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Edited Transcript of MSBI earnings conference call or presentation 25-Jan-19 1:30pm GMT

Q4 2018 Midland States Bancorp Inc Earnings Call

EFFINGHAM Jan 28, 2019 (Thomson StreetEvents) -- Edited Transcript of Midland States Bancorp Inc earnings conference call or presentation Friday, January 25, 2019 at 1:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Jeffrey G. Ludwig

Midland States Bancorp, Inc. - President & CEO

* Stephen A. Erickson

Midland States Bancorp, Inc. - CFO

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Conference Call Participants

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* Andrew Brian Liesch

Sandler O'Neill + Partners, L.P., Research Division - MD

* Kevin Kennedy Reevey

D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst

* Michael Perito

Keefe, Bruyette, & Woods, Inc., Research Division - Analyst

* Terence James McEvoy

Stephens Inc., Research Division - MD and Research Analyst

* Tony Rossi

Financial Profiles, Inc. - SVP

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2018 Midland States Bancorp, Inc. Earnings Conference Call. (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.

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Tony Rossi, Financial Profiles, Inc. - SVP [2]

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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 have not done so already, please visit the Webcasts and Presentations page of Midland's Investor Relations website to download a copy of the presentation. The management team will discuss the fourth quarter results, and then we will open 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 and 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.

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Jeffrey G. Ludwig, Midland States Bancorp, Inc. - President & CEO [3]

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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 3 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 2 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 rate 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 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 more details on the financial performance. Steve?

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Stephen A. Erickson, Midland States Bancorp, Inc. - CFO [4]

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Thank you, Jeff. I'm going to start with our loan portfolio on Slide 4. Our total loans outstanding declined $18.7 million from the end of the prior quarter. This is 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 is in-line with the mid-single-digit range that we had expected.

Turning to deposits on Slide 5. 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 runoff of the brokered deposits, the declines in the other areas were primarily related to outflows of public funds and normal fluctuation 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 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 7. 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 was primarily the result of a 5- basis point increase in our net interest margin, excluding the accretion income. With the impact of repricing on our loan portfolio and 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 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 8. 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 include 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 to lock interest rates due to exposure to extension fees associated with holding the rate lock. There's also a backlog that will be needed to be worked through once HUD -- through HUD 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 9. We incurred $0.6 million in integration and acquisition expense in the fourth quarter. Excluding integration and acquisition expense as well as the loss on 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 3 commercial real estate loans. We have 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 31, and our credit marks accounted for another 53- basis points.

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

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Jeffrey G. Ludwig, Midland States Bancorp, Inc. - President & CEO [5]

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Thanks, Steve. We will 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 2 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 improved 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.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Michael Perito from KBW.

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Michael Perito, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [2]

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A few questions for me. I wanted to start maybe just on the commercial FHA. Can you just maybe give us a little bit more color about the shutdown? I mean, are revenues are going to be, what, close to 0 in the first quarter? Or is there like leftover from the fourth? I'm just trying to get a better sense of what the magnitude of that should be.

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Jeffrey G. Ludwig, Midland States Bancorp, Inc. - President & CEO [3]

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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. So the rate locking of a loan generates the revenue. And we do have some borrowers that are at the point of rate locking, which -- there has been -- to do that with the shutdown because they can't then get the loan closed because HUD isn't open. And then we are 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 the next couple of weeks, we could still generate some revenue this quarter. If the government shutdown is the whole quarter, it's going to be a tough quarter.

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Michael Perito, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [4]

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Great. 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 a government agency, 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 does the -- do revenues annually get pushed out as well? Or was it really just a timing issue on a quarterly basis?

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Jeffrey G. Ludwig, Midland States Bancorp, Inc. - President & CEO [5]

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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 pushed 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 quarters, either the second or third quarter.

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Michael Perito, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [6]

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Helpful. 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 a base case, and you're hopeful that there's a chance maybe you guys could find efficiencies that we will bring you either to the lower end or slightly below that range next year?

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Jeffrey G. Ludwig, Midland States Bancorp, Inc. - President & CEO [7]

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

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Michael Perito, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [8]

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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 on how you're going into 2019.

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Jeffrey G. Ludwig, Midland States Bancorp, Inc. - President & CEO [9]

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Yes, 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 $1 million. But those are 2 quarters that are typically the lower seasonal quarters, so we hope to see a little less in the middle 2 quarters. So yes, I think that's right. We've made the cost adjustments that we needed to make in that business and have done that in previous quarters. So I think we feel that we are in a good operating position today, and now it's -- how can we drive some more revenue.

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Operator [10]

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And our next question comes from Andrew Liesch from Sandler O'Neill.

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Andrew Brian Liesch, Sandler O'Neill + Partners, L.P., Research Division - MD [11]

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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 but then coming on and replacing some of the portfolios that might be lower and that are paying down, why shouldn't some modest margin expansion increase? I recognize funding costs are rising as well, but it seems like you have tailwind of mix shift going here. That should help support the margin expansion.

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Stephen A. Erickson, Midland States Bancorp, Inc. - CFO [12]

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Andrew, I would think -- again, it's a good point. The problem is we just don't know. 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 basis points drop. We just don't know at this point.

