Midwestone Financial Group, Inc. (NASDAQ:MOFG) Q2 2022 Earnings Conference Call July 29, 2022 12:00 PM ET
Company Participants
Charles Funk – CEO & Director
Barry Ray – CFO & Senior EVP
Len Devaisher – President & COO
Gary Sims – Senior VP & Chief Credit Officer
James Cantrell – CIO, Senior EVP & Treasurer
Conference Call Participants
Brendan Nosal – Piper Sandler & Co.
Terence McEvoy – Stephens Inc.
Damon DelMonte – KBW
Brian Martin – Janney Montgomery Scott
Operator
Good morning, and thank you for attending today’s MidWestOne Financial Group Second Quarter 2022 Earnings Call. My name is Jason, and I will be the moderator for today’s call. [Operator Instructions].
This presentation contains forward-looking statements relative to the financial condition, results and operations and business of MidWestOne Financial Group. Forward-looking statements generally include words such as believes, expects, anticipates and other similar expressions. 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 pressure, general economic conditions and risk factors detailed in the company’s periodic reports and registration statements filed with the Securities and Exchange Commission. MidWestOne Financial Group undertakes no obligation to publicly revise or update these forward-looking statements to reflect current events or circumstances at the date of the presentation.
I would now like to pass the conference over to our host, Charlie Funk, CEO. Please go ahead.
Charles Funk
Thank you, Jason, and good morning/good afternoon to all of you, and thank you for joining us on the call. On the call this morning in Iowa City, we have Len Devaisher, our President; Gary Sims, our Chief Credit Officer; Barry Ray, our Chief Financial Officer; and Jim Cantrell, our Treasurer and Chief Investment Officer.
I’ll begin with a few preliminary remarks and just say that I think we have many good things to discuss with you today as well as a few hurdles that we have to clear going forward. Overall, we thought it was a very good quarter for MOFG, and obviously, we had a lot of moving parts due to the Iowa First acquisition. And we do think our core income is higher than what was reported in our earnings release.
We had an excellent quarter of loan production. We saw good growth in the Twin Cities in Denver and in Dubuque, Iowa, and the linked quarter annualized rate of growth was roughly 10.5%. We also have a decent pipeline in the third quarter. As always, we can’t predict payoffs, but we should have good production going forward. And if July is any indication, we did have a good July with — in terms of loans closed.
Along with the loan growth, we also saw a significant improvement in asset quality. Nonperforming assets came in at 0.76% of total loans, and even with the addition of the Iowa-first nonperforming assets, we nevertheless still saw a decline in NPAs. And to give you some perspective, a year ago, we were at 121 basis points of NPAs divided by total loans today. Again, we stand at 0.76% outstanding progress.
Net charge-offs of 3 basis points, and we still note that our allowance for credit losses, we believe is a relatively strong, 1.45% of total loans. As far as the credit outlook, as far as we can see, it’s good. We are clearly — we clearly hear all of the talk of a recession. We’re wary of that. But nevertheless, our overall portfolio is performing well, and we feel somewhat confident as we go forward.
In terms of deposits, I think a pretty good performance on deposits. In the legacy bank, we were essentially flat in total deposits, down just $4 million for the quarter. We were able to hold our pricing for the most part. We do think that’s about the change due to the rapid increases that the Fed has undertaken. And we’re seeing more customers demand higher rates on deposits. We acknowledge that.
We do believe we will be able to successfully defend our strong deposit base. And we also note that the 2 Iowa first banks that we acquired bring very good and very low-cost deposits to us, and we are appreciative of that. In terms of the net interest margin increase of 8 basis points. We have roughly 25% of our loans being variable rate and we define variable rate as 1 year and less although the bulk of loans reprice in 90 days or less.
We need to manage the margin as closely as we can going forward. And we do note that for the most part, loan has gotten better during the quarter, although it is still very competitive, it is nevertheless better than it was 90 days ago.
In terms of noninterest income, it’s no surprise that mortgage production has been down but we did get the nice benefit from the mortgage servicing rights increase of $2.4 million of income. And in terms of wealth management, we saw clearly the market declines had an effect on our assets under management.
The one thing I would note in terms of wealth management is, you will recall last November, we brought over a wealth management team in Eastern Iowa generally located in the Cedar Rapids area. They are continuing to be subject to non-solicitation agreements, but those agreements will be up later this year. And when those agreements expire, we do expect to see meaningful increases in our assets under management, which I would think would show up in the first quarter of 2023.
