Earnings Call Transcript - MSBI Q2 2022

Operator, Operator

Good day, and thank you for standing by. Welcome to the Q2 2022 Midland States Bancorp, Inc. Earnings Conference Call. Please be advised that today's conference is being recorded. And I would now like to hand the conference over to your speaker today, Mr. Tony Rossi of Financial Profiles. Mr. Rossi, please go ahead.

Tony Rossi, Presenter

Thank you, Chris. Good morning, everyone, and thank you for joining us today for the Midland States Bancorp second 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 have 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. Jeff?

Jeff Ludwig, CEO

Good morning, everyone. Welcome to the Midland States earnings call. I'm going to start on Slide 3 with the highlights of the second quarter. Despite an increasingly challenging operating environment, we continue to generate improvement in our financial performance as a result of the strategic initiatives we have implemented over the past few years to strengthen our commercial and retail banking teams, increase our focus on higher-growth markets, and improve operational efficiencies. Our strong execution on these strategies produced another strong quarter of very strong loan growth, additional expansion in our net interest margin, and greater operating leverage. This resulted in a stronger quarter with net income of $21.9 million or $0.97 per share, pretax pre-provision earnings of $35.9 million, and increases in our ROA, ROE, and ROTCE relative to the prior quarter as we continue to generate a higher level of performance. The most significant driver of our improved performance is the higher level of productivity we are seeing from our commercial banking teams. Our teams are doing an outstanding job of developing new commercial relationships, and our strong loan production resulted in 18% annualized growth in total loans. Our commercial banking teams are focused on relationship lending within our markets across a variety of loan types. And as a result, total loans within our community banking markets were up $192 million. We continue to see a higher level of growth in St. Louis as a result of our increased focus on this market. Total loans in the St. Louis market were up 11% from the prior quarter and have increased 23% over the past six months. Our St. Louis team is also doing a very good job of developing more commercial deposit relationships, which has resulted in our deposits in the St. Louis market increasing 19% over the past six months. The strong loan growth we are seeing is helping us to drive positive trends in a number of key metrics. Our net interest margin increased 15 basis points in the second quarter on top of the 25 basis point increase in the first quarter as the strong growth in loans resulted in a favorable shift in earning assets, while we also benefited from higher rates on new loan originations. The higher revenue we are seeing from the loan growth and margin expansion is also helping us to realize more operating leverage as we effectively manage our expense levels. This resulted in an improvement in our efficiency ratio to 53.1% from 55.7% in the prior quarter. In addition to our strong organic growth, we also completed our branch purchase transaction with FNBC Bank & Trust late in the second quarter. We are very pleased to be able to execute on this transaction that perfectly fits our acquisition criteria at the current time. It's low risk and easily digestible, so it won't distract the organization and disrupt the strong execution we are seeing on our growth and efficiency improvement strategies. It's immediately accretive to earnings and provides a meaningful amount of low-cost deposits that we can use to fund our strong loan growth. And from a strategic perspective, the addition of a branch in Mokena provides another physical presence in the Greater Chicagoland area that will support the increased business development efforts we have in this higher growth market. It's the ideal type of small tuck-in deal that nicely complements the strong organic growth that we are generating without presenting any execution or integration risk. At this point, I'm going to turn the call over to Eric to provide some additional details around our second quarter performance. Eric?

