a good amount of activity, so I expect some solid draws this quarter. Additionally, the equipment finance sector has a robust pipeline, and historically, the fourth quarter is their busiest time, so we anticipate similar activity in the fourth quarter as we've experienced in the third quarter.

Great, thanks. And can you also shed some color on the new relationship with Dwight Capital and what type of revenue and deposit growth opportunities we might expect?

I prefer not to get into specifics about customers during an earnings call, but as mentioned, we have a warehouse line with them, and you will start to see it. We also have another customer in that area. As we move forward, we'll highlight it as the balances fluctuate. The companies we finance require a significant line availability, in the hundreds of millions of dollars. That's what the warehouse lines are for. Similarly, like we did with Love Funding, we have engaged in commercial loan bridging, originating a loan, holding it on the balance sheet for a while, and then taking it to the secondary market. We will provide that type of financing to that customer when necessary as well. I believe there is a strong opportunity to generate revenue with this new customer, which could help offset some of the revenue and earnings decline from Love Funding.

And then final one. Do you expect that capital can start to build from here, just given pre-tax pre-provision earnings outlook should improve after all the cost initiatives? And then also, what is your appetite for continued share repurchases versus other uses of capital at this point?

Yes, we are trying to find a balance. We want to build capital, but with our stock trading at $0.70 on the dollar, there is limited interest in repurchasing shares each quarter. We are managing this as we aim to strengthen our tangible common equity ratios. Our bank capital ratios are robust, and we have significant liquidity at our holding company, which makes us feel confident about our overall capital position. However, we need to improve our ratios at the holding company level, and enhanced earnings and better pre-tax pre-provision results will contribute to that.

Our next question comes from Nathan Race of Piper Sandler. Your line is open.

I was hoping to just follow-up on the operating expense discussion. Eric, appreciate your guidance for the first quarter. I guess I'm just curious if there's going to be some redundant costs, just given that you guys are kind of working through those branch optimizations here in 4Q, which may carry over into 1Q and just how we should kind of think about the core run rate has been through the second quarter of '21?

Yes, I believe we've achieved significant cost savings through both branch and office rationalization along with Love Funding. We had a positive year regarding expenses, particularly with medical costs. Our incentive plans are currently at half their usual levels for this time of year, so we expect them to return to 2019 levels. This creates some expense challenges when compared to 2020. You might be suggesting that the quarterly run rate could be below the $39 million to $40 million mark, but we are encountering some expense pressures as we move into 2021.

And then just changing gears on credit. The provision has been pretty stable last few quarters. I guess, obviously, it was elevated this quarter with the commercial real estate credits and so forth. Those 3 isolated incidents, it seems like. How should we be thinking about additional reserve build just given the macro inputs that factor into your CECL model and just given how you guys are seeing deferrals trend at this point and just overall changes in criticized and classified loans as well, at least in the fourth quarter, I suppose?

Yes. I mean we continue to get a better look at deferrals. And as that starts to narrow, you get a better look at where you might have real problems, right? So I think what we said at the end of last quarter is that provisioning in the back part of the year would be similar to the first part of the year. And I think we probably continue to see it that way. So hopefully, that helps, yes.

Our next question comes from Cooper Brown of Stephens. Your line is open.

This is Cooper on for Terry. Just wanted to quickly touch on the equipment finance portfolio. I think you mentioned you're expecting some growth going forward like you saw this quarter. Specifically, it was from construction and manufacturing. Any additional industries that are worth noting that you might have seen the demand from?

I think those are the sectors. We believe we have a well-diversified approach to the equipment finance business and that we're positioned in areas with growth potential. While the shuttle bus segment is currently inactive, we are experiencing strong demand in construction and manufacturing. So it focuses on those sectors.

Can you provide the total size of the transit and ground passenger portfolio where deferrals are elevated within equipment finance?

Yes. We are aware of the deferrals, and while I don’t have the exact figure for the total portfolio, a significant portion of it is comprised of deferrals.

And then just finally, I think you guys touched on some opportunities to help the NIM out in this coming quarter. With the CD maturities, how are things looking for early '21? And are there any other deposit cost reduction opportunities over the next several quarters?

Yes, we have mostly completed the reduction of deposits. However, we still have CDs that will continue to mature into 2021, with about $400 million expected to roll down over the next year. This is the primary area where we see opportunity at this time. While the savings may amount to just a few basis points here and there, we have successfully lowered our deposit costs over the last two quarters to align with current market rates.

Our next question comes from David Konrad of D.A. Davidson. Your line is open.

I just had a quick follow-up question on the NIM. You just kind of filled in the questions on the CD side. But on the asset side, I thought loan yields held up remarkably well. I’m just curious on the equipment finance, kind of a front book, back book. What's the current yields you're booking now versus the portfolio yields? Is there a gap there? And maybe the same question for the securities portfolio for maybe if there's any pressure on that as we look into next year?

I'm fairly certain that our portfolio yield is slightly above what we're currently putting into new production. However, new production in that business is over 4, potentially nearing 4.5. We've also been able to expand spreads in that area over the last 3 to 4 months. While we are experiencing a decrease in yield as the portfolio pays down and we introduce new production, the variation in that spread is not significant. Yes. Right. I mean, it's rolling. I mean, Eric, you can talk about it. It's rolling down.

Yes. David, on the securities portfolio, that yield continues to drop. We've been looking at new purchase opportunities, and those are in the range of 100 basis points to 140 basis points depending on what type of security in the duration. Yes, we're continuing to expect that to roll down a little bit over the course of next few quarters.

But then I guess the flip side of that is if you can deploy some of the cash at probably 10 bps into the leasing portfolio that will help offset some of those pressures?

Correct.

I show no further questions. I'd like to turn the call back over to management for closing remarks.

Alright. Thanks, everybody for joining today, and we'll see everybody in 2021. Thanks.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect. Everyone, have a great day.