Allyson Pooley - Senior Vice President, Financial Profile Leon Holschbach - Vice Chairman, President Chief Executive Officer Jeffrey Ludwig - Chief Financial Officer.

Kevin Reevey - D. A. Davidson & Co. Michael Perito - Keefe, Bruyette & Woods, Inc. Andrew Liesch - Sandler O’Neill & Partners Terry McEvoy - Stephens Michael Perito - KBW.

Good day, ladies and gentlemen, and welcome to the Third Quarter 2017 Midland States Bancorp Inc. Earnings Conference Call. At this time, all participants are in a listen-only mode. And later, we will conduct a question-and-answer session and instructions will follow at that time.

[Operator Instructions] And as a reminder, this conference is being recorded. I would like to introduce your host for today’s conference, Ms. Allyson Pooley from Financial Profile. Ma’am, you may begin..

Thank you, Amanda. Good morning, everyone, and thank you for joining us today for Midland States Bancorp’s third quarter 2017 conference call. On the call this morning from Midland’s management team are Leon Holschbach, President and CEO; and Jeff Ludwig, CFO. We will be using a slide presentation as part of our discussion this morning.

If you haven’t done so already, please visit the Webcasts & Presentations page of Midland’s Investor Relations website to download a copy of the presentation. Leon and Jeff will discuss the third quarter results, and then we will open the call up for 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’ll turn the call over to Leon..

Thank you, Allyson. Good morning, everyone, and welcome to Midland’s earnings call. Let us start with Slide 3, which summarizes the highlights for the third quarter and our most recent announcements. Clearly, the most significant development was the announcement earlier this month of our definitive agreement to acquire Alpine Bancorporation.

We were able to move quickly on the Alpine deal because of the efficiency with which we have integrated the Centrue acquisition. We completed the Centrue system conversion during the third quarter and have phased in the majority of the cost savings that we projected for the transaction.

As we mentioned during our conference call last week, when the Alpine deal closes we will have doubled the size of the company since our IPO in 2016. We have done this by executing on transactions that increased the scale of our core community bank operations and our wealth management business.

These are businesses that generate excellent returns and have good long-term growth opportunities.

With these areas of the company increasing in scale, the commercial update today in residential mortgage banking businesses will still be meaningful contributors to our financial results, but they will be smaller components within our overall revenue mix.

During the third quarter, we made the decision to sell the majority of our mortgage servicing rights in the residential mortgage banking business as this will eliminate a source of volatility in our earnings stream and also free up capital for the Alpine acquisition.

The sale resulted in a $3.6 million loss as we marked the MSRs to market ahead of the sale. As a result of the loss on the MSRs and the integration and acquisition related expenses, we reported $0.10 per share in the third quarter. When these items are excluded, then we have $0.49 in adjusted earnings per share.

We saw positive revenue trends in the quarter as a result of the full quarter impact of adding Centrue’s operations. Relative to the prior quarter, our net interest income was up 25%, while our non interest income was up 13%.

A couple of themes that we talked about on the second quarter call that continued to play out in the third quarter were our currently high loan to deposit ratio, and the loss of our Colorado residential mortgage team and the impact that has on our residential mortgage business. We also had a lighter contribution from Love Funding in the quarter.

We entered the third quarter with a loan to deposit ratio of 95%, and while we see loan demand across our various markets, it is a more difficult environment for core deposit gathering.

Therefore we continue to be more selective in the loans that we originated this quarter, and opted not to match some of the more aggressive pricing that some of our current customers received from competing banks.

This resulted in a lower level of originations and a higher level of payoffs then we saw in the first half of the year, but we were also able to increase the average interest rate on new and renewed loans in the quarter by 48 basis points. On a final note as you saw yesterday, Kevin Thompson has left the company to relocate to a larger market.

We are in a fortunate situation to have Jeff Ludwig to step in and fill the CFO role on an interim basis. As you know, he has served as our CFO for the last 10 years. There isn't anybody better suited to manage our finance department while we conduct a search for a permanent replacement.

And so with that, I will turn the call over to Jeff to walk through the details of our third quarter performance. Go ahead, Jeff..

Thanks Leon. Starting with Slide 4, I’ll review our net interest income and net interest margin. Our net interest income increased by 25.1% from the second quarter. This was primarily the result of higher interest income on loans due to the full quarter impact of Centrue.

