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Midland States Bancorp, Inc.  (NASDAQ:MSBI)
Q4 2018 Earnings Conference Call
Jan. 25, 2019, 8:30 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day ladies and gentlemen and welcome to the Fourth Quarter 2018 Midland States Bancorp Inc., Earnings Conference Call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. (Operator Instructions) And as a reminder this conference call is being recorded.

I would now like to introduce your host for today's conference Mr. Tony Rossi. Mr. Rossi you may begin.

Tony Rossi -- Senior Vice President

(Technical Difficulty) Chief Executive Officer; and Steve Erickson, 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 webcast and presentations page of Midland's Investor Relations website to download a copy of the presentation. The management team will discuss the fourth quarter results and then we'll open up the call to questions.

Before we begin I'd like to remind you that this conference call contains forward-looking statements with respect to the future performance and financial condition of Midland States Bancorp that involve risks and uncertainties. Various factors could cause actual results to be materially different from any future results expressed or implied by such forward-looking statements. These factors are discussed in the company's SEC filings which are available on the company's website. The company disclaims any obligation to update any forward-looking statements made during the call.

Additionally management may refer to 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 G. Ludwig -- President and Chief Executive Officer

Good morning everyone. Welcome to the Midland States earnings call. Before we review the fourth quarter results, I want to first thank Leon Holschbach, who retired as the CEO of Midland at the end of 2018, following more than a decade of service to the company. It was a great experience to work side-by-side with Leon, as we built Midland into one of the largest community banks in Illinois. We spent a great deal of time together developing our strategy and ensuring we have the management team to execute it. I'm very proud to step into the role of CEO and lead Midland through its next phase of growth.

Now turning to the quarter. Slide three summarizes the highlights of the fourth quarter, which reflects solid execution of the strategies we have outlined for creating shareholder value. We generated $0.67 in earnings per share, up from $0.64 on an adjusted basis in the prior quarter. Having successfully completed the integration of Alpine, we are seeing the synergies that we projected for this transaction, and delivering a higher level of earnings and profitability.

For the fourth quarter, we generated a return on average assets of 1.14% and a return on average tangible common equity of 16.4%. Importantly with our higher earnings power, our internal capital generation has improved, and we are seeing significant increases in all of our capital ratios, which was a key priority following the closing of the Alpine acquisition. Our strong financial performance also increased our tangible book value per share by nearly 4% in the fourth quarter.

Our balance sheet and revenue generation largely reflect a continuation of the trends we experienced over the past few quarters. We continue to see strength in commercial lending, driven largely by our equipment finance group as well as consumer lending. The growth in these two portfolios which generate more attractive risk adjusted yields is helping to offset the decline in our commercial real estate portfolio, where we are seeing consistent payoffs due to our unwillingness to match the aggressive rates and terms being offered in the market. The disciplined approach to new loan production is helping us to manage the pressure on our net interest margin from rising deposit costs.

Our average rate on new and renewed loans increased 34 basis points to 5.83% from the prior quarter. The resulting positive impact on our average loan yields helped drive a 5 basis point increase in our net interest margin, excluding the impact of accretion income. We are also seeing strong consistent generation of noninterest income, which accounted for 30% of our total revenue in the fourth quarter.

Our wealth management business continues to be the largest single contributor to our noninterest income, while our commercial FHA group produced a solid quarter and continues to perform well following the adjustments we made in the business midway through 2018.

Now I'm going to turn the call over to Steve to walk through more details on the financial performance. Steve?

Stephen A. Erickson -- Chief Financial Officer

Thank you Jeff. I'm going to start with our loan portfolio on slide four. Our total loans outstanding declined $18.7 million from the end of the prior quarter. This was primarily due to declines in portfolios we are deemphasizing due to the less attractive risk adjusted yields in the current environment, most notably commercial and residential real estate. This was partially offset by growth in our commercial loan and leases and consumer lending areas.

