MSBI - Midland States Bancorp Offers Attractive 8.3% Yielding Preferred Share

2023-06-05 07:38:56 ET

Summary

• Midland States Bancorp's preferred shares are yielding 8.3% and are an attractive holding for income investors.
• The bank's net income covers the preferred share dividends by nearly 10 to 1.
• Preferred shareholders should feel comfortable with their income returns and ability for the bank to call this security in at or after 2027.

Midland States Bancorp (MSBI) is another regional bank beat up by the recent events in the sector. Like many other banks, Midland offers a Series A preferred share ( MSBIP ). During the regional bank selloff, the 7.75% dividend preferred shares followed suit. While they have recently rallied, the shares are still yielding 8.3% and based on the bank's first quarter earnings, I believe these are an attractive holding for income investors.

Midland's financial performance in the first quarter was slightly better than the same quarter a year ago. The bank increased interest income by $32 million as interest rates rose. Consequently, interest expense rose by $30 million led by the cost of deposits. Ultimately, net interest income grew by nearly $4 million, a number which grew to nearly $5 million after incorporating a reduced allowance for credit losses. Despite increases in operating costs (led by employee salaries), the bank's net income increased by $1 million. Midland States Bancorp's net income covers the preferred share dividends by nearly 10 to 1.

Like many bank balance sheets, Midland States' balance sheet consists of mostly loans and deposits. During the first quarter, the bank grew its loans by just under 1%, while reducing its cash balance. On the liability side, the bank also grew deposits by approximately 1% and slightly increased its outside borrowings through the Federal Home Loan Bank. Overall, shareholder equity grew $17 million to $775 million in the first quarter.

As Midland States Bancorp navigates the world of higher interest rates, it is important for the bank's net interest margin to remain stable. The bank's loan yield increased 125 basis points from a year ago to 5.65%. Interestingly, the bank's alternative holdings helped buoy the return on interest bearing assets by nearly 150 basis points to 5.35%. Consequently, the bank deposit rate and interest-bearing liabilities have increased by nearly 200 basis points. This has led to an 11-basis point drop in net interest margin to 3.39%.

Midland States' loan composition also helps provide investors with information on the bank's exposure to various sectors. The bank has close to a third of its loans tied into commercial real estate, followed by commercial & industrial (C&I), then consumer. Theoretically, these loans should be getting refinanced in terms of five years or less, therefore a near-term opportunity to improve yields and net interest margin exists.

Until the bank can refinance more of its loans, earnings headwinds will persist, making the common shares less attractive versus the preferred shares. Additionally, slightly over 1% of the bank's loans are past due or in non accrual status, which is slightly higher than the bank's loan loss allowance. Increasing the bank's loan loss allowance causes earnings to drop and directly impacts common shares because they are junior to preferred shares.

When it comes to overall risk to the bank, approximately 20% of the bank's deposits are uninsured, accounting for approximately $1.4 billion. The bank's liquidity, at nearly $1.6 billion, covers this risk. However, it is important to note that the bank's leverage will likely need to increase to cover any losses in loans or deposits as the bank's cash ratio is much lower than its peers, but its leverage ratio is also manageable compared to the banking sector.

The bank's preferred shares do face interest rate risk as the dividend is set to reset in September 2027 at the five-year Treasury rate plus 4.713%. The five-year Treasury would need to be slightly over 300 basis points to maintain its current dividend (currently 385). While the likelihood of rates being below those levels seems reasonable, it is also possible that the bank will be able to call in the preferred shares and reissue new shares at a lower interest rate.

The challenges ahead could impact the bank's common shares, but the 8.3% preferred shares are only at risk if the bank eliminates its preferred dividend. This would only come if the life of the institution were threatened. The bank has the liquidity to cover its uninsured deposits, can refinance most of its loans over the next five years to increase earnings, and has a lower leverage ratio than the industry to allow for additional borrowings. Preferred shareholders should feel comfortable with their income returns and ability for the bank to call this security in at or after 2027.

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