Eric Lemke, CFO

Thanks, Jeff, and again, good morning, everyone. I'm starting on Slide 4, and we'll take a look at our loan portfolio. Our total loans increased $256 million from the end of the prior quarter. The strongest growth came in the commercial real estate portfolio, which increased 10% during the second quarter. We also had small increases across most of our other portfolios, which were partially offset by declines in commercial FHA warehouse credit lines and the continued forgiveness of PPP loans. During the second quarter, we began to originate loans through our new fintech partnership with LendingPoint, which accounted for the growth we had in the consumer loan portfolio. Turning now to Slide 5, we'll look at our deposits. Total deposits increased $127 million from the end of the prior quarter, a portion of which was attributable to the FNBC branch acquisition that Jeff previously discussed. We had an increase in noninterest-bearing deposits and all of our lower-cost interest-bearing deposits, while our time deposits were essentially unchanged during the period. Our commercial banking and treasury management teams are doing a good job of developing new commercial deposit relationships that are providing a steady inflow of lower-cost deposits to fund our strong loan growth. Turning now to Slide 6, we'll walk through the trends in our net interest income and margin. Our net interest income increased 7.9% from the prior quarter primarily due to the higher average loan balances and the increase in our net interest margin. We brought down our average cash balances by $158 million and our investment securities portfolio by $76 million from the end of the prior quarter with those funds redeployed into the loan portfolio to support our strong loan growth. This favorable shift in our mix of earning assets as well as higher average rates on cash, investment securities, and loans helped drive a 15 basis point increase in our net interest margin. 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 June, the average rate on our new and renewed loans was 4.79%, an increase of 69 basis points from the month of March. In particular, we are seeing significantly higher rates on commercial loans, which includes our Midland Equipment Financing. Turning to Slide 7, we'll look at trends in our wealth management business. Our assets under administration decreased by $446 million from the end of the prior quarter primarily due to market performance. The decrease in assets under administration resulted in lower wealth management revenue in the second quarter. On Slide 8, we'll review our noninterest income. We had $14.6 million in noninterest income in the second quarter, a decrease of 6.4% from the prior quarter. The decrease was primarily due to the lower wealth management revenue, which offset increases in deposit service charges and interchange revenue resulting from the growth in our client base. Now turning to Slide 9, and we'll review our noninterest expense. On an adjusted basis, excluding integration and acquisition expenses, our noninterest expense was up slightly from the prior quarter primarily due to higher salaries and benefits expense resulting from a modest increase in staffing levels and higher incentive compensation. With the completion of the FNBC branch acquisition, we'll have a slight increase in expenses in the third quarter, but they should remain within the range of $41 million to $42 million that we have previously guided for a run rate in 2022. As we have done over the past couple of years, we continue to have opportunities to renegotiate vendor contracts to help us generate cost savings to offset the increases we are seeing in labor costs and the investments we're making in various initiatives to grow and further diversify the company. We're also continuing to leverage our technology investments to drive more automation throughout the organization in order to further improve efficiencies and control expenses. Turning now to Slide 10, we'll look at our asset quality trends. Our nonperforming loans increased $4 million from the end of the prior quarter, which was 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 watch-list loans as more borrowers demonstrate sustained performance with the impact of the pandemic declining. While there is broader concern about how inflation and higher interest rates will impact customers through June 30, the delinquency rate in our consumer portfolio remains exceptionally low and has actually declined a bit since the beginning of the year. And should any deterioration begin to occur, we have approximately $39 million in an escrow account that is available to cover any losses on the GreenSky portfolio. We had $2.8 million in charge-offs in the quarter or 20 basis points of average loans, and we recorded a provision for credit losses on loans of $4.7 million, which was largely related to the growth in total loans and changes in our economic forecast. Now on Slide 11, we show the components of a change in our allowance for credit losses from the end of the prior quarter. Our allowance for credit losses increased by approximately $2 million. This increase was driven by the growth in total loans, changes in the mix of the portfolio, and changes in forecasts from weakening economic conditions. On Slide 12, we show our ACL broken out by portfolio. While our overall coverage ratio remained relatively stable, we increased coverage a bit within the commercial portfolio, primarily due to changes in economic variables and forecast. And with that, I will turn the call back over to Jeff.

