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..

[Technical difficulty] and 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 Webcasts 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 the call up for questions. Before we begin, I would 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..

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 had 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 increases 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 pay-offs 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 five basis point increase in our net interest margin, excluding the impact of accretion income. We are also seeing strong, consistent generation of non-interest 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 non-interest 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 the more details on the financial performance.

Steve?.

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 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 is in line with the mid-single digit range that we had expected. Turning to deposits on slide five.

Total deposits for $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, non-interest bearing demand deposits and checking accounts.

Outside of the intentional runoff for the broker 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 6, 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 in the prior quarter to $5.7 million primarily driven by a higher level of revenue generated from the state 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 in the prior quarter.

This was primarily the result of a five basis point increase in our net interest margin excluding the accretion income. With the impact of repricing in our loan portfolio, in the 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 the 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 non-interest income on slide eight, our total non-interest 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 include service charges on deposits and interchange revenue.

Included in our commercial FHA revenue this quarter was $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 to lock the interest rates due to exposure to extension fees associated with holding the rate lock. There is also a backlog that will be needed 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 our expenses and efficiency ratio on slide nine. We incurred $0.6 million in the integration and acquisition expense in the fourth quarter.

Excluding integration acquisition expense as well as the loss in mortgage servicing rights that we recorded last quarter our non-interest 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 dollar range. Moving to slide 10, we’ll look at our asset quality.

Our non-performing 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 allowance to 51 basis points of total loans as of December 31st and our credit markets accounted for another 53 basis points. With that, I will turn the call back over to Jeff.

Jeff?.

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 2013.

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 fourth 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..

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

Hey good morning guys..

Good morning Mike..

A few questions for me. I wanted 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 revenue is going to be like close to zero in the first quarter, or is 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?.

Yes. So we have servicing revenue that is in in the FHA revenue line, so there will be revenue there.

But at this point we are we are not able to rate like loans or the rate locking of loan generates the revenue, and we do have some borrowers that are at the point of rate locking, which you know there -- there has to do that with the shutdown because they can’t then get the loan closed because HUD isn’t open.

And then, and then we’re not getting anymore HUD approvals to get to the rate lock stage because HUD is closed. So, it’s all going to depend on, if they open the government in the next couple of weeks so we can still generate some revenue this quarter. If the government shutdown is the whole quarter it’s going to be a tough quarter..

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, its 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 precedence for this in the past in this business, but does the -- do revenues annually get pushed out as well? Or was it really just a timing issue on a quarterly basis?.

We believe at this point it’s a timing issue.

So we’re going to have revenue push to the second quarter and probably some push to the third quarter, but full-year we still expect the full-year to kind of be in the range we’ve talked about previous calls that $3 million to $5 million per quarter, but it 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 quarters either second or third quarter..

Helpful. Thank you.

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

Yes. I think that’s our best 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..

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?.

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 last couple of quarters we’ve been right around the million, but those were two quarters that are typically the lower seasonal quarters, so we hope that you’d see a little less in the middle two quarters.

So I think that’s right. We’ve made the cost adjustments that we’ve needed to make enough business and have done that in previous quarters. So, I think we feel that we’re in a good operating position today and now how can we drive some more revenue..

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

Yes. Thanks Mike..

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

Good morning, guys..

Good morning, Andrew..

Just some questions on the margin here, something nice to see the core expansion and just given your comments about adding the consumer loans, adding the leases and certainly higher yielding with them coming on and we’re replacing some other portfolios that are might be lower yielding that are paying down.

And why shouldn’t some modest margin expansion increase? I recognize funding costs are rising as well, but seems like you have tailwind of mix shift going here that should help support margin expansion?.

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 deposit side in order to be defensive and hold on to deposits versus how much upside we do have with new and renewed continue 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, but we have to be a little more aggressive on deposit side and we may see a couple of basis points drop. We just don’t know at this point..

Okay. And then, I think in the presentation you guys referenced maybe like some, like infill or like maybe some – maybe some small deals just tuck-in like sell-in filling, I’m pulling 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?.

Yes. So, I think what we’re saying there is 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 in-market kind of acquisitions. We’re not looking to go to a new market. We could find some smaller banks in-markets.

We’d be looking to -- we would look at those types of opportunities. I guess what we’re not going to be doing in the near term is looking at bigger acquisition opportunities kind of an Alpine, the billion dollar acquisition, we’re not interested in that today.

Given the internal work we’re working on we’ll focus more on smaller kind of in-market acquisition opportunities..

Okay. That’s really helpful. Thank you..

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

Good morning, guys..

Good morning..

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?.

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

And then, one of 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 shutdown period before the backlog works through and they can move forward with the deal that they're looking at?.

Yes. So 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 couple hundred million dollars on the balance sheet today. So we’ve seen some really nice traction in that business.

A lot of its kind of on the construction side, so you don’t – you’re not seeing a lot of balance sheet movement quite yet, but as those projects get underway we’ll start to see some balance sheet growth.

I think we saw what – Steve, 40 million growth in that portfolio in the quarter?.

Yes. 33..

Yes. So, we’re seeing some growth there 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..

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 taken and ultimately do you think you've captured the potential losses in the reserve build this past quarter?.

Yes. One of the things that we keep looking at, and if you look at 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 nonperformings. Most of these are longer-term projects to us. There are things that we're going to continue to work through.

While there's nothing really similar between the three this 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 are nonperforming, but they are still occurring at this point. We’ve made adjustments to have those continue to perform.

So they’re not similar to each other, other then they are CRE..

Okay. Thank you..

[Operator Instructions] Your next question comes from Kevin Reevey of D.A. Davidson. Your line is now open..

Good morning..

Good morning, Kevin..

Can you give us some color on the type of revenue synergies that you’re seeing from Alpine now that its been fully integrated into your franchise?.

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 non-interest income from that point of view.

Jeff, do you have any other kind of…?.

No. 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 actual liquidity they have in their balance sheet.

We’ve since absorbed that liquidity and put that money to work. So, we’ve seen some on the revenue side, that’s were some of the synergies would be..

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 increase the loan yields in the quarter? Were there any interest recoveries or the like?.

No, there was nothing else significant. It was just the repricing of the existing portfolio plus new and renewed; nothing one time or unusual items..

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?.

I don’t think there is any outsized winning of clients that happen in the quarter that might – I mean, we are continuing to win client. So that decrease in AUM was primarily result of the market downdraft, but we continue to win clients and build assets, but the primary job was due to market conditions..

Excellent. Thank you very much..

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

Just two modeling questions, the BOLI gain that was referenced in the press release.

Is that about $900,000 and if so, what’s a kind of more normal run rate for that line?.

That was $700,000 instead of 9. So that’s one event. And as far as modeling is concerned BOLI is not a line item that we expect any significant changes in a quarterly basis..

Yes. We won’t expect that to recur..

Yes. That is a non-recurring item..

Yes. Okay. And then….

It will recur periodically overtime..

Yes, unfortunately..

Yes..

Understood. And then just the last question, do you expect to fund your loan growth with core deposits. And as I just look at 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?.

I mean, that does – obviously, that is our challenge, right, 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..

Got it. Thanks again..

And now 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..

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

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..