On a reported basis, our net interest margin increased 8 basis points to 3.78%, due to a $1.7 million increase in accretion income. Excluding accretion income, our net interest margin declined 6 basis points due to the full quarter impact of adding Centrue’s lower yielding assets.

As a partial offset to this, the average rate on our new and renewed loans in the third quarter was 4.72%, 48 basis points higher than the prior quarter. This reflects the impact of the last Fed rate increase in June, as well as the more selective approach we have taken to loan production and pricing that Leon discussed.

Looking ahead to the fourth quarter, we would expect our accretion income to be lower. Excluding the impact of accretion income, we anticipate that our net interest margin will be relatively stable. Moving to our noninterest income beginning on Slide 5, total noninterest income increased to $1.8 million, or 13.1% from the prior quarter.

The key driver of this increase was the 72% increase in service charges and interchange revenue, which largely resulted from the full quarter addition of Centrue. Our residential mortgage business had $2.3 million in revenue this quarter, which reflects the lower level of production following the departure of our Colorado loan production team.

With the smaller production team, it is likely that the loans we originate for sale will remain at this lower level. As we discussed on our last call, we plan to rebuild our residential mortgage production team by adding originators that focus on our core markets of Illinois and Missouri as we head into 2018.

Turning to Slide 6, we are going to review wealth management. We had a strong quarter as we added approximately $72 million in assets under administration, of which approximately 50% was from net new business and 50% from market appreciation. This put us over $2 billion in assets under administration for the first time in our history.

As a result of the growth in assets, our wealth management revenue increased 2% from the prior quarter. Measuring the organic growth on a year-over-year basis, excluding the assets added from Sterling Trust and CedarPoint, our total assets under administration increased by $172 million or 14% as of September 30.

Turning to Slide 7, and looking at Love Funding, we originated $112.5 million in rate-lock commitments during the quarter, and had total commercial FHA revenue of 3.8 million. Through the first nine months of the year, excluding MSR impairment, Love Funding had generated total revenue of $15.8 million.

This run rate is consistent with that $18 million to $20 million of annual revenue and is generally what we expect to see in this business. Although there maybe stronger years from time to time, we believe that this is the baseline that we can deliver each year. Love Funding continues to be a business that we very much like.

It provides consistent annual fee income, generates 20% to 25% pretax profit margins, and offers good margin loan opportunities through our bridge loan program, and we currently have approximately $120 million of these loans on our books. And most importantly Love Funding provides a growing source of low-cost servicing deposits.

Our average servicing deposits were $322 million in the third quarter, up 6% from the prior quarter and up 17% over the same quarter last year. Our weighted average cost on the servicing deposits was just 9 basis points. Turning to Slide 8, we’ll take a look at our expenses and efficiency ratio.

We incurred $8.3 million in integration and acquisition-related expenses in the quarter, as well as a $3.6 million loss on the mortgage servicing rights that we moved to held for sale. Excluding these items, our noninterest expense increased $6.2 million, or 20.7% on a linked-quarter basis.

As Leon mentioned, we have largely phased in the cost savings projected for the Centrue acquisition. As a result, excluding integration and acquisition-related charges, we believe our operating expenses will be in the range of $35 million to $36 million in the fourth quarter.

Moving to the balance sheet on Slide 9, we’ll take a look at our loan portfolio. Total loans were essentially flat from the end of the prior quarter. We saw growth in our residential mortgage, construction and consumer portfolios, which was offset by a decline in commercial loans.

The decline in commercial loans was largely driven by payoffs related to companies or properties that were sold, as well as efforts to move lower rate credit out of the bank. Turning to Slide 10, we’ll take a look at our deposits, during the quarter there was a lot of movement within our various deposit categories.

Within our core banking group, average total deposits trended higher throughout the quarter, increasing approximately $30 million. This increase in deposits was offset by some repositioning we did with our non-core funding sources.

We ran off some of our broker CDs and replaced them with lower cost FHLB advances, and we had some fluctuations in our end of period servicing deposits. At the end of the second quarter, we received some large payoffs on FHA loans that were then remitted in June.

As a result, our end of period balances at September 30 reflect a more normalized level of servicing deposits. The net effect in the movement in our various deposit categories was a $219 million decline in total deposits from the end of the prior quarter. Moving to Slide 11, we will look at our asset quality.