Jeff Ludwig, CEO

All right. Thanks, Eric. We'll wrap up on Slide 13 with some comments on our outlook. Although the operating environment will continue to be challenging, we expect most of the positive trends we have seen in the first half of the year to continue over the rest of 2022. Our loan pipeline remains strong, particularly in equipment finance, but smaller than it was at the start of the second quarter. We still expect to see growth in our loan portfolio over the second half of the year, but not at the same level that we have had in the first half given the smaller loan pipeline and the likelihood that higher rates and concern about weakening economic conditions will start to have a greater impact on loan demand. But with continued loan growth and further expansion in our net interest margin as we benefit from our asset sensitivity, we should continue to see higher levels of revenue, more operating leverage, and further increases in pretax pre-provision earnings and returns during the second half of the year. As we mentioned on our call last quarter, while we continue to improve our near-term financial performance, we are also making good progress on long-term initiatives to enhance the value of the Midland franchise. One of the initiatives is the Banking-as-a-Service strategy that we discussed last quarter, and we expect to add fintech partnerships over the second half of the year, which will put us in a position to see this initiative start to become a contributor to our financial performance in 2023. Another initiative is to accelerate growth in our wealth management business. We recently hired a new Head of Wealth Management, Jayne Hladio, who has held several senior wealth positions at a number of large financial institutions. And she will be leading our efforts in this area. As you know, we have made a number of wealth management acquisitions over the past several years in which we have added expertise in new areas, and we have the opportunity to increase revenue by adding financial advisers and enhancing our cross-selling within our client base. So improving our cross-selling will be a key focus now as well as recruiting more talent and enhancing our overall business development capabilities. It will take some time for these efforts to gain traction, but we feel very good about the leadership and strategies in place, and we believe that over the long-term we will increase our organic growth rate in this business. Through the first six months of the year, we have executed very well and delivered strong results for our shareholders. Our return on average assets was 1.19% in the second quarter, and pretax pre-provision income increased 33% over the second quarter of 2021. In addition, we are delivering strong returns on average tangible common equity with a 19% return in the second quarter. Strong earnings performance will allow us to continue to grow our franchise and build capital as growth slows towards the back half of the year. On our last earnings call, we mentioned that we would be evaluating other options to strengthen our capital ratios to support the continued growth of our franchise, and evaluating these options will continue to be a priority for the company as we are highly focused on making capital management decisions that are in the best long-term interest of our shareholders. We believe this franchise we have built is well positioned to drive strong profitable growth when economic conditions are favorable while effectively managing credit and interest rate risk so that we can preserve shareholder value and continue to deliver solid results when economic conditions deteriorate. With that, we'll be happy to answer any questions you might have. Operator, please open the call.

Operator, Operator

Yes, thank you. Our first question comes from Manuel Navas of D.A. Davidson. Your line is open.

Clark Wright, Analyst

Hi, good morning, this is Clark Wright on for Manuel. In terms of your near-term expectations for NIM expansion, what are you looking at in terms of the year-end, and then also pertaining to that, the peak NIM to the rate cycle?

Jeff Ludwig, CEO

Eric, do you want to sort of talk about...

Eric Lemke, CFO

Yes Clark, good question, good morning to you. As we think about sort of our NIM, as we've done our modeling, I know we've talked in the past about our loan portfolio, and that's roughly around 55% fixed rate with the remaining being variable. However, that fixed rate, primarily if you look at our MEF portfolio, turns pretty quickly, and we're seeing higher prices there or higher pricing on new activity. So as we kind of think about the back half of the year, our modeling shows us that in an up 100 basis point environment, we basically improve our NIM somewhere between 4% and 4.5%. And so as we look up a 100, we think that translates to an additional 5 to 10 basis points of NIM through the back half of the year. In peak NIM, that's a really tough question to answer in this kind of rate environment, but we are looking for additional expansion through the back half of the year, somewhere into that range.

Clark Wright, Analyst

Thank you. And then just in terms of deposit betas that are going into those assumptions? And then what kind of what do those look like as well on the other side?

Eric Lemke, CFO

Our deposit betas that we're using are somewhere in that 30% to 35% range. Now thus far, through the rate increases through the second quarter, we've been able to be below that. So we think our model inputs have been conservative up until now. But I think we're kind of expecting that the betas we've seen through the second quarter will be a little bit higher through the third and the fourth as we see additional rate increases. But we're pretty comfortable with what we have in our model.

Clark Wright, Analyst

Thank you, appreciate it.

Operator, Operator

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

Damon DelMonte, Analyst

Hi, good morning, guys. Hope you're all doing well today. Just wanted to start off with the loan growth outlook, I mean, obviously, two very, very strong quarters to start the year. And I think, understandably, that pace isn't sustainable through the whole year. So as you kind of look at your pipeline and you think about some of the drop-off in growth - pace of growth in the back half of the year? Can you just put a little bit more perspective around kind of where you see that settling in? Is it kind of more in the mid-single-digit range or do you think you could still stay at the double-digit level?

Jeff Ludwig, CEO

Yes, I think it's going to come in below the double-digit levels, I think, as we think about the back part of the year. I mean, our first six months have been really, really strong, and so we do think it's going to come back a little bit in the back part of this year.

Damon DelMonte, Analyst

Okay. And then as far as the drivers of that, anywhere in particular that you feel more confident or - and also, are there any segments that are starting to maybe show signs of stress from the supposed recession that we're entering?