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Andrew Brian Liesch, Sandler O'Neill + Partners, L.P., Research Division - MD [13]

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Okay. And then I think in the presentation, you guys referenced maybe also some, like, infill or like some -- maybe some small deals, just tuck-in like fill -- 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 there?

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Jeffrey G. Ludwig, Midland States Bancorp, Inc. - President & CEO [14]

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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 into a new market. If 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 out to new -- kind of like an Alpine, the billion-dollar acquisition, we're not interested in that today. Given the internal work we are working on, we will focus more on smaller kind of in-market acquisition opportunities.

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Operator [15]

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And our next question comes from Terry McEvoy from Stephens.

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Terence James McEvoy, Stephens Inc., Research Division - MD and Research Analyst [16]

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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?

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Jeffrey G. Ludwig, Midland States Bancorp, Inc. - President & CEO [17]

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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 operating leverage point of view going forward. So there's a little, but not a lot.

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Terence James McEvoy, Stephens Inc., Research Division - MD and Research Analyst [18]

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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, for your customers on the FHA side to get them through this shutdown period before the backlog work through, and they can move forward with the deal that they are looking at?

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Jeffrey G. Ludwig, Midland States Bancorp, Inc. - President & CEO [19]

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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 3 to 6 months. I think bridge is probably pushing a couple of hundred million dollars 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 see 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, the $40 million growth in that portfolio in the quarter.

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Stephen A. Erickson, Midland States Bancorp, Inc. - CFO [20]

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Yes, $33 million.

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Jeffrey G. Ludwig, Midland States Bancorp, Inc. - President & CEO [21]

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So we're seeing some growth there, and I -- and that is a -- something we can talk to customers about with the shutdown. If they need to get bridged even for 6 months or 3 months or for short periods of time, we can do that.

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Terence James McEvoy, Stephens Inc., Research Division - MD and Research Analyst [22]

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Okay. And then just the last question. The 3 CRE loans that were referenced in the press release, anything in common between those 3? I know -- I believe in the fourth quarter of last year, there was an increase in charge-offs for similar loans. Can 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?

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Stephen A. Erickson, Midland States Bancorp, Inc. - CFO [23]

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One of the things that we keep looking at, if you look at that -- the 2 tables on that page in the presentation. And you've got the charge-offs there clearly not following the same pattern as the increase in the non-performings. Most of these are longer-term projects to us. There are things that we're going to continue to work through. While there is nothing really similar between the 3 this quarter other than they are all CRE, I think it is important to note that 2 of them are TDRs at this point and are still accruing. Yes, they are nonperforming, but they are still accruing at this point. We've made adjustments to have those continue to perform. So they are not similar to each other, other than they are CRE.

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Operator [24]

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(Operator Instructions) Your next question comes from Kevin Reevey from D.A. Davidson.

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Kevin Kennedy Reevey, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [25]

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

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Stephen A. Erickson, Midland States Bancorp, Inc. - CFO [26]

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I would think -- this is Steve -- I would 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...

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Jeffrey G. Ludwig, Midland States Bancorp, Inc. - President & CEO [27]

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No, I mean, they had a nice wealth business that integrated nicely into ours, and they have 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 had on their balance sheet. We've since absorbed that liquidity and put that money to work. So we've seen some -- on revenue side, that's where some of those synergies would be.

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Kevin Kennedy Reevey, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [28]

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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?

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Stephen A. Erickson, Midland States Bancorp, Inc. - CFO [29]

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

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Kevin Kennedy Reevey, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [30]

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

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Jeffrey G. Ludwig, Midland States Bancorp, Inc. - President & CEO [31]

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

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Operator [32]

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We do have a follow-up question from Terry McEvoy from Stephens.

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Terence James McEvoy, Stephens Inc., Research Division - MD and Research Analyst [33]

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Just 2 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?

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Stephen A. Erickson, Midland States Bancorp, Inc. - CFO [34]

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It was $700,000 instead of $900,000 for that one. And as far as modeling is concerned, BOLI is not a line item that we expect any significant changes in on a quarterly basis.

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Jeffrey G. Ludwig, Midland States Bancorp, Inc. - President & CEO [35]

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Yes, we wouldn't expect that to reoccur.

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Stephen A. Erickson, Midland States Bancorp, Inc. - CFO [36]

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Yes, that is a nonrecurring item.

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Jeffrey G. Ludwig, Midland States Bancorp, Inc. - President & CEO [37]

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It's going to appear periodically over time.

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Stephen A. Erickson, Midland States Bancorp, Inc. - CFO [38]

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Yes, unfortunately.

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Terence James McEvoy, Stephens Inc., Research Division - MD and Research Analyst [39]

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Understood. And then just the last question, do you expect to fund your loan growth with core deposits? As I just look at that Page #5, deposits have been trending lower. So I guess my question is, how do you fund loan growth? And can you fully do so and kind of in-market with your traditional deposits?

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Stephen A. Erickson, Midland States Bancorp, Inc. - CFO [40]

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I mean, 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 had planned for the next 12 to 18 months.

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Operator [41]

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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.

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Jeffrey G. Ludwig, Midland States Bancorp, Inc. - President & CEO [42]

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

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Operator [43]

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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.