Our equipment financing group continues to perform well and our total outstanding balances increased by $64.7 million or 20.8% from the end of the prior quarter. For the full year in 2018, this portfolio was up $170.4 million or 82.9%. The fourth quarter tends to be seasonally strong in the equipment financing business, so we do expect to see a lower level of production in the first quarter. Our organic loan growth in 2018 was 3.9%, which was in line with the mid-single-digit range that we had expected.

Turning to deposits on slide five. Total deposits were $4.07 billion at the end of the fourth quarter, a decline of approximately $69 million from the end of the prior quarter. The declines were primarily seen in broker deposits, noninterest-bearing demand deposits and checking accounts. Outside of the intentional run-off for the brokered deposits, the declines in the other areas were primarily related to outflows of public funds and normal fluctuations in servicing deposits.

Turning to wealth management on slide six. At the end of the quarter, our assets under administration were $2.95 billion, down approximately $272.9 million from the end of the prior quarter. The decline was primarily attributable to market performance. Despite the decline in AUA, wealth management revenue increased from the prior quarter to $5.7 million, primarily driven by a higher level of revenue generated from estate fees. On a year-over-year basis, our wealth management revenue increased 57.5%.

Turning to our net interest income and net interest margin on slide seven. Our net interest income increased by 7.7% from the third quarter. Excluding accretion income, net interest income increased $0.9 million from the prior quarter. This is primarily the results of a 5 basis point increase in our net interest margin, excluding the accretion income. With the impact to repricing in our loan portfolio in higher rates on new and renewed loans, the increase in our average loan yields more than offset the increase in our cost of funds during the fourth quarter. Although we saw some expansion in the fourth quarter, we continue to expect our net interest margin to be relatively flat going forward, excluding the impact of accretion income.

In terms of our scheduled accretion income which does not include the impact of prepayments on acquired loans, we are expecting $2.3 million in the first quarter of 2019, and a total of $8.1 million for the full year.

Moving to our noninterest income on slide eight. Our total noninterest income increased 15.9% from the prior quarter. The increase was attributable to higher levels of revenue across most of our fee generating areas, including Wealth Management, Commercial FHA and community banking fees, which includes service charges on deposits and interchange revenue. Included in our Commercial FHA revenue this quarter was a $1.4 million recapture of mortgage servicing rights impairment. The one area where we didn't see growth was in residential mortgage banking revenue. This was relatively consistent with the prior quarter and reflects both seasonality in this business, and lower overall demand, due to higher mortgage rates.

Looking ahead to the first quarter, we anticipate that the government shutdown will have an impact on revenue in our Commercial FHA business. There are no new HUD approvals being issued during the government shutdown, and borrowers are reluctant for lock the interest rates, due to exposure to extension fees associated with holding the rate lock. There is also a backlog, that will be need to be worked through once HUD -- through HUD, but once the shutdown is over. Depending upon how long the shutdown lasts and how large the backlog becomes, we could see an impact on Commercial FHA revenue into the second quarter.

Turning to expenses and efficiency ratio on slide nine. We incurred $0.6 million in the integration and acquisition expense in the fourth quarter. Excluding integration and acquisition expense, as well as the loss in mortgage servicing rights that we recorded last quarter, our noninterest expense increased by 10.7% on a linked-quarter basis. The increase is primarily due to higher variable compensation. As a result of the higher expense levels, our efficiency ratio increased to 65.5% from 63%. Using a more normalized assumption for the level of variable compensation, we expect that our quarterly run rate for operating expenses in 2019 will be in the $42 million to $43 million range.

Moving to slide 10. We'll look at our asset quality. Our nonperforming loans increased by $4.3 million, which was primarily attributable to three commercial real estate loans. We had a 21 basis points of net charge-offs in the quarter, while for the full year of 2018 our net charge-offs were 13 basis points. We recorded a provision for loan losses of $3.5 million, which exceeded our net charge-offs in the quarter. The provision increased our loans to 51 basis points of total loans as of December 31st and our credit marks accounted for another 53 basis points.

With that, I'll turn the call back over to Jeff. Jeff?