Our non-performing loans increased $5.8 million from the end of the prior quarter. The increase was primarily attributed to one commercial real estate loan that was added to non-accrual during the quarter. Our net charge-offs were just $52,000, or 1 basis points of average loans. We recorded a provision for loan losses of $1.5 million in the quarter.

The provision was primarily related to specific reserves set against two nonperforming loans, one of which was the commercial property placed on the nonaccrual this quarter. This provision brought our allowance plus credit marks to 99 basis points of total loans at September 30. With that I will turn it back to Leon..

Thanks, Kevin. I will wrap-up on Slide 12 with some comments on our outlook. We are very excited about what we have been able to accomplish this year. Through the acquisitions of Centrue and Alpine we have been able to continue our strategy of making accretive acquisitions that enhance shareholder value.

We are significantly increasing our scale and deepening our presence through the state of Illinois, and growing the contribution of the steady, recurring revenue from wealth management, and we are increasing our base of low-cost core deposits.

When we have completed the Alpine acquisition and captured the synergies we project for the transaction, we believe we will be a higher performing bank with a more consistent earnings stream. We believe that will result in significant value being created for our shareholders in the years ahead.

And with that we will be happy to answer any questions that you might have. Operator, go ahead and open up the call line..

[Operator Instructions] And our first question is from the line of Kevin Reevey of D. A. Davidson. Your line is open..

Good morning..

Good morning Kevin..

So, Jeff, just looking at the margin going into the fourth quarter, you said it should stabilize, is that on a core basis or on a GAAP reported basis?.

That would be on excluding accretion basis. And there will be a little pressure on that number with the $40 million of sub-debt that we took down as part of the Alpine acquisition, but we feel that that will be a stable rate going into the quarter..

And then how do you think that should play out as we head into 2018?.

I think as we have said on the call, we are working real hard here increasing loan rates, and saw some good lift in the third quarter, a 48 basis point increase over the prior quarter on new and renewed loans.

So I expect that trend to continue, so that will help the loan yields lift and if we can hold deposit costs, we could see a slight increase in margin as we move forward..

And these assumptions, is that assuming we do get a December rate hike or that assumes kind of a steady state?.

That is a steady-state as we sit here today..

Great. Thank you..

Thank you. And our next question comes from the line of Michael Perito of KBW. And your line is open. .

Good morning gentlemen..

Good morning Michael..

I have a handful of questions.

I guess just a clarification question on the margin for Jeff, so I mean it sounds like the core ex-accretion margin is stable next quarter, and I guess is that the function of – because obviously the sub-debt coming on would weigh on that, but I mean is some of this, initiative you’re taking on the rate side with the loan and funding side seem -- the hope is that that will offset some of the drag from the debt?.

Yes, that is kind of what we are thinking. Again, the sub-debt does put pressure on, but I think we are going to – with the focus on increasing yields in the loan portfolio, we are hopeful we can offset that increase..

Okay, and then just how does this all factor in – there wasn’t a ton of kind of perspective commentary on balance sheet growth from here, I mean, is there still opportunities to grow loans and deposits while being a bit more selective on rate or how should we be thinking about that organic level of origination capacity at Midland?.

Yes, I think that we have opportunities on both fronts. I think we mentioned in the commentary that the community banking group did increase core deposits by $30 million in the quarter, so we are seeing opportunities to increase deposits. We are on the streets with some campaigns to increase deposits. So we are hopeful that we can continue to do that.

And on the loan side, we are continuing to be selective. We did have probably more payoffs in the current quarter than we have seen in prior quarters, but we are going to continue to be selective. But we still have, I will say a strong pipeline of opportunities to look at.

So I think there’s good opportunities, but the deposit side of this is probably the thing we are focused on most right now, and as we can start to drive deposits, we will be able to drive the asset side..

Okay. And then just on the residential – the pending residential MSRs, and I'm sorry if I missed it, but when do you expect that to be completed and you mentioned in your prepared remarks that Jeff I believe that the residential mortgage kind of revenue line should stay about where it is.

I guess does that already take into account the strip out of any servicing income that is going to be lost; and secondly, I mean there is still going to be some seasonality, I guess, so will that drop off in the fourth and first quarter here, or are there other things that we should be thinking about?.

