Good day, and welcome to the MidWestOne Financial Group, Inc. Third Quarter 2018 Earnings Conference Call. [Operator Instructions]. Please note, this event is being recorded. I would now like to turn the conference over to Charles Funk, President and CEO. Please go ahead..

Thank you very much, Gary, and good morning or good afternoon to everyone, and thank you for being on the call today. Let's begin with the forward-looking statements message. This presentation contains forward-looking statements relating to the financial condition, results of operations and business of MidWestOne Financial Group.

Forward-looking statements generally include words such as believes, expects, anticipates and other similar expression. Actual results could differ materially from those indicated.

Among the important factors that could cause actual results to differ materially are interest rates, changes in the mix of the company's business, competitive pressures, general economic conditions, and the risk factors detailed in the company's periodic reports and registration statements filed with the SEC.

MOFG undertakes no obligation to publicly revise or update these forward-looking statements to reflect events or circumstances after the date of this presentation. And with that, to make a few comments to begin the call, this was a quarter with a lot of noise, certainly in the income statement and nonrecurring items.

We recognized the sale on our South St. Paul Minnesota office. We recognized a onetime severance payment or compensation-related payment, and there were merger-related expenses from our ATBancorp transaction that are also in there.

And also we did take advantage of the strong bid in the municipal bond market and sold some very short-term municipal's and took a small gain in the quarter as well. And just interesting to note that the bid we got was through the treasury curve, so we thought that was the right thing to do.

I think our fundamentals, the fundamentals of the company are fine, and I will articulate those more on this call. And as we - I think we've previewed on the last quarterly call, we closed a lot of loans at the end of the second quarter and we expected slightly slower loan growth this quarter.

We think it would be better in the fourth quarter, our pipeline seems to be reasonable, and I think, as far as guidance, we would guide you to, right at the 5% mark, in terms of loan growth this year, which is right in the middle of the 4% to 6% range that we've talked about all year.

Of note, in the - in our loan portfolio, Denver is still a strong market. I will say the Iowa City market is better for us than it has been for several quarters and the Twin Cities continues to show decent loan demand. Like many of our peers and competitors around the country, deposits are tough to come by.

I think we've had nice inflows, as I referenced in the earnings release, over the past 30 days, and we do have a decent pipeline of deposits ready to go. There's probably some seasonality to that.

We certainly saw our balances grow in the fourth quarter last year, but certainly, at this point in time, the needle is pointed in the right direction on deposits. Loan pricing has improved a little bit. It's probably not where it should be, but I would say in the last 30 to 45 days, loan pricing seems to be a little bit better.

Deposit competition is everywhere and that is as it has been for the last 18 months-or-so. In terms of the income statement, we did talk about this in the earnings release. The net interest income was hurt by less accretion income than the prior quarter. And also, we charged-off $310,000 in interest income. Again, disclosed in the earnings release.

We figure that the core net interest margin narrowed by 2 basis points from the prior quarter.

How we get there is the accretion - the less accretion income costs us about 3 basis points and the charge-off of the interest income was about 4 basis points, and then as you round everything up, it comes up to about 2 basis points, which I think is pretty much what we've guided to, and I don't think we see any change.

We think there continues to be pressure on the core net interest margin, with a couple of basis points a quarter, it could be 1, it could be 3, but that's sort of what we've been running in the core margin for the last several quarters. For those who are interested in deposit data, I've got all kinds of numbers for you.

The cost of total deposits was up 8 basis points in the quarter. Interest-bearing deposits was 10 basis points and our overall cost of funds was up 9 basis points, pretty much about what we expected. So again, our guidance on the core margin would be as it has been, slightly narrower, with the emphasis on slightly, over time.

I don't have a lot of comment this quarter on the noninterest income.

I might just mention that, you see our mortgage top line revenues are down, which is an industry phenomenon, but we have increased our servicing income over the year as interest rates have risen, and we've done a nice job in our mortgage unit, perhaps unlike prior years of reducing expenses.

So the bottom line contribution from our mortgage unit is actually higher than it has been in prior quarters and years, and that is a definite step in the right direction for our company.