I do have 2 observations on noninterest expense. It’s certainly a competitive market for employees. We’ve talked about this before. It’s not unique to MidWestOne, and this is ongoing and will continue to be ongoing, we predict. And we did have outsized legal expenses in the first half of 2022, we will not see this continue into quarter 3. We believe that is behind us.
In terms of capital management, I think we were opportunistic that we bought more or less 65,000 shares of our own stock at a price of just under $30 per share, $29.67 to be exact. We think that’s good value. We’ve currently paused that program, but we do expect to reenter the market if we see good opportunity going forward.
Tangible common equity was affected not only by the AOCI adjustment, but also by the acquisition, which I will remind you, was an all-cash acquisition of Iowa First, and our regulatory capital continues to be more than adequate in our view. And just a few words about the Iowa First acquisition. Finally, we were able to close that. It took almost 7 months to gain approval. And as we said in the first quarter call, there were no specific questions that were being asked of us. It was just took a long time for the approval process to work.
We integrated the smaller of the 2 banks, First National Bank of Fairfield last weekend. And by all accounts, this integration with extremely smoothly, partly any issues to report. We are on target to exceed cost saves, meet or exceed cost saves estimated on the transaction, and we do think that our earnings accretion will be better than anticipated and previously reported in 2022, but especially in 2023.
And with that, I would like to turn the mic, so to speak, over to our Chief Financial Officer, Barry Ray.
Barry Ray
Thank you, Charlie. I’ll start with the balance sheet. Total assets increased $482 million from the linked quarter, which reflected the $515 million of assets acquired in the Iowa First or IOFB acquisition we completed on June 9, 2022. With Iowa First, we acquired approximately $282 million in loans held for investment, $119 million in debt securities and assumed $464 million of deposits. The accretable purchase discount on IOFB-acquired loans was approximately $11 million, as provisionally measured during the second quarter of 2022. We expect to recognize the purchase discount through interest income on an accelerated basis over the next 4 to 5 years.
Adjusted core loans, which exclude both SBA PPP and Iowa first acquired loans increased $82.3 million or 10.5% annualized from the linked quarter. Excluding the $464 million of deposits assumed from Iowa First, deposit balances, as Charlie indicated earlier were basically flat from the linked quarter. The allowance for credit losses increased $6.2 million due to the $3.4 million allowance for purchased credit deteriorated loans established in the Iowa First acquisition as well as a $3.1 million of credit loss expense or CECL double count related to loans acquired in the Iowa First acquisition. Nonperforming assets were $27.6 million at June 30 or 0.43% of total assets and were down 35% from the prior year period.
Finishing the balance sheet. Total shareholders’ equity was down $38.6 million from year-end 2021 due to $56.4 million after-tax change in valuation adjustment on available-for-sale debt securities, $9.7 million in cash returned to shareholders in the form of quarterly dividends and share repurchases, partially offset by net income of $26.5 million. On the income statement, net interest income of $39.7 million was up $2.4 million or 6.4%. The reported net interest margin of 2.87% in the second quarter of 2022 was up 8 basis points from the linked quarter. Reported loan yields were up 4 basis points. If you exclude PPP and purchase discount accretion, the weighted average loan yield in the second quarter was 3.95%, which was up 15 basis points from the linked quarter.
Interest-bearing deposit costs were up only 2 basis points, which reflected our efforts to proactively manage our core deposit franchise. Noninterest income was $12.3 million for the first quarter — for the second quarter of 2022, which was up from the linked quarter, primarily due to the $1.4 million provisionally measured bargain purchase gain from the Iowa First transaction. Noninterest expenses were $32.1 million, up from $31.6 million in the linked quarter. We expect the first quarter of 2023 to be the next clean quarter for expenses, following the core system conversions of the former Iowa First Bank in Muscatine, which is scheduled for the fourth quarter of this year — sorry, third quarter of this year, excuse me.
Income tax expense was negatively impacted by an $835,000 charge in connection with the remeasurement of our deferred tax assets stemming from an Iowa Bank franchise tax rate change. Briefly, that tax law change reduces the bank franchise tax rate from 5% to 3.5% over the next 5 years. Assuming no further franchise tax rate changes, we expect to recoup this onetime charge via reduced Iowa state tax expense over the next 3 years.
With that, I’ll turn it over to our President, Len Devaisher.
Len Devaisher
Thanks, Barry. I just want to provide some color commentary on what we’ve seen from the revenue drivers piece of the business One of the things that you all have heard us talk a lot about is our focus on improving the earning asset mix of our balance sheet. So obviously, we’re pleased with the loan growth that we’re seeing. And my comments about loan growth would be exclusive of the acquired loans with Iowa First. But our loan growth in the second quarter was across every segment. Consumer, mortgage and commercial. And I think the commercial growth is especially notable in light of the decline in non-pass credits. You can see in our release about the decline in nonperforming assets. But overall, if you look at the decline in non-pass credits, we see core commercial, again, excluding PPP and Iowa First, core commercial growing $54 million of the quarter, and that’s net of a $33 million decline in non-pass credits.
