Midland States Bancorp, Inc. Q1 FY2022 Earnings Call

Good day, and thank you for standing by. Welcome to the Q1 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. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Mr. Tony Rossi of Financial Profiles. Mr. Rossi, the floor is yours.

Thank you, Chris. Good morning, everyone, and thank you for joining us today for the Midland States Bancorp first 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'll 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 at 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 a 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 three with the highlights of the first quarter. As we expected, we saw a continuation of many of the positive trends we experienced in the second half of last year. Most notably, we had very strong loan growth and expanding net interest margin and disciplined expense control. This resulted in a strong quarter with net income of $20.7 million or $0.92 per share, and pretax pre-provision earnings of $32 million. Relative to the first quarter of 2021, our return on average assets, return on average tangible common equity and adjusted pretax, pre-provision, return on average assets have all increased, which reflects the consistent improvement we are seeing in the level of profitability as we generate strong organic growth and realize more operating leverage. Despite the first quarters typically being a seasonally slower period for loan production, we had another strong quarter of loan originations. We had $673 million in new commercial and commercial real estate originations, which is 115% higher than in the first quarter of last year. The higher level of loan originations reflects the more productive commercial banking teams we have built and the increased presence we now have in higher growth markets. Our loan production was more heavily weighted towards commercial real estate this quarter, as we continue to see good results from our specialty finance group that primarily originates loans for multi-family and senior care properties and provides bridge to HUD financing. Within commercial lending, our Midland equipment finance team had a strong quarter of originations, with production being about 60% higher than the first quarter of 2021, although a higher level of payoffs impacted the growth we had in this portfolio. From a geographic perspective, we had a strong quarter in loan production in the St. Louis market, which reflects the improved business development capabilities we have following changes in leadership and additional resources we have added to the team. The record level of loan production resulted in 24% annualized growth in total loans. This strong growth in loans enabled us to redeploy a lot of our excess liquidity into the loan portfolio, which resulted in a favorable shift in our mix of earning assets and significant expansion in our net interest margin. We are seeing higher rates on new loan originations, which is also contributing to the increase in our net interest margin. Notably, we are generating the strong loan growth and increase in net interest income, while maintaining relatively flat expense levels. As we have mentioned in the past, we've kept the size of our overall banking teams relatively consistent, but we have made many changes in personnel over the past couple of years that have upgraded the quality and productivity of the teams. And we are also continuing to realize more efficiencies from the investments we have made in our technology platform. As a result, while we are seeing some degree of inflationary pressure, particularly in labor costs, we have been able to largely offset this pressure by increasing efficiencies and productivity, which allows more of the strong organic growth we are generating to fall to the bottom line and improve our earnings and returns. At this point, I'm going to turn the call over to Eric to provide some additional details around our first quarter performance.