On noninterest expense, I would be the first to acknowledge, we have some fine-tuning to do on the salaries and benefits run rate, and we are in the process of reviewing that. As we get into the budget for 2019, we do that knowing that the core efficiency ratio needs to head back below 60%.

We won't get there overnight, but there is a commitment in our company to do that. And I would remind longtime followers of our company that in the 2011 or '12 to 2015 time frame, we ran in the mid-50%s in efficiency ratio. I don't know if we'll get back to the mid-50%s, but there's no doubt that we could get back to a 5 handle.

So there is a focus and a commitment to do that. It won't happen overnight, but we will get there. I imagine many people will be interested in asset quality, and specifically ag. I would say, as disclosed in the earnings release, our MPAs were up, but the good news is that those loans had been properly reserved for and identified in prior periods.

The conditions of the individual borrowers worsened somewhat during the last couple of quarters, so we've put those loans on nonaccrual, but it's fair to say that we did not see any surprises in new loans come on that we hadn't identified. These are all loans that had been identified in the past.

Specifically, to talk about ag, a lot to talk about in ag. It's been a very good crop year in most of our footprint. The yields on the soybeans and corn are slightly below last year in most of our footprint, but certainly well above average.

So the fact that we have above average yields is a positive, but of course, that does not offset the lower prices on corn and soybeans. The government subsidies will help marginally individual borrowers, so I think the message is much like it has been in prior quarters.

Producers who sold forward in June at much higher soybean and/or corn prices, should fare okay in this growing season. Those who didn't or who didn't sell enough of their production, will struggle with cash flow and the ability to clean up operating lines. So generally, our collateral values are still good.

They're narrower than they were a year ago, they're narrower than they were two years ago but, in most cases, they're still good. Land prices remains stable, which is an interesting phenomenon to many of us. But in most parts of the state of Iowa, land prices are within a 3% range of a year ago.

So there are probably going to be some tough conversations with some borrowers this fall and early winter. I think we'll get through this, and we just have to continue to be willing to have those tough conversations. But again, the message is as it has been. Maybe to zoom out just a little bit and give you a little bit of longer-term perspective.

And if you write these things down, they will be - it will be readily apparent what's going on in our ag portfolio. At December 31, 2017, we had $36 million in watch and substandard loans in our ag portfolio. At September 30, 2018, we had $41 million. So an increase of slightly over 10%.

However, when you divide up the watch and the substandard, you see what's really happening in the ag portfolio. Of the $36 million at the end of 2017, we had $32 million that was watch, and we had $4 million that was substandard.

The $41 million at 9/30/18, we have $24.5 million that are watch and $16.5 million that are substandard, and I think that right there would illustrate the erosion and the poor cash flows that our borrowers are seeing.

I continue to think that we will have few charge-offs in this portfolio so long as we manage it properly, and I also think we're reserved properly. And I would remind everyone that we remain at about just under 150% of reserve for our nonperforming assets as of quarter end.

Elsewhere, in terms of credit quality, we're certainly - have become more cautious on nonowner occupied, and we're near our self-imposed house limit, but we are still making, selectively, nonowner occupied commercial real estate loans and we're trying to do that with stronger borrowers or borrowers that bring more on the table, i.e. deposits.

We just need to make sure that we keep the pricing as it should be. In terms of construction and development loans, we still have a few projects that are funding, and that we'll continue to expand that book and those continue to be to our biggest and to our strongest borrowers.

Vis-à-vis regulatory guidelines, we are at commercial real estate in the 240% to 250% range as a percentage of the capital. And in terms of our construction land and development, we're in the 60% to 65% range, so well within regulatory guidelines.

And again, I would repeat that the commercial development loans are to our largest and strongest borrowers. So the commercial real estate book continues to be clean. Very few past dues in that book. And finally, in terms of credit, I would say that you might have noticed that our provision continues to come down.

It was at $900,000 this past quarter, our prior guidance had been at $1,250,000 per quarter, so I'd say the new guidance is probably in the $900,000 range, give or take, and I think the needle probably is pointed lower, but we'll see. Certainly, a good trend in that part of our company's income statement.

We will have a onetime gain on the sale of a building in the fourth quarter, an Iowa city building. That gain will probably be in the $800,000 to $900,000 range, give or take, so that will be in the fourth quarter, if everything goes off as planned. And then, to conclude my part of the commentary, just a word or two on the ATBancorp transaction.