In quarter two, we’re particularly encouraged as we see total loan production up over 26% over the first quarter of the year. So we see good momentum in terms of the asset side revenue growth. On the deposit side of the balance sheet and thinking about the strength of our deposit franchise, we were pleased with our level deposits quarter-over-quarter. But the key drivers we talk and look at consistently would be 3. Number one, net new deposit accounts. Number two, number of households; and number three, services per household. Again, in all 3 of those categories across both consumer and commercial client base, we see improvement. We continue to see growth in net new deposit accounts, net households and services per household on quarter-over-quarter. We’re proud of the team’s effort, and it’s really an example of the entire franchise contributing to those positive numbers.
And with that, we’re pleased to entertain questions.
Question-and-Answer Session
Operator
[Operator Instructions]. First question is from Brendan Nosal with Piper Sandler.
Brendan Nosal
And maybe just to start off on expenses. Certainly, it came in lower than I was thinking, just given that you had a partial quarter’s impact of Iowa First. Maybe just update us on the expected timing of cost savings from the deal and thoughts on the total cost run rate for the rest of the year once Iowa First is solely the numbers?
Barry Ray
Yes. This is Barry, Brendan. I’ll take that. I think that with respect to the cost savings from Iowa First, seems as if we’re on track to probably recognize those, I would say, by the end of this year. And so with respect to the ongoing run rate of expenses for the latter half of the year. We’re probably somewhere in the $33 million to $34 million range on a quarterly basis, and that reflects the addition of Iowa First. And I’m also including in there the increase attributable to the CDI amortization from that acquisition, Brendan. Does that answer your question?
Brendan Nosal
Yes, that’s very helpful. Maybe 1 more for me. I was just wondering if you folks could give us an update on the state of the ag sector across your markets?
Charles Funk
I’d say the state of the ag sector is pretty good. This is Charlie. Prices have been good. And while input costs, in other words, anything that has to do with petroleum is going to increase a lot of the — a lot of our borrowers that locked those costs in earlier this year and haven’t experienced the increase that the rest of us have. So I think, the outlook for this year is good. The crops look pretty good. We could use another rain. But at this point in time, I think it’s going to be a — certainly a good crop yield in Iowa, in our footprint. In terms of next year, there are going to be a little more margin pressure for our ag growers.
And because they’re going to have to deal with the increase in cost. And so next year, it’s probably an okay year. We expect prices to stay up because food demand is not going away and the food situation worldwide is, I think, tenuous. I think we all understand that. So next year could be a little tighter year, but notwithstanding some disaster that we see, we think this is a good year for ag. And I think our watch and substandard loans in the ag sector reflect that.
Operator
Our next question is from Terry McEvoy with Stephens.
Terence McEvoy
Okay. Sorry about that. If I could start with a question on the net interest margin. Charlie, you mentioned the likelihood of deposit rates moving higher given recent Fed actions, but then you also stressed that 25% of the loan portfolio is variable rate. So when you think about the third and the fourth quarter, which 1 outweighs the other? And I guess, my direct question is you think the margin can expand at least in the third quarter?
Operator
It seems we’ve lost connection with our speaker. One moment please, while we try to get him back on.
James Cantrell
Terry, this is Jim. I was I think in mid answer, maybe when we got disconnected .
Charles Funk
Can you hear us, Terry?
Operator
You are back online?
James Cantrell
Where should I start?
Charles Funk
The beginning.
James Cantrell
Okay. What I was talking a little bit about the core margin at the bank. I think the reported margin expanded 8 basis points. If you look at the core margin, which factors out some PPP fees that we took in the first quarter that really didn’t have in the second quarter, our core margin expanded 15 basis points, and I think that’s probably a better reflection of the earnings power. On a go-forward basis, I think we can manage our deposit costs increases at a pace that would be below our asset yield increases. So — but that’s something we’ll watch very closely.
And one of the other things I would point out is that we’ve had tremendous deposit growth over the last two years. and we do value those deposits, and we are going to price to retain, but we’re going to be pretty disciplined about that. And so we will use a combination of exception pricing and just outright changes to rate to maintain that deposit base. We do have some significant competition in the Eastern Iowa market, in particular.