Thanks Jeff, and again, good morning everyone. I'm starting on slide four and we'll take a look at our loan portfolio. Our total loans increased $315 million from the end of the prior quarter. As Jeff mentioned, the strongest growth came in the commercial real estate portfolio, which increased 16% during the first quarter. We also had small increases in equipment finance, conventional, commercial, and consumer loans. These increases were partially offset by declines in commercial FHA warehouse credit lines, residential real estate loans, and the continued forgiveness of our PPP loans. Turning to slide five, we'll take a look at our deposits. Total deposits decreased $53 million from the prior quarter. The largest decline was in non-interest bearing deposits, which was primarily attributable to fluctuations in end-of-period balances of commercial FHA servicing deposits. We had growth in interest bearing checking, money market, and savings deposits, which was due to inflows from new business development, as well as some clients and customers starting to transfer balances out of non-interest bearing accounts. One of the contributors to the new business development is the increased focus we have in growing our market share in St. Louis. In the first quarter, we had $120 million increase in our commercial deposit balances in this market. Looking at slide six, we'll walk through the trends in our net interest income and margin. Our net interest income increased 4.7% from the prior quarter, primarily due to higher average loan balances and the increase in our net interest margin. We brought down our cash balances by $348 million from the end of the prior quarter, which was primarily redeployed into the loan portfolio to fund our strong loan growth. This favorable shift in our mix of earning assets drove a 25 basis point increase in our net interest margin, or 26 basis points when accretion income is excluded. As interest rates increase, we're seeing improvement in new loan pricing, which is also positively impacting our net interest margin. In the month of March, the average rate on our new and renewed loans was 4.10%, an increase of 17 basis points from the month of December. The most significant driver of this increase is our equipment finance business, although we are seeing some higher rates on originations across all of our commercial lending. Turning to slide seven, we'll look at the trends in our wealth management business. Our assets under administration decreased by $173 million from the end of the prior quarter, primarily due to market performance. Despite that decrease, our wealth management revenue was essentially flat with the prior quarter as seasonal tax preparation fees offset the decrease in assets under administration. Compared to the first quarter of the prior year, our wealth management revenue increased 20%, which reflects our strong progress on growing our recurring sources of income. Turning on to slide eight, we'll look at non-interest income. We had $15.6 million in non-interest income in the first quarter, a decrease of 30.7% from the prior quarter, which included a number of one-time items. Excluding these items, most areas of non-interest income were slightly down from the previous quarter, except for impairment on commercial mortgage servicing rights, which decreased $1.7 million due to refinancing activity as interest rates continue to increase. Turning to slide nine, we'll take a peek at our non-interest expenses on an adjusted basis excluding the FHLB advanced prepayment fee recorded last quarter and integration and acquisition expenses; our non-interest expense was essentially flat with the prior quarter. We had slight variances in each major line item, some a bit higher, some a bit lower, which all essentially offset each other and enabled us to come in at the low end of the range of guidance we provided for operating expenses in 2022. Looking ahead to the second quarter, we expect to keep expenses relatively stable, although the completion of the FNBC branch acquisition will bring on some additional personnel and occupancy expenses. Turning to slide 10, we'll look at asset quality trends, our non-performing loans increased $10.3 million from the end of the prior quarter, which was entirely attributable to one commercial real estate loan where no loss is currently expected. Outside of this one credit, trends in the portfolio were generally favorable with continued upgrades of watchlist loans as more borrowers demonstrate sustained performance with the impact of the pandemic declining. We had $2.3 million in net charge-offs in the quarter, or 17 basis points of average loans. We recorded a provision for credit losses on loans of $4.1 million, which was largely related to the growth and total loans. On slide 11, we will show the components of the change in our allowance for credit losses from the end of the prior quarter; our ACL increased by approximately $1.9 million. The increase was driven by growth in total loans and changes in the mix of the portfolio. And then on slide 12, we show the allowance for credit losses segmented by portfolio. Given the positive trends we're seeing, we continue to bring down our coverage ratios in most areas of the portfolio. And with that, I'll turn the call back over to Jeff.

Thanks, Eric. We'll wrap up on slide 13 with some comments on our outlook. Our loan pipeline remains very healthy and we continue to see good demand in both commercial and commercial real estate lending. Based on our current pipeline, we expect another quarter of strong loan growth. Beyond that, it's difficult to predict the level of loan growth in the second half of the year, as it's uncertain how rising interest rates will impact loan demand. But based on current trends, we expect low double-digit loan growth in 2022. Although higher rates could impact loan demand, resulting in slower growth during the back part of the year. We're already seeing significant expansion in our net interest margin and as we continue to grow loans and the Fed continues to increase rates, we should see further expansion in our margin. We expect to continue to be able to fund our loan growth with low-cost deposits. Our treasury management group is having more success in bringing in large commercial deposit relationships. And the closing of the FNBC branch acquisition later this quarter will provide another source of low-cost deposits. As Eric mentioned, we expect to keep expenses relatively flat, which should lead to further operating leverage, as our expected loan growth and margin expansion generate higher levels of revenue. With the combination of continued balance sheet growth and expanding margin and greater operating leverage, we expect to see further improvement in earnings and our level of profitability as we move through the year. While we continue to see good results from the efforts we have made to enhance our business development capabilities and improve our financial performance, we're also making good progress on our long-term initiatives to further enhance the value of the Midland franchise. Over the past few years, we've talked about the investments we've made that have significantly strengthened our technology platform. One of the strategies of our long-term technology roadmap is to position the company to effectively compete within the banking-as-a-service space. Our relationship with GreenSky has given us valuable experience that we will leverage with other Fintech partnerships that can be meaningful contributors to our balance sheet growth and fee income in the years ahead. With the improvement we have made in our technology platform, we are now in a position to begin implementing our broader banking-as-a-service initiative. Earlier this month, we announced the partnership with Synctera, which will help us develop new partnerships with other Fintechs that will contribute low-cost deposits and increase the number of customers using our payment solutions. We have a pipeline of potential Fintech partnerships that we are in the early discussions with and we look to bring onboard towards the second half of the year. We expect to announce a new partnership with a consumer lender similar to GreenSky, while we also are reviewing other Fintechs focusing on deposit gathering. We're being very balanced in the implementation of this initiative, doing it in a way that does not require much incremental investment in our technology platform and enables us to learn from the experiences that we can prudently manage the growth in the area over the coming years. Over the long term, we expect banking-as-a-service to become another important catalyst for our earnings growth and further improvement in our financial performance. And finally, strengthening our capital ratios will continue to be a priority for the company. With the efforts we have made to increase loan production having been very successful and the pipeline remaining very healthy, we want to make sure that we can continue to have the capital strength to support our strong balance sheet growth, as well as continue to have the ability to execute on attractive transactions like the FNBC branch purchase. So, as we move through the year, we will be evaluating the best options for strengthening our capital ratios, as well as optimizing our capital stack, as we have some subordinated debt that is callable later this year that we may redeem. Whatever capital actions we take will be in the best long-term interest of shareholders and enable us to continue executing on the strategies that have contributed to the improvement in our financial performance. With that, we'll be happy to answer any questions you might have. Operator, please open up the call.