Jeffrey G. Ludwig -- President and Chief Executive Officer

Thanks Steve. We'll wrap up on slide 11 with some comments on our outlook. As we begin 2019, we intend to remain consistent with the balance sheet management and fee income generation strategies that we employed throughout 2018. We continue to expect low-to-mid single digit loan growth, primarily driven by growth in our commercial and consumer portfolios. We will continue to be disciplined in our loan pricing, so that we can offset the increases we are seeing in deposit costs and continue to protect our net interest margin. We also remain open to transactions that we believe can enhance the value of our franchise, with our focus more on smaller, tuck-in acquisitions in the near term.

Over the past two years, we have employed our acquisition strategy to gain scale, expand our geographic presence within Illinois, and build our wealth management business. In the process, we have nearly doubled the size of the company and tripled our wealth management business since our IPO. While we have achieved the cost savings projected for all of our transactions, the integration of these acquisitions required a great deal of time and attention on the part of the entire company.

Accordingly, one of our top priorities in 2019 is taking a thorough look at the entire organization and making sure that we are harvesting all the synergies that we now have available to us as a nearly $6 billion institution. We are highly focused on continuing to enhance efficiencies and realizing more operating leverage in the business. We believe that the combination of prudent balance sheet growth, consistent fee income generation, a stable net interest margin and approved operating efficiency can deliver a solid year of earnings growth for our shareholders and position us well to continue enhancing the value of our franchise in the years ahead.

With that, we'll be happy to answer any questions you may have. Operator, please open the call.

Questions and Answers:

Operator

Thank you. (Operator Instructions) Our first question comes from Michael Perito from KBW. Your line is now open.

Michael Perito -- Keefe, Bruyette & Woods -- Analyst

Hi. Good morning guys.

Jeffrey G. Ludwig -- President and Chief Executive Officer

Good morning Mike.

Michael Perito -- Keefe, Bruyette & Woods -- Analyst

A few questions from me. I want to start maybe just on the Commercial FHA, I mean, can you just maybe give us a little bit more color about the shutdown. I mean, revenues are going to be like close to zero in the first quarter or is there like left over from the fourth. I'm just trying to get a better sense of what the magnitude of that should be?

Jeffrey G. Ludwig -- President and Chief Executive Officer

Yes. So we have servicing revenue that is in the FHA revenue line. So there'll be revenue there. But at this point, we are not able to rate lock loans or the rate locking of a loan generates the revenue, and we do have some borrowers that are at the point of rate locking, which they're hesitant to do that with the shutdown, because they can't then get the loan closed because HUD isn't open. And then we're not getting any more HUD approvals to get to the rate lock stage because HUD is closed. So it's all going to depend on -- if they can open the government in the next couple weeks, we can still generate some revenue this quarter. If the government shutdown is the whole quarter, it's going to be a tough quarter.

Michael Perito -- Keefe, Bruyette & Woods -- Analyst

And how does that impact the full year for that business? I mean when you say a backlog with HUD, I mean will that take them -- I mean, it's government basically right. So I mean will that take them a lot of time to work through. I don't know if there's been any precedence for this in the past in this business. But I -- this -- is the revenues annually get pushed out as well? Or is it really just a timing issue on a quarterly basis?

Jeffrey G. Ludwig -- President and Chief Executive Officer

We believe at this point it's a timing issue. So we're going to have revenue pushed to the second quarter, and probably some push to the third quarter. But full year we would still expect the full year to kind of be in the range we've talked about in previous calls that $3 million to $5 million per quarter, but could be a little higher in the out quarters as that backlog comes out. And we might see a little more volume in one of the the quarters either the second or third quarter.

Michael Perito -- Keefe, Bruyette & Woods -- Analyst

Helpful. Thank you. And then, on the expenses the $42 million to $43 million run rate, does that incorporate some level of action on the efficiency side that you were alluding to in your comments Jeff or is that kind of a base case? And you're hopeful of that, there's a chance maybe you guys can find efficiencies that will bring you either to the lower end or slightly below that that range next year?