Jeff Ludwig, CEO

Maybe that we're already in. I think our equipment finance business, I mean, our backlog there is probably as big as it's been, and part of that is driven off of supply chain issues where customers want equipment and the equipment it's not getting to them quite yet. So there's a good backlog. So I do think we'll continue to see good growth in the equipment finance business. I think on the commercial real estate side that will slow as we get to the back part of the year. I do think we've done a nice job growing commercial real estate and just - that is just going to naturally slow. And so I think that's why I see some slowness, and I do see the equipment finance business still doing quite well through the back part of the year.

Damon DelMonte, Analyst

Okay, great. And then just one last question on the loan book, the LendingPoint relationship, could you just remind us what the nature of those customers are and the size of those credits? And any kind of color on that would be great? Thanks.

Jeff Ludwig, CEO

Yes, so it's real similar to our GreenSky program - around that home improvement type of credit with high FICO type of borrowers with credit enhancements similar to our GreenSky portfolio where we have waterfall cash flows and escrow balances. So we feel really good about that credit.

Damon DelMonte, Analyst

Got it, okay. And then just one final question on credit itself, I mean, you noted that in the provision this quarter, you incorporated some softness in the economy. How should we think about provision going forward, something similar to this quarter's level or possibly a little bit higher if the macro trends continue to go in that direction?

Jeff Ludwig, CEO

I believe, like this quarter, I'm optimistic that our charge-offs will start to decrease in the latter part of the year. Even if there is a slight change in the economic outlook, that might be beneficial. However, predicting these factors is challenging. Overall, I expect trends to be similar to what we've seen this quarter.

Damon DelMonte, Analyst

Got it, okay, I'm pulling that. Thanks a lot. Appreciate it.

Jeff Ludwig, CEO

Yes, thanks.

Operator, Operator

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

Terry McEvoy, Analyst

Good morning everyone.

Jeff Ludwig, CEO

Good morning.

Terry McEvoy, Analyst

Maybe just talk about your expectations for deposit growth and whether you think you can fund your future loan growth with more core deposits or do you think you'll have to rely on other sources of borrowings and funding?

Jeff Ludwig, CEO

I believe we've had a really strong year and have been focused on growing deposits from the start. Our Community Bank group has successfully increased deposits by around $280 million this year. While servicing deposits were down at the beginning of the year, which offset some gains, our teams have been very active in their outreach efforts. We've been running retail specials throughout the second quarter and will continue to do so as we head into the latter part of the year to position ourselves well for potential changes in deposit levels. Unlike many banks reporting declines in deposits, we've seen an increase. Although we did acquire a branch which contributed to this growth, even without that, our deposits increased in the quarter, and we've had a solid year overall. We will maintain our focus on deposit growth. Our loan-to-deposit ratio is around 90%, and we need deposits to keep growing. I believe we can achieve further deposit growth in the upcoming months, although various environmental factors may impact this prediction, putting it at around a 60% to 70% certainty. If we struggle to secure enough deposits, we will explore alternative funding sources, which we can manage.

Terry McEvoy, Analyst

Thanks for that, Jeff. Could you remind me of the size of the escrow deposits related to the FHA business? Are those high beta relationships?

Jeff Ludwig, CEO

They have high beta relationships. We likely have around $800 million in servicing deposits with a few different customers. The deposits are quite specific to properties and are linked to Fed funds, which means they tend to fluctuate quickly with changes in Fed funds. This is incorporated in our ALCO model that Eric mentioned, and we expect to see an increase in our net interest margin with a 100 basis point rise in rates, as we've observed in the first half of the year.

Terry McEvoy, Analyst

Okay. Thanks. And then just the last question here. Wealth management, you talked about new leadership. I guess, will there need to be some investments in that business to achieve the results that you're looking for? And you've done some acquisitions over the years within that area. Is that something that you're evaluating as well?

Jeff Ludwig, CEO

Yes. The acquisition aspect is currently somewhat limited in our plans. To draw a parallel, this is similar to our commercial banking situation from two years ago, where our main focus should be on strengthening our sales and business development teams, reinvigorating our staff with fresh leadership, and proving both to ourselves and to others that we can achieve higher organic growth without the distractions that come with mergers and acquisitions. If we are successful in this endeavor over the next couple of years, I believe we could revisit the possibility of acquiring firms in the wealth management sector.