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

All right, good morning. Nice start to the year, Jeff and Eric.

Thank you.

Hey, first question. Can you just maybe expand on the growth in the CRE portfolio, multifamily retail, some segments that maybe kind of contributed to that growth? And maybe as a follow-up there, how are you stress testing the portfolio as rates continue to rise or are expected to continue to rise, how are you stress testing and getting comfortable with the relative size of your CRE portfolio?

Most of the growth came from multifamily, senior care, and industrial warehouse portfolios. Retail saw a slight increase, but those three portfolios were the main drivers. In our underwriting process, we evaluate interest rates and cap rates on a deal-by-deal basis. Additionally, we conduct annual full stress testing on commercial real estate, assessing those factors at the portfolio level, so we are addressing these aspects regularly.

Thank you for that. As a follow-up, much of the discussion we just had was about growing revenue. I’m not sure if I’m surprised, but I expected your expenses to be higher than 41 to 42, considering the revenue initiatives. Can you discuss how you’re balancing your investments and where you see opportunities to reduce expenses to maintain that level this year or at least in the next quarter?

Yes, we have discussed our commercial banking team over several quarters, and we’ve kept the headcount relatively stable, potentially even slightly reduced. However, we have improved productivity and pipeline management since implementing Salesforce a few years ago, which has matured effectively. The efforts in pipeline follow-up from the President of the bank down to relationship managers have been strong, allowing us to maintain a lower headcount without needing to expand the commercial team for additional growth. While we'll need to adapt over time, that’s our current situation. The pause we've taken on mergers and acquisitions over the last couple of years has allowed us to focus on our operations and vendor management. We continue to discover both significant and smaller opportunities that contribute to revenue growth while keeping expenses stable. This situation may not last indefinitely, but for now, we are managing it effectively.

If I could squeeze one last one. The equipment finance yields up 76%, a big jump, was there something going on within that business last quarter to contribute to the higher yields?

Yes, that business involves five-year contracts, and we observed an increase in prices during that period. In March, our new contracts were about 530 compared to around 450 or 460 in December. While we are still facing some overall pressure on loan pricing, this specific segment of the business saw a notable increase due to its national scope and the demand remains strong. As Jeff pointed out, there was significant demand in the first quarter compared to the same period last year, which is usually a quieter time.

Great. Thanks a lot. Have a good weekend, guys.

Thanks.

Thank you. Our next question comes from Damon DelMonte of KBW. Your line is open.

Hey, good morning, guys. Hope everybody is doing well today.

Good morning.

Good morning. My first question is about the margin. Could we discuss that? The expansion this quarter was very impressive, and I’d like more detail on what contributed to that growth. Specifically, I want to dive deeper into the core margin. I understand there was some accretion yield; can you tell me how much the PTP impact was? I'm trying to ascertain a core level and see if there were any other one-time loan fees or items that might not be recurring next quarter as we model this out.