As we move into the third and fourth quarter, I would anticipate we would continue to see a little bit of core margin expansion as we’re able to, again, lag the deposit side and see the benefit of some improved asset mix. I think we’re growing loans now. The deposit growth has really stabilized and has been pretty flat for the last 6 months. And I think we’ll benefit on the asset mix side as those loans replace investments on a go-forward basis. So we’re probably 5 to 10 to 15 basis points wider in the first quarter as compared to second quarter.
Operator
Our next question is from Andrew Corsica with D.A. Davidson.
Unidentified Analyst
This is Andrew on for Jeff Rulis today. Just a question on the deposit side. I was just wondering if you can speak to the deposit pricing competition in your footprint and the expectations on deposit pricing going forward?
James Cantrell
Yes. Andrew, this is Jim again. I will say we have a kind of a bifurcated market when it comes to deposit pricing. The franchise is located in Eastern — in the Eastern Iowa, Iowa City and towns in Eastern Iowa really see a lot of price competition on the deposit side coming from credit unions. So it wouldn’t be unusual for credit unions to be offering CD rates well above 2% in the current market, whereas many of the bank competitors that we see are nowhere close to that level. As we move — stay into the Twin Cities market, in some of our — and in Florida and in Denver, we don’t find as much price competition. And so that’s 1 of the things we’ll also do is pay attention to where we can differentiate ourselves regionally and price according to local market competition.
Unidentified Analyst
That’s helpful. Another question, more on the loan side. solid quarter loan growth wise. Just wondering how much of that might be attributable to pull forward demand as borrowers anticipate higher rates? Have you seen any of that?
Len Devaisher
Andrew, this is Len. I would say I do not see acceleration of projects in that way. That we ended the quarter with a strong pipeline, and we saw that pipeline convert as we expected.
Operator
Our next question comes from Damon DelMonte with KBW.
Damon DelMonte
So first question, just wanted to talk a little bit about on the credit front. Obviously, good trends this quarter, and you guys seem to feel pretty good about the direction of legacy credit trends. But as we think about loan growth occurring in the back half of the year and then potentially some softening in the broader macro picture. How do we think about provision level over the next couple of quarters?
Gary Sims
Damon, this is Gary Sims. I’ll start that conversation for you. I mean, what we see for the rest of the year relative to provision and our reserve levels are, we’re kind of going into this cycle that we are looking at pretty well reserved. So we feel like our go-forward provisions should be moderated relative to loan growth. And they primarily will be associated with loan growth. And the caveat that I’ll put there is, unless we see change.
Damon DelMonte
Okay. Great. And then with respect to the loan growth, based on the pipeline outlook and Charlie, I think you said July was off to a good start. I mean do you guys feel confident that you can do kind of mid- to upper single digits? Or do you feel it’s kind of like more of that 3% to 5% kind of level?
Len Devaisher
Damon, this is Len. I would stick more to the latter guidance. As I look forward, just given the pipeline, it’s interesting, remains pretty solid, and I feel good about the pipeline. What I would say is the, what I might call, the pre-pipeline, just the kinds of conversations and activity levels that we are hearing in the marketplace. We do see signs of caution, not panic, just caution. And so as a result of that, I still feel that low to mid-single-digit number is the right one as we look forward.
Damon DelMonte
Okay. Great. That’s helpful. And then just one quick question on the margin for Barry or Jim, either one. So the core margin this quarter, so you had about a 4 basis point impact from the accretable yield. Is that correct?
Barry Ray
Well, let’s see. The number I have, this is Barry, Damon. And I’m looking at it without the PPP or the — I’m sorry, the new purchase discounted — or you talking about just purchase discount overall Damon?
Damon DelMonte
Well, I’m just trying to get to a core margin ex PPP, ex accretable yield for this quarter, so I can kind of think about that going forward.
Barry Ray
Yes. So we were up on an 8 basis points on a reported basis. I would say, without PPP and purchase accounting, it was 14 basis points.
Damon DelMonte
Okay. All right. That’s helpful. And as far as like scheduled accretable yield in the coming quarters, do you have a ballpark we could use for that?
Barry Ray
I don’t have a number per se, Damon. It kind of like our experience would indicate and when we model these things for acquisition, we use an accelerated amortization method in the number that we recorded was $11 million for the Iowa First acquisition. And so — and usually, we look at that over the expected life of the loan portfolio 4 to 5 years.
Operator
[Operator Instructions]. Our next question comes from Brian Martin with Janney Montgomery.
Brian Martin
So just maybe one follow-up on Damon’s question I guess I was just trying to understand the same thing if you guys know it. I guess I was thinking that the core margin ex those 2 items you called out, either Barry or Jim was kind of in that low 280s range. Does that seem like that’s the right wheelhouse of where we start based on kind of what you guys calculate?