Terry McEvoy, Analyst

Great. Appreciate that. Have a nice weekend, guys.

Jeff Ludwig, CEO

Yes, thanks.

Operator, Operator

Thank you. We have a question from Nathan Race of Piper Sandler. Your line is open.

Nathan Race, Analyst

Hi guys. Good morning.

Jeff Ludwig, CEO

Good morning.

Nathan Race, Analyst

A question on the balance sheet mix going forward. You guys continue to rotate out securities and redeploy excess liquidity on the balance sheet into loans. Is that dynamic going to continue over the next couple of quarters? And does that kind of imply like kind of a flattering asset base from here depending on deposit flows? Or how are you guys kind of thinking about what's the right level of kind of cash on the balance sheet to operate with going forward at this point?

Jeff Ludwig, CEO

My view is that it will not be significantly different from what is currently on the balance sheet. I expect the investment portfolio to remain relatively unchanged, possibly seeing slight decreases or increases, and the same applies to cash. Therefore, I don't anticipate much further reshuffling.

Nathan Race, Analyst

Okay. Got it. And then you guys also had nice growth in card revenue and deposit service charges versus the first quarter. And I know a lot of that's a function of some of the technology and analytics and CRM initiatives that you guys have undertaken over the last several quarters now. Is that growth kind of sustainable in the back half of this year in terms of what we saw here in the second quarter? Or is it kind of flat line from here maybe due to some seasonality in a couple of those items during the second quarter?

Jeff Ludwig, CEO

We are heavily focused on enhancing our retail efforts to ensure customers have access to cards and to promote the use of debit cards instead of credit cards in our marketing and customer interactions. I believe the trend is looking positive. There's always some seasonality to consider, especially as spring arrives and more people are out spending. Although the third quarter typically shows good activity with back-to-school spending, it's challenging to predict whether the growth will continue at the same pace.

Nathan Race, Analyst

Sure. I would like to ask about the trends in criticized and classified loans for the quarter, excluding the one commercial real estate loan you mentioned where you don't anticipate a loss. Can you also share what you're hearing from commercial clients regarding their sentiment, liquidity, and the overall characteristics of your client base at this time?

Jeff Ludwig, CEO

Yes. Nonperformers increased slightly this quarter, but our substandard capital ratio decreased, which is a positive indicator. Our delinquency rate this quarter has been the lowest in the past five quarters, and we are not receiving requests from customers for assistance with their loans at this time. Overall, things are looking stable, and currently, we are not observing any pressing credit concerns.

Nathan Race, Analyst

Got it. That's great to hear. I appreciate you guys taking the questions. And congrats on the great quarter. Thank you.

Jeff Ludwig, CEO

Thanks, Nate.

Operator, Operator

Thank you. And we have a follow-up from Manuel Navas of D.A. Davidson. Your line is open.

Manuel Navas, Analyst

Sorry about that. Can you hear me now?

Jeff Ludwig, CEO

Yes.

Operator, Operator

Loud and clear.

Manuel Navas, Analyst

Thank you. Jeff, my question relates to the overall strategy for enhancing your franchise value and your expansion into St. Louis. What steps are you taking to make the St. Louis market an appealing area for growth for the company?

Jeff Ludwig, CEO

Back in 2014, we acquired a bank in St. Louis, marking our entry into the market for eight years now. Initially, it wasn't a primary focus as we transitioned to being public and directed our energy towards a couple of other acquisitions. However, in early 2019, we strategically decided to commit to St. Louis. We recognized it as a valuable market that required more leadership attention and team building to fully capitalize on the opportunities available. About 18 months ago, we made a leadership change in the market, and we brought on additional bankers and personnel for treasury management and deposit gathering. Similar to what we are experiencing across our entire footprint, our sales efforts and pipeline management have started to yield positive results in St. Louis. This market presents significant opportunities, and we are successfully gaining traction there, which is encouraging to see.

Manuel Navas, Analyst

Thank you for the follow-up. Appreciate it. And have a great weekend.

Jeff Ludwig, CEO

Yes, thanks.

Operator, Operator

Thank you. And I see that the Q&A session has ended. I would now like to turn the conference back to management for closing remarks.

Jeff Ludwig, CEO

Yes. Thanks, everybody, for joining today and look forward to seeing everybody in the third quarter. Have a good weekend.

Operator, Operator

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