I would say that we are pretty much on target there on that transaction. I would say that we have seen excellent cooperation from our Dubuque counterparts, and it's as good as we've experienced since I've been in the company, in terms of cooperation from another party. I think our estimates on cost saves are still accurate.

They may move around a little bit between 2019 and 2020, depending on the close, and we will give more guidance on that in next quarter's earnings conference call. But in terms of the aggregate amount of cost saves, I think we're right on target, perhaps could exceed them, but I'll leave it now as right on target.

We hope to close the transaction on February 1. That's not written in ink yet, because that assumes the sale of the American Trust Retirement business, and that's still in process right now.

So again, this is our third large deal in the last 10 or 11 years, and so far, I would say it's been the smoothest and we continue to expect that, and that's because of the outstanding cooperation we've received from Dubuque. So in summary, I would say that I think our fourth quarter will be better from a revenue standpoint than the third quarter.

I reiterate cautious optimism on credits, and that's even on the ag space, and especially in terms of identification and resolution. So we'll leave that with those comments.

And again, we'll reiterate that we are - we do intend to focus on efficiency as we go through the budget process for 2019, with the idea that we need to get back to a quarterly run rate of under 60 sometime in 2019. And with that, Gary, I will send it back to you. We would be happy to answer questions.

I should say, in the room to answer questions, are Chief Credit Officer, Gary Sims; our Chief Financial Officer, Barry Ray; our Chief Investment Officer, Jim Cantrell; and our Chief Operating Officer, Kevin Kramer..

[Operator Instructions]. The first question comes from Jeff Rulis with D.A. Davidson..

Good morning, and we can barely hear you, Jeff..

Okay.

Any better there?.

Much better. Thank you..

I guess, on the - first on, just expenses. Obviously, someone-timers in there. You backed those out. This quarter would be kind of the low- to mid-$21 million.

Is that a good - knowing that the merger coming on early next year, but just trying to get a baseline of - and taking into your accounts, Charlie, the comments on improving efficiency, but is that a level that is a good starting point? And then, to use relative to - as we roll into Q4?.

Jeff, this is Barry. I think that's a good number to use. If you back out the orders that we disclosed as one time, then I think that gets you to a good run rate to use going forward..

And Charlie, maybe - or on credit. Just the nonaccruals added. I mean, it sounds ag related, but if you could provide a little more color on it sounded like identified credits that just - that shifted into - both into nonaccruals, but then, kind of the other buckets, if you could discuss the OREO..

Yes. They were - again, they were already identified and reserved for and there was one large ag credit, and I'll let Gary speak more, but there were also a couple of commercial credits..

Right. One large ag credit that, as we have said, really deteriorated in the first couple of quarters of 2018, and then, recognized a nonaccrual, it continued to deteriorate in the third quarter and then two C&I credits, again, that had already been identified in the first half of the year..

Okay.

And the buckets of - what was the piece that was nonaccrual? And the other, that's OREO?.

We didn't have any of those moved to OREO..

Okay. Fair enough. Got it. And then I just - Charlie, I wanted to - on the margin, the math there. I guess, if you - the accretion impact in charge-off. I guess, we're getting to a core of 3.63% versus 3.65% last quarter. Is that....

Jim?.

Jeff, this is Jim. I can talk a little bit about margin. I think you're right, if you do the math. If you want to look at 3.65% is where we were in the second quarter. I think Charlie walked you through pretty well, the impact. We think the core coupon margin is down 2 basis points.

So I think you're looking at it the way I would look at it, which is a core margin decline, excluding the interest reversal, excluding the impact of purchase accounting, which is going to happen regardless of what happens to interest rates going forward, it's about down 2 basis points.

I will just say that the pattern on the purchase accounting is it's declining at a rate of about 2 basis points a quarter on the margin in addition. So either you can - if you want to project that forward, I would use that as somewhat of a projection through the next couple of quarters..

Yes. Okay. Except, that's tough. Well, I guess until the additional mergers rolled in. But okay. That was is it for me..

Your next question comes from Andrew Liesch with Sandler O'Neill..