Barry Ray
That’s the correct real house, Brian.
Brian Martin
Okay. All right. So low 280s is a good number. then. Can you just talk a little bit, Barry, or just maybe Jim, whomever just as you kind of factor in the — what the forward curve is showing here, kind of where you think the margin may — once you get a little bit more benefit here, does it begin to level out early next year? Is that how you guys are thinking about it? And just given kind of the pricing dynamics in your market and the deposit betas you guys are expecting certainly get the benefit early on as it lags, but as it catches up, is that how we should think about it?
James Cantrell
I’m happy to take a stab. This is Jim, Brian, and I’ll hand it over to Barry. That is how I do think about it. I think over the next couple of quarters, if we’ve had, what, 225 basis points of increase so far. I think the forward curve is projecting another 75 of the next meeting 50 to 75, probably another 100 in total.
During that period, while rates are rising, I do think there’s opportunity for us to see margin expansion, during that period. The forward curve says that the Fed funds are going to peak in January or February in the low 3. Once that happens, depending on the shape of the yield curve, and deposit mix and all those other variables, I think we probably see a slowdown in margin expansion in the holding. And we’ll just have to see what happens then. It will be a function of what’s the shape of the yield curve looks like in our deposit — in our loan or our asset mix at that point. But I do think during this period, this next 6 months, we probably have an opportunity to see a little bit of widening.
Brian Martin
Got you. Okay. And I guess just on the well side, Charlie, you talked about or maybe Len, whoever, just on the pickup you expect from the focus you’ve got that you’ve brought it forward. Can you put any kind of context around how we should think about how much of a lift we should see from that down the road as they bring on their books of business and kind of work through those noncompetes?
Charles Funk
Well, yes, that’s — it’s a great question. I’m not sure I can give you a definitive answer. But I’ll take a stab at it. There are a couple of variables that we have. Number one, you can get a customer’s consent to move assets. And depending on where the assets are moving from, it can take 2 or 3 months to move. So that enters into it, but I would think by a year from now that it could easily be — and this is a wide range, but at least $100 million and it could be as much as $200 million. And we would also include the Twin Cities wealth team in that because we expect them to continue to gather momentum. But that’s a wide range, Brian, but that’s what we would hope to do at a minimum.
Brian Martin
Got you. Okay. That’s helpful. Just to add some context to how to think about it is good. And maybe just the last 1 or 2 for me. Just the mortgage business, obviously, you talked about Charlie, but just as far as kind of putting in the floor about what we should expect there is this quarter a pretty good level as far as how to think about the go-forward look at mortgage?
Charles Funk
Yes. I mean things have slowed down quite a bit for mortgage and you probably noticed we’re doing more in-house loans now, and most of those would be 5/1 and 7/1 arms. It might be a few 10 ones, but most of them are 5/1s and 7/1s. So we have — we still have a pretty robust pipeline of pre-approved loans, but where people haven’t bought the house yet. Now some of those, they probably will wind up not buying because of interest rates, but if we’re not at a floor, I would think we’re close to a floor.
Brian Martin
Got you. Okay. That’s helpful. And then with that, maybe for Barry, I don’t know the tax rate change the go-forward tax rate we should think about, does it change Barry? Or is this kind of a good level — what’s a good level to think about on that tax rate?
Barry Ray
Yes. We’re thinking the for the tax rate for the year, 20% to 22%, Brian, is what we’re thinking.
Brian Martin
Okay. And then just to be clear, Barry, your comment about the accretion on the transaction with Iowa first. The way we should think about it is if that $11 million mark, the way you’re thinking about the world today is it’s just a straight line, and you did that you said over 3 years or so. Is that kind of the best way to model it? I mean we saw early signs with the deal closing now, I guess. But just as we think about next quarter, just take that and look at it from a straight-line basis? Or what’s your suggestion? Maybe it sounds like you were a little bit quicker accelerated than that.
Barry Ray
Yes. What my comments were accelerated in around 4 to 5 years. It’s difficult to say how it’s actually going to flow through the earnings given what we’re seeing in the environment right now, it could be straight line, might be a better approximation. But my comments really centered around how we modeled it, which was accelerated.
Operator
There are no further questions waiting at this time. So I’ll pass the call back over to the management team for closing remarks.
Charles Funk
Thank you to everyone who joined the call. We apologize for the blip in the middle of the call. Our phones went dead in Iowa City. But fortunately, we were able to get back on the line. So thanks again. Have a great weekend, and I’ll send it back to you, Jason.
Operator
That concludes the conference call. Thank you for your participation. You may now disconnect your lines.
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