Yes, Damon, this is Eric. So, on the PPP impact is roughly about five basis points or so to our margin. Those fees are shrinking, of course, they're a little bit over $1 million in the last quarter. There were a few odds and ends. Jeff, in his remarks mentioned some earlier deferrals that we're seeing in equipment finance. And so we've seen with the increase in the price of that used equipment, we've had some customers that have been selling that equipment, paying off their contracts early. So, we have seen some prepayment fees in that portfolio. And then a few other kind of odds and ends, but not more than just a few basis points overall during the course of the quarter.

Okay, so is it fair to assume that you're kind of somewhere in the high 330s for your core?

I think probably more like low 340s.

Low 340? Okay. All right. That's great. And then I guess, as far as the commentary on loan growth, your pipeline continues to be strong going into the second quarter here. Do you expect it to be continued to be driven by commercial real estate or do you see other areas of the portfolio starting to contribute more?

Yes, that's likely going to be the main factor driving growth, but we also anticipate growth in the commercial sector. The equipment finance business is expected to improve. Typically, we perform better in the second quarter compared to the first, and if pay down slows, that will positively impact the commercial line. I expect consumer growth to remain relatively flat, with more growth likely occurring in the commercial real estate sector.

Got it. Okay. And then just lastly, on the fee income, any kind of guidance there? So, what to expect for the quarterly run rate? I know the other line was lower than previous quarters? Do you think you get back up over that $16 million quarterly run rate?

Yes, I think so. We have a little lighter interchange quarter, which I think is sort of seasonal and service charges, which sort of go hand-in-hand. And I think just seasonally the first quarter is a little lighter. So, we do expect those to come back. But yes, I think that's not a bad number.

Okay. All right, great. That's all that I had for now. Thanks a lot, guys. Appreciate it.

Yes. Thanks.

Thank you. Next, we have Nathan Race of Piper Sandler. Your line is open.

Yes. Hi, guys. Good morning.

Hello.

Question just on the deposit growth expectations. I appreciate some of the decline of the quarter was tied to the FHA servicing partnership. So, just curious how you guys are thinking about deposit growth over the course of 2022 to fund continued strong loan growth expectations? And just within that context, it sounds like you guys are in the process of onboarding some partnerships to drive some deposit growth as well. So, just curious how we should think about the rate sensitivity of those potential deposits coming on board relative to kind of your lower beta deposit franchise?

We experienced a significant increase in deposits at the end of the year due to our servicing business, which we anticipated. Our first quarter was very strong in terms of deposit gathering, treasury management, and retail deposits also saw a nice increase. The team's productivity has been impressive, and our salesforce is effectively driving pipelines, especially in treasury management, which are in a solid position heading into the second quarter. We secured some valuable accounts in the first quarter and expect to continue this success in the second quarter. Additionally, the branch acquisition will enhance our efforts, as the cost of funds from the branch we're acquiring is relatively low, allowing us to bring in quality core deposits. We're effectively working on both sides of the balance sheet by gathering deposits and making loans, and I believe we are succeeding in both areas. Regarding banking-as-a-service, it's a longer-term strategy, and while it isn't expected to significantly impact our financials this year, we anticipate a more substantial effect in the coming years.

Okay, I understand. So, deposit growth may be slightly slower compared to loans. However, the ability to increase your loan-to-deposit ratio, considering average balances at 89% for the quarter, seems reasonable.

With the branch acquisition coming in, that number should stay relatively in that range, up some, down some based on where loan growth ends the quarter and where to deposit growth ends the quarter with the branch acquisition, that'll help supplement that.

Okay, great. And then just kind of thinking about the margin outlook from the low 340 range on a core basis, going forward. I believe, around 35% of your portfolio is floating rate and I imagine most floors will be not a factor assuming the Fed moves by 0.5% next month. So, just kind of how should we think about the progression of the core margin from here? Is it fair to just expect by the end of this year that we could get it to core margin in the mid-350 if not low 360s range or how are you guys kind of thinking about the cadence of the NIM over the next few quarters from that low 340 range?