Jeffrey G. Ludwig -- President and Chief Executive Officer

Yes. I think that's our base case right now. And as I said in my comments we're reviewing lots of things in the company today to find opportunities to find efficiencies and improve productivity.

Michael Perito -- Keefe, Bruyette & Woods -- Analyst

Okay. And then just lastly on the residential mortgage platform, any initial thoughts on next year? Any other, I guess tweaking on the expense side that can or needs to be done to try and help the profitability of that business. I mean do you think you're at a point now where $6 million annually give or take is a fair production goal from a revenue perspective for that business. Just obviously, it continues to be a little tough fight in there. Just curious, what your thoughts are heading into 2019?

Jeffrey G. Ludwig -- President and Chief Executive Officer

Yes. I mean I think that's a fair probably revenue line. We've got -- we have some work to do to get to the $6 million number. I think we're -- the last couple of quarters we've been right around $1 million, but those were two quarters that are typically the lower seasonal quarters. So we'd hope to see a little lift in the middle two quarters. So, I think that's right. We've made the cost adjustments that we've needed to make in that business and have done that in previous quarters. So I think, we feel that we're in a good operating position today. And now it's how can we drive some more revenue.

Michael Perito -- Keefe, Bruyette & Woods -- Analyst

Got it. Helpful. Thank you guys for taking my questions and for the color. I appreciate it.

Jeffrey G. Ludwig -- President and Chief Executive Officer

Yes. Thanks, Mike.

Operator

Thank you. And our next question comes from Andrew Liesch from Sandler O'Neill. Your line is now open.

Andrew Liesch -- Sandler O'Neill -- Analyst

Good morning guys.

Jeffrey G. Ludwig -- President and Chief Executive Officer

Good morning, Andrew.

Stephen A. Erickson -- Chief Financial Officer

Good morning, Andrew.

Andrew Liesch -- Sandler O'Neill -- Analyst

Just some questions around the margin here. It's certainly nice to see the core expansion. And just given your comments about adding the consumer loans, adding the leases and certainly higher yielding with and coming on and replacing some other portfolios that are maybe lower yielding that are paying down. And why shouldn't some modest margin expansion increase our recognized funding costs arising as well. But it seems like you have tailwind or mix shift going here that should help support more margin expansion?

Jeffrey G. Ludwig -- President and Chief Executive Officer

Yes. Andrew I would think, again it's a good point. The problem is we just don't know and we're not ready to say right now, what exactly we'll have to do on the deposit side in order to be defensive and hold on to deposits, versus how much upside we do have with our new and renewed continuing to increase quarter-over-quarter. And so that's really where the rub is for us and that's why we're calling it flat going forward. We may have a few quarters where we have to be a little more aggressive on the deposit side, and we may see a couple of basis points drop. We just don't know at this point.

Andrew Liesch -- Sandler O'Neill -- Analyst

Okay. And then I think in the presentation you guys referenced maybe like some like infill or like some -- maybe some small deals just to kind of fill in and pointing up right now to see what the exact phrasing you used is like tuck-in opportunities. What do you mean by that and what's an example of something that you're talking about there?

Jeffrey G. Ludwig -- President and Chief Executive Officer

Yes. So I think what we're saying there is that we're going to look for -- if we're going to look at acquisitions what we're going to look at right now would be smaller acquisitions that are in market. So tuck-in equals end market kind of acquisitions. We're not looking to go to a new market, and if we could find some smaller banks end-markets we'd be looking to -- we would look at those types of opportunities. I guess we're not going to be doing in the near term is looking at bigger acquisition opportunities kind of like an Alpine. The $1 billion acquisition we're not interested in that today, given the internal work we're working on, we'll focus more on smaller kind of end market acquisition opportunities.

Andrew Liesch -- Sandler O'Neill -- Analyst

Okay. That's really helpful. Thank you.

Jeffrey G. Ludwig -- President and Chief Executive Officer

Yes.