Yes, so a little color on mortgage servicing rights, and it is not as easy as selling a bond where you can sell it. It is off your balance sheet pretty quickly. So we have got letter of intent to sell – I think we are looking in November, December to actually execute the sale of the mortgage servicing rights themselves.

We will then be required to essentially sub service the loans for 60 to 90 days until we can – if you will, deconvert the loans and transfer the actual files and the servicing to the buyer.

So that takes some time, i.e., we are going to continue to have a servicing group that has work to do here until they are fully deconverted, and through the conversion process which will be probably in the first quarter.

So, we will – so, on the revenue side we will lose some revenue; on the servicing side once the sale happens mostly towards the end of this quarter. And then that will continue into ’18. On the gain on sale side of our revenue, we are going into the fourth quarter. So in the residential mortgage business in the Midwest it slows in the fourth quarter.

So I wouldn't expect – I would expect our revenue to come down a little bit from where it is at now just from the seasonality of the business. We are looking at bringing on new producers here in the fourth quarter, and probably in the first quarter, but the market in the fourth and the first quarter is slower in general in the Midwest..

And then the capital that you guys expect to free up, the regulatory capital from this, is it about $10 million, $12 million?.

Yes, right about $10 million..

Okay, and then just one last one from me, for you Leon, just as we think about, on a – I appreciate the kind of the strategic remarks about the way you think the bank is heading. So as we think about as we move into 2018, you still have the Alpine transaction pending, we got the MSR transaction ongoing.

Are we in a stage here where it is more internal than external focused to try and rip out all the cost saves, and get the bank operating on a more profitable consistent level, or are there still kind of requisite and capital deployment opportunities that we should be considering in the next few quarters?.

Yes, thanks Mike. So, sure, our plates are going to be full. We are just finishing up on the Centrue acquisition, which went real well. But we do a lot of training and so on that stresses some of the human resource assets in the quarter two. After all that is going well.

And then Alpine, which should be a large and significant and important transaction for us. Yes, our objective will be to execute really effectively on those to deliver what the pro forma of that combined opportunity looks like into ’18. Yes, internal focus will be top priority..

Great. Thank you, guys. I appreciate all the color..

Sure. Thanks mike..

Thank you. And our next question comes from the line of Andrew Liesch of Sandler O’Neill, and your line is open. .

Good morning guys..

Good morning Andrew..

Just curious the weaker credits that you mentioned that you that exit the bank, I mean, where those loans that came over from Centrue that you did really have much interest in keeping or are they legacy Midland States loans, what's the nature behind those?.

Yes. I would say more legacy and probably legacy Heartland loans. That was where they came from. They were pricing, mostly pricing, yes, pricing in terms related..

Okay.

Is the more of that that you think might be coming, like is competition out there just that tough that you guys don’t want to compete?.

I won't say we don’t want to compete..

Yes. I mean on pricing underwriting..

Sure. Just speaking specifically of the Heartland legacy deals that I think most of you know that St. Louis alone has over a 120 banks operating in the greater MSA and a ton of those banks are smaller community banks. And they if the smaller community banks often that apply the most pricing and rate pressure, not always but often.

So yes, they have hard pressure for earnings increases, they work hard steel business and were holding onto pricing and underwriting terms and I think that's the right thing to do..

Okay. And then on the last quarter you said the balance sheet still has a sensitive.

Is that to play out if we have a rate hike in December?.

Yes. I think it does. We've seen it play out here in the last couple of quarters and another one should help it..

Got you.

And then just lastly on the expenses, when you get the -- thanks for the color on the your expectation for the fourth quarter, but as you get through Alpine and the cost saves in there, where do you hope to have the expense base to say to start the third quarter of next year?.

That's a long way lane I get, Andrew, sorry. I don’t have that in front of me, I moved on the model. We've got our models, we kind of gave you a baseline of where our expenses are today. We've talked about what the cost stage in at Alpine will be. So, you can kind of get there that right.

Take 36% cost save on Alpine's baseline, our baseline and then obviously there's some growth, expense growth on top of that and you're going to get pretty close..

Got you. Thank you, that's helpful..

Alright. Thanks, Andrew..

Thank you. [Operator Instructions] And the next question comes from the line of Terry McEvoy of Stephens. And your line is open..

Hi, good morning guys..

Hi, Terry..

Hi.