Yes, Nate, that’s definitely an important question. We are currently less asset-sensitive compared to the end of last year. This change is primarily due to loan growth and how we've been utilizing cash throughout the quarter. Your numbers are close, but we’re now around 67% to 68% fixed, with the remainder being variable in some capacity. In late March, we reduced some of our asset sensitivity by executing a fixed swap on approximately $200 million of our variable rate loans, which resulted in an increase of about 190 to 195 basis points from that trade, effectively accelerating the benefit of eight rate increases. Looking ahead to the next quarter, we expect to gain three to four basis points from the swap, which will help balance out the PPP fees we previously discussed. We'll mostly move past our floors for that portfolio and may gain a couple of basis points as the Fed implements the anticipated next 50 basis point increase. If we continue with this pattern and see a couple more 50 basis point rises throughout the year, we could achieve around 350 basis points or possibly slightly more in core by year-end.

Okay, great. That's super helpful. Thanks Eric. And maybe just one last one on the fee income outlook, excluding mortgage, which is a challenge across the industry. Is the expectation outside of that line to generate some growth, just consistent with kind of what we've been talking about the last few quarters, increased card spending, and just share gains there across our clients? And then also, Wealth Management, I imagine would hopefully stabilize with equity market valuations hopefully stabilizing as well.

Yes, I think that's right.

Okay, perfect. I appreciate you guys taking the questions and all the color. Congrats on a great quarter.

Yes, thanks.

Thank you. Our next question comes from Manuel Navas of D.A. Davidson. Your line is open.

Hey, good morning.

Good morning.

What are some of the guideposts or metrics we should watch as you kind of create these Fintech partnerships and continue along the banking-as-a-service evolution? Are you really focused on on-balance sheet items, the income growth, number of customers? Any color that would be helpful?

Yes, our primary focus will be on gathering deposits and processing payments, particularly interchange. We are currently exploring a Fintech partnership in the loan sector, which will help us diversify our Fintech loan partnerships further. GreenSky is a significant partner for us at the moment. Over the next 12 months, we plan to add more Fintech partnerships to enhance our diversification. However, our main emphasis on banking-as-a-service will remain on deposits and payments.

Okay, that's helpful. Maybe I missed it. Is there any change to your expectations for the GreenSky portfolio?

No, no, I think that will stay relatively up or down 3%, 4%, or 5% either way, depending on how the quarter goes. We've sort of set our limit and we're about at our limit.

And kind of a modeling question that swap that you entered into that, is that going to show up in your loan yields or a different part of the average balance sheet?

It'll show up in the loan yields.

Okay, that's helpful. I appreciate that. With the fluctuations in AOCI that people have been noticing, has that affected your M&A discussions at all? What are you hearing about in your markets?

Yes, we're monitoring the situation. Our investment portfolio saw a decrease in fair value of roughly $48 million to $49 million during the quarter. This impacted our tangible book value by about 3.6%. One factor that has worked in our favor compared to some others in the industry is our strong loan growth, which means a smaller percentage of our balance sheet is in investments than some peers. Additionally, we have some forward-starting swaps that allow us to secure funding on the liability side at attractive rates, which is helping to offset the decline in our investment securities portfolio. While we are keeping a close watch on it, we do not anticipate any significant moves to address or change the situation.

Is everyone's keeping an eye on it, is that kind of limiting M&A discussions? Do you feel like it's hurt it at all?

We have been clear that we are not pursuing mergers and acquisitions at this time. We are considering small acquisitions, such as last year's all-cash deal in wealth management and a small all-cash branch acquisition. We are not interested in large mergers and acquisitions that would require using our stock. Therefore, this is not an issue for us. Regarding accounting, we generally hold our bonds until maturity, so any losses that have occurred will eventually recover. Unless one has to sell investments to fuel loan growth, which could lead to losses, we are not in that situation. So, we expect everything to recover over time.

That's great. Thank you very much.

Thank you. I'm show no additional questions at this time. I would like to turn the call over to management for any closing remarks.

Thank you. I want to thank everybody for joining. We had a really good quarter and I look forward to talking to everybody next quarter. Have a good weekend. Thanks.

This concludes today's conference call. Thank you all for participating. You may now disconnect. Have a pleasant day and enjoy your weekend.