Operator

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

Terry McEvoy -- Stephens Inc -- Analyst

Good morning guys.

Jeffrey G. Ludwig -- President and Chief Executive Officer

Good morning.

Stephen A. Erickson -- Chief Financial Officer

Good morning.

Terry McEvoy -- Stephens Inc -- Analyst

Just circling back to the Commercial FHA. Are there any expense offsets if we -- if the shutdown continues longer than expected or into the second quarter?

Jeffrey G. Ludwig -- President and Chief Executive Officer

There's a little -- there's some variable comp, but we've made -- we've made adjustments in the business on the expense side to get that business, I think in a really good spot from operating leverage point of view going forward. So there's a little bit, but not a lot.

Terry McEvoy -- Stephens Inc -- Analyst

Okay. And then, what are the advantages of operating this business as a bank is to utilize your balance sheet. What about bridge lending and anything that you can use your balance sheet for your customers on the FHA side to get them through this -- the shutdown period before the backlog works through, and they can move forward with the deal that they're looking at?

Jeffrey G. Ludwig -- President and Chief Executive Officer

Yes. So we've -- our bridge program, we continue to have our bridge program. We've seen a lot of good opportunities in the last three to six months. I think bridge is probably pushing a $200 million on balance sheet today. So we've seen some really nice traction in that business. A lot of it's kind of on the construction side. So you don't -- we're not seeing a lot of balance sheet movement quite yet. But as those projects get under way, we'll start to see some balance sheet growth. I think we saw -- what Steve, $40 million growth in that portfolio in the quarter?

Stephen A. Erickson -- Chief Financial Officer

$33 million.

Jeffrey G. Ludwig -- President and Chief Executive Officer

Yes. So we're seeing some growth there and I -- and that is something we can talk to customers about with the shutdown if they need to get bridged even for six months or three months or for short periods of time, we can do that.

Terry McEvoy -- Stephens Inc -- Analyst

Okay. And then just the last question on the three CRE loans that were referenced in the press release. Anything in common between those three, I know -- I believe in the fourth quarter of last year there was a increase in charge-offs for similar loans. Could you just give us some background what actions you've taken and ultimately do you think you've captured the potential losses in the reserve build this past quarter?

Stephen A. Erickson -- Chief Financial Officer

Yes. One of the things that we keep looking at and if you look at that -- the two tables on that page in the presentation, and you've got your charge-offs there, clearly not following the same pattern as the increase in the non-performing. Most of these are longer term projects to us. There are things that we are going to continue to work through, while there's nothing really similar between the previous quarter other than they are all CRE. I think it is important to note that two of them are TDRs at this point and are still accruing.

Yes, they're in non-performing, but they are still accruing at this point. We've made adjustments to have those continue to perform. So they're not similar to each other other than they are CRE.

Terry McEvoy -- Stephens Inc -- Analyst

Okay. Thank you.

Operator

(Operator Instructions) And our next question comes from Kevin Reevey from D.A. Davidson. Your line is now open.

Kevin Reevey -- D.A. Davidson & Co. -- Analyst

Good morning.

Jeffrey G. Ludwig -- President and Chief Executive Officer

Good morning Kevin.

Stephen A. Erickson -- Chief Financial Officer

Good morning Kevin.

Kevin Reevey -- D.A. Davidson & Co. -- Analyst

Can you give us some color on the type of revenue synergies that you're seeing from Alpine, now that it's -- it's fully integrated into your franchise?

Stephen A. Erickson -- Chief Financial Officer

I would think -- this is Steve, I think the biggest one if you look at their portfolio of clients, it was very much retail focused relative to the rest of our bank and really grew our retail portfolio of accounts. And so, if you look at interchange revenue and banking fees, particularly in the seasonally high fourth quarter, they contributed significantly to the noninterest income from that point of view. Jeff do you have any other kind of --

Jeffrey G. Ludwig -- President and Chief Executive Officer

No. I mean they had a nice wealth business that integrated nicely into ours, and they had done a nice job of expanding wealth through their commercial base. So they've done a nice job there. And I think the other synergy that was there is the deposits and the extra liquidity they had on their balance sheet. We've -- we've since absorbed that liquidity and put that money to work. So, we've seen some on the revenue side. That's where some of the synergies would be.