Charlie, I just wanted to talk a little bit about like deposit growth and pricing there. I know, in the past, you've talked about having certain accounts to try to bring in new funds, bring in new customers.

Just kind of curious like what you're seeing in the market? And if you have, like, any sort of accounts that you have out there that you're trying to promote to bring in some new clients?.

We have promoted a couple of - we've had a couple promotions that we've had great success in retail, a little bit less in commercial, but good success in retail, where we offer a money market account, I believe we require $25,000 in new money to open the account, and that - when I say new money, it has to come from outside our bank.

And then, we guarantee the rate for a year. And we did one in the early - late spring, early summer, and we attracted about $40 million into that account, about 2/3 of that, maybe 70% was new money to the bank, as I recall, and that was at 1.50%, and we're getting ready to do it again, and we hope to have the same success.

We've also been out and been a little bit more aggressive throughout our footprint. Some areas of our footprint are more aggressive than others in deposit generation, but we just got a commitment.

The money is not in the bank yet from one of our Iowa communities, and they've received a customer, and I believe the rate was 1.92%, and it was between $5 million and $10 million in new money. 1.92% is not bad for that size of account.

So I just think, seasonally, the last couple of years, we've seen a build in deposits in the fourth quarter, which boost our earning assets and - but I think you're going to continue to see rates in the - for the large pieces in the 1.80% to 2.20% range right now, absent another Fed move, and then it probably moves up accordingly.

So, Jim, do you have anything to add to that?.

Well, I think you characterized the market pretty well. It is just a competitive market on - we see it on the retail side, where we have access to competitor rates through just regular monitoring.

And then, two larger deposits where we know that competitors are calling on our customers, and we've been in a position where we needed to raise rates, match rates in order to maintain deposit levels.

So I could give you specific examples, but I think you get - kind of get the idea that it's a pretty competitive marketplace on the deposit side right now..

Andrew, this is Kevin. I will add that, on top of what Charlie talked about from a money market point of view, we also have launched a partner product to our mortgage group for first time homebuyers.

It's a savings account that allows them to a reduction not only in some closing cost, but in three of our states, there's some state tax benefits for first-time homebuyers on these savings accounts.

So we've launched that product as well to take advantage of those opportunities in a good part of our footprint that should drive some deposit activity as well. That's something unique that we have not done in the past..

Yes. Yes.

And then, I was just wondering, like up in the Twin Cities, with Wells and USB controlling a lot of the market, I mean, are there opportunities there to maybe price above them, just to bring in some funds? Might be of lower cost than, let's say, your Iowa footprint?.

Yes. And we are - we do that. We do have regional pricing in our company.

It's interesting, if you look at our deposit growth over the last 12 months, and you look at the different regions in our company, and I exclude Denver, because they're more of a start up, but the Twin Cities has had, by far, the best deposit growth and I would argue they're just scratching the surface, but they've shown remarkable improvement.

The deposit growth, as I recall, and my numbers would be August to August, but the numbers were between 8.5% to 9% deposit growth in the Twin Cities, and in that, I include Western Wisconsin, so - and if you look at the FDIC market share data for Minnesota, it's very clear that there's been a shift in deposits out of the largest two banks in that state, to community banks.

And what's happened at MidWestOne has happened also in, what I can see, at other banks. So I think that perhaps answers your question..

Our next question comes from Nathan Race with Piper Jaffray..

Charlie, I wanted to start on kind of loan growth outlook for next year. You said good C&I growth in the quarter, construction too, and that you're still getting good traction in Denver and so forth.

So just curious to get an update on kind of the thoughts on loan growth, and kind of what the puts and takes are as we looked out into next year?.

I'll be very simple on that one. The preliminary budget that we have started on, it's 5% loan growth and 5% deposit growth..

Okay. Got you.

And then, in terms of what you're seeing out in Denver, I mean, is that still the most strength, and I imagine you're still getting better traction in the Twin Cities with some of the hires that you've made there and the expectation that those two markets are going to offset maybe some continued softness in Iowa?.

Yes. And as I said in my opening comments, I'm very pleased with what we're seeing in Iowa City. I think we have a chance for Iowa City to really contribute in a meaningful way in the fourth quarter, and if not the fourth quarter, certainly 2019, in our company. Denver is doing fine.