Just to start, when you were modeling out Centrue and discussed the earnings accretion when that deal was announced, did you assume the step down in the margin because of their investment portfolio?.

That's probably of all the assets that came over, that's the biggest driver. Their loan yields were lower than ours, but that was the big driver..

And thanks for providing some insight into the full-year low funding revenue and I recognize it's just one quarter to go. But if I just look at that range of $18 million to $20 million, it's telling us the revenue will be $3.3 million to $5.3 million, which is a pretty wide range.

And I guess my question is, on a quarter-to-quarter basis, is that the type of volatility that you internally are projecting or is there anything unique headed into the fourth quarter of this year that maybe adds to that range either on the upside or the downside..

Yes. So, this is Leon, so thanks. Yes, we talked about the fact that we look at this on a annual basis exactly because of the range that you mention in the average size of their deal which now runs just a little over $10 million. As those deals move between quarter ends for closing, yes, it can be that kind of range.

But a full year basis, I'm looking at the last few years and looking at the last five or six quarters, you take out the top quarter the last five or six and you annualize it, that's what it looks like. And that's how we like to look at it.

As Jeff said, the $18 million to $20 million business was a 20% to 25% pretax and a really inexpensive and stable deposit gathering machine. We like that business a lot but we appreciate it early on. And I think that the worlds getting it. We appreciate it early on that this is not one that you can throw darts on the quarter.

It's just not going to work.

And so, yes, the range that you mentioned is above the rate range and it maybe, it will be right down to December as deals are locking or holding off to the end of the year, what kind of rate movement we have on the 10 year for example might influence borrowers to lock or hold for Q1 and that's what we have come to appreciate and understand about how the business works and why we are looking at and encouraging our investors to look at it on a annual basis..

But you are right, even internally that those are the ranges even as we sit here on month end, through a quarter..

Yes..

Those are the ranges we're looking at. It's really even a quarter, in the quarter wherein very difficult to project the actual number..

Okay. And then Jeff, can you just run through the change in deposits quarter-over-quarter, Love had deposits of $322 million at the end of the third quarter.

Where was that in the second quarter and then again where did that on the top bottom left of slide 10, where did that flow out of the deposit mix? I just want to make sure I understand that correctly..

So, in the increase and decrease in deposits, we're talking about end of period balances. When I talk about the average balances in servicing 322, there is left volatility in the in our averages because this money comes in and out pretty quickly in the quarter. So, if we look at slide on Slide 10, so the $108 million of servicing deposits.

So, what happened in the end at the end of June in the low funding servicing book, so the loans that we serviced for Love, we had a $108 million that Jenny made pay off that happen. Those that money comes into the bank as a deposit in cash. So, we had an elevated cash position as well at the end of the second quarter. And then by June 15th --..

July..

Oh sorry, July 15th, those dollars get remitted to Jenny Mae and then come back after balance sheet. The 108 is all in non-interest bearing demands. So, that's where it comes in and then it goes out..

Great, thank you..

Okay..

Thank you. And we do have a follow-up question from the line of Michael Perito of KBW. And your line is open..

Hey, thanks for taking the follow-up, guy. I just want a couple of quick questions and hoping if you could just give me some stats. I didn’t see the slide in the deck on the resi mortgage platform.

I was just curious if you can give us the closings in the quarter and then also I was just wondering what the size of the servicing books with the quarter end..

We're looking for the number. Yes, so secondary production was $63 million in the quarter. The servicing the total residential servicing I assume you mean unpaid balance on loans so it's right around $2 billion..

Okay.

And then what's the refi purchase split fairly steady with last quarter?.

I think refi was a little up but pretty small percentage of the production. So, we mean a couple of headwinds we'll lose the Colorado team and the refi market has where the rates is just kind of picking up as hasn’t been there either. Now, we're mostly a purchase shop, not a refi shop. But when it comes, it does help us..

And there were no adjustments on any whether the Love Funding or the residential servicing in the quarter, correct?.

There is no impairment on residential. So, that was all in the loss on moving that asset to help the sale. There is I think a $100,000 impairment on the commercial side. So, pretty insignificant..

Okay, perfect. Thank you, guys..

Okay..

Thank you. And at this time I'm showing no further questions. I'd like to turn the conference back over to management for any closing remarks..

Thank you all for joining us. And we'll talk again soon..

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program, you may now disconnect. Everybody have a great day..