Kevin Reevey -- D.A. Davidson & Co. -- Analyst

And then on the loan yields, obviously your loan yields were up. It sounds like it was mostly due to newer yields being booked at higher rates. Was there anything unusual also that increased the loan yields in the quarter? Were there any interest recoveries or the like?

Stephen A. Erickson -- Chief Financial Officer

No, there was nothing else significant. There was -- it was just that -- the repricing of existing portfolio plus new and renewed. Nothing one-time or unusual items.

Kevin Reevey -- D.A. Davidson & Co. -- Analyst

And then, lastly on the wealth management side while your trust AUM was down, which was to be expected given the market performance. Were there any significant business wins that might have muted the growth, given the market performance?

Jeffrey G. Ludwig -- President and Chief Executive Officer

I don't think there's any outsized winning of clients that happened in the quarter that might -- I mean, we have continued to win clients. So that decreased in AUM was primarily a result of the market downdraft. But we continue to to win clients and build assets. But the primary drop was due to market conditions.

Kevin Reevey -- D.A. Davidson & Co. -- Analyst

Excellent. Thank you very much.

Operator

We do have a follow-up question from Terry McEvoy from Stephens. Your line is now open.

Terry McEvoy -- Stephens Inc -- Analyst

Just two modeling questions. The bully game that was referenced in the press release, is that about $900,000. And if so what's the kind of more normal run rate for that line?

Stephen A. Erickson -- Chief Financial Officer

That was $700,000 instead of $900,000 for that (inaudible). And as far as modeling is concerned, bully is not a line item that we expect any significant changes on a quarterly basis.

Jeffrey G. Ludwig -- President and Chief Executive Officer

Yes, we wouldn't expect that to reoccur.

Stephen A. Erickson -- Chief Financial Officer

Yes, that is a non-recurring item.

Terry McEvoy -- Stephens Inc -- Analyst

Yes. Okay. And then --

Jeffrey G. Ludwig -- President and Chief Executive Officer

It will reappear periodically over time.

Terry McEvoy -- Stephens Inc -- Analyst

Yes, unfortunately.

Jeffrey G. Ludwig -- President and Chief Executive Officer

Yes.

Terry McEvoy -- Stephens Inc -- Analyst

Understood. And then just the last question. Do you expect to fund your long growth with core deposits and as I just look at that page number five, deposits have been trending lower. So I guess my question is how do you fund loan growth and can you fully do so kind of in-market with your traditional deposits?

Stephen A. Erickson -- Chief Financial Officer

I mean that does obviously that is our challenge right, there is a 102% loan-to-deposit, as we continue to look at growth we need to balance our growth on the asset side with our ability to generate deposits at a reasonable cost of funds to maintain that margin, right. That is our challenge going forward through the next year. And so our focus is very squarely on deposit generation in our markets in order to support the growth that we have planned for the next 12 to 18 months.

Terry McEvoy -- Stephens Inc -- Analyst

Got it. Thanks again.

Operator

And I'm not showing any further questions at this time. I would now like to turn the call back over to management for any further remarks.

Jeffrey G. Ludwig -- President and Chief Executive Officer

Thank you. I'd like to thank everyone for joining the call today and we'll talk next quarter. Thanks.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program and you may all disconnect. Everyone have a wonderful day.

Duration: 30 minutes

Call participants:

Tony Rossi -- Senior Vice President

Jeffrey G. Ludwig -- President and Chief Executive Officer

Stephen A. Erickson -- Chief Financial Officer

Michael Perito -- Keefe, Bruyette & Woods -- Analyst

Andrew Liesch -- Sandler O'Neill -- Analyst

Terry McEvoy -- Stephens Inc -- Analyst

Kevin Reevey -- D.A. Davidson & Co. -- Analyst

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