It slows down a little bit because I think they've gotten the low-hanging fruit. But they continue to have good activity, and I think the loan book will continue to grow as will deposits in Denver. And the Twin Cities continues to be steady.

I think the Twin Cities has been a little bit slower for us, and some of that is self-imposed with the nonowner occupied, because they have lots of opportunities in that market, but recognizing where we are in the credit cycle, and what our internal guidance is, we've just been a little bit more selective, but that said, we still see decent activity out of the Twin Cities..

Okay. Got it. That's great color. and just lastly, on the provision. I think, last quarter, you're thinking about $1 million in a quarter's kind of a good run rate.

It sounds like you guys are in a good position from a reserving standpoint with some of the downgrades ahead in the quarter, is that still how we should kind of be thinking about reserving needs in the provision line going forward?.

I'd say you never can pinpoint this exactly, but plus or minus a couple of hundred thousand from the $900,000 guidance. And I continue to think that, that number can continue to come down over time. But we have to see what happens with the economy, we have to see what happens in the ag renewal season.

But I think we sit in a much better position there than we did, for example, a year ago..

Okay. Great. I appreciate the new layout in the press release. Nice work..

Thank you. Barry Ray will be happy to hear that..

Thank you, Nate..

The next question comes from Damon DelMonte with KBW..

Just kind of a broader question on the outlook for loan growth.

Have you guys noticed any impact from the tariffs on your customers? Are they talking about that at all?.

They talk about it. They talk about it, and if you look at corn and bean prices and you look what happened after the tariffs were announced, it's pretty evident that they've had a negative effect on the prices. And when it has a bad effect on prices, it has a bad effect on our borrowers. So yes, they have not been helpful..

Okay.

But like, no tangible signs of stress on the borrowers themselves as of yet?.

Well, I think I - I think, with the prices where they are, especially marginal borrowers will continue to have cash flow problems.

And - what we have to make sure of is, that the collateral from the land that they've pledged to the bank - that the margin there doesn't get too narrow, and when the margin gets into our discomfort zone, then we have decisions to make.

And can we get more collateral? Or does that borrower - they need to find their operating loan someplace else next year. So - and these are very, very tough decisions, and the decisions we have to make on a borrower by borrower basis. There's not - it's not one-size-fits-all..

Got it. Okay. That's helpful. Then, just kind of a technical modeling question. The accretable yield was lower this quarter.

Is there any guidance as to what we could expect for the fourth quarter? And then, obviously, it all changes when the deal closes, but at least for the fourth quarter?.

This is Barry, I'll take that. I think it's down like around $175,000 is kind of the run rate that it's going down per quarter..

Okay. Okay. Great. And then, I guess, my last question kind of along the lines of capital management.

I know you guys kind of re-upped your share buy back in with the volatility in the market and the weakness in the shares, just want to know what your thoughts were on becoming a little bit more active in the buyback?.

Well, one of the things that complicates that is our ATBancorp transaction, but we're certainly evaluating every opportunity. Let's just leave it at that..

[Operator Instructions]. The next question comes from Brian Martin with FIG Partners..

Charlie, just on the last capital question, I mean, do you guys currently have an authorization in place on the buyback? Or is there not one in place, presently?.

No. We have one. It was just re-upped..

Okay. You just re-upped it. Okay. All right.

And just going back to the margin for just a moment, just on the - you talked about getting better pricing from - I mean, are you guys getting any push back? And does that give you a little bit more optimism that maybe it can limit that compression in the margin from the funding cost rise and that you guys and everyone else in the industry continue to see.

I guess, it feels like that's been - I guess, maybe, it seems as though you're a little bit more optimistic, if that's the right word, on the margin, or maybe a little bit less of a decline than the last couple of quarters. And just wondering if that's more on the loan pricing side or....

Yes. I don't want to - when I say that loan pricing is a little better, I don't want to oversell that. But it - I always call it modestly better than it has been. Jim's got the numbers in front of him, in terms of what our quarterly yields go up in the new loans we booked, so I'll let Jim answer the bulk of that..

