Midland States Bancorp: A Value Investor's Check of the Moat and Margin of Safety

The core question for any value investor is whether a business possesses a durable competitive advantage-a wide moat that can protect its economic profits over decades. For Midland States Bancorp, the evidence suggests a classic community bank moat is intact, but it is currently being tested by a management team executing a difficult strategic retreat. The durability of this franchise now hinges on the discipline shown in capital allocation.

The first sign of management's discipline is the clear-eyed decision to exit higher-risk portfolios. The bank has ceased equipment finance originations, sold its LendingPoint fintech platform, and exited the GreenSky partnership. This is a necessary, if painful, step to repair credit quality and simplify operations. The cost is visible in the numbers, with a $20.5 million provision for credit losses in Q3 2025, largely tied to the winding down of these segments. While this creates near-term earnings pressure, it is a classic example of sacrificing short-term profit for long-term stability-a move that aligns with the principle of preserving capital. The strategic retreat is a sign of maturity, acknowledging that some bets have not worked and choosing to focus