Yes, Brian. This isn't a direct response. This isn't really talking about the competition in what the front line lenders were seeing in the marketplace, but just from a modeling perspective, what I am seeing is that the new loans for the quarter, for the third quarter, came on at a rate of 5.20% - 5.29%, which is well above what our average rate is.

So that's encouraging. I would say that we've seen an increase in the average coupon. Again, this goes back to just the coupon on the loans. It's not purchase accounting adjusted or anything like that. It's simply the coupon on the loans. And then, increasing at a rate of approximately 7 or 8 basis points a quarter for the last 3 or 4 quarters.

That is an increase over the rate of acceleration from the prior year, but it's pretty steady. And so, I would say if we do more loans at the higher rate, if we can churn more, we'll see a slight increase in that coupon in future periods. If we do a little less, we'll see a little less increase in that coupon in prior periods.

So I'm not sure like it's precisely to your answer, but that's - from a modeling perspective, that's kind of what I see on the ALCO side..

Okay. And Jim, the C&I loans, I mean, that was obviously a good quarter.

I mean, are those some of the higher yielding loans? I guess that's - but if you continue to grow that bucket, I guess, I assume that's the case?.

Well, I'm just kind of glancing through rates that have come on. I think, some of the ag loans, have actually been some of the higher yielding loans in the portfolio. If we have C&I loans, you're probably right at about the average of $530,000 coming on to the books in the most recent quarter..

Okay. Perfect. That's helpful. And just the other 2 things for me, guys. Just, Charlie, you talked about efficiency ratio and kind of your target in taking some steps to get there.

And do you think, at this point, most of that is going to come via the expense line? You talked about salaries being something you were kind of reassessing or kind of looking at there, but is that how you guys would be looking at - the primary way to achieve that over time?.

I think it's both. It's one reason I like the efficiency ratio, Brian. You get there - you can get there through revenue and/or expenses, and I think we need to do both, and that's one of the reasons, I think, in our fourth quarter, you'll see a little bit better revenue growth than you saw this quarter.

I think this quarter was just a timing thing on a lot of the loan growth, but I think we'll see better - a little bit better loan production this quarter. And then, we'll start to evaluate the expenses, and I think as 2019 rolls on, we'll be able to get some expense savings and productivity gains as well..

Okay. All right. And then, just the last one for me, Charlie, or whomever. Just on that, with the AT transaction, if you guys look at the - one of the benefits of that was the fee income lift that you guys would get as a boost. Then you guys are at a 17%-, 18%-type of level on that, the fee income.

With the trust business you get and - from AT, where do you see the fee income line kind of settling out as a percentage of revenue? Is it in the upper to - is it kind of the 24%, 25% range? Or is it more on the, maybe a 22% type of range on the lift that you guys would expect to get?.

I don't have it in front of me, Brian, but I believe it should settle out as modeled in the 24% to 25% range. And one of the reasons is our - is we - we're going to basically triple the size of our Trust Department. And we have the earnings release call, I think I said nine employees. I think it might be 12, or 13, or 14 employees.

It's going to be more than nine employees, but we'll get a nice boost with not many employees. So I think 24%, 25%, and it's one of the things that excites us the most about the transaction..

Yes. Okay. I just had to make sure I have that right. And the loan growth this quarter, Charlie, there was not - was there much in the way of chaos? I mean, we've heard a lot of banks talk about the payoffs that had been out there and restricting some of the loan growth, I guess.

Just were they - any sense they are elevated more this quarter than in the past? If you guys are pretty steady there? Nothing unusual?.

Yes. Brian, this is Kevin. Yes. It was actually - that's exactly right. Pretty steady. At the second quarter, we had a few more planned chaos than we anticipated. Fourth quarter, as we look forward to fourth quarter, we have a few and a couple of our SBA debenture payoffs, so they are normal course of business.

But nothing out of the ordinary in the third quarter..

This concludes our question-and-answer session. I would like to turn the conference back over to Charles Funk for any closing remarks..

Well, I would just say thank you for joining us on the call this morning. And if there's anyone who needs further clarification, please give any of us, who are on the call this morning, a call. We'd be happy to address your questions. And so thank you again for joining us. And I'll send it back to you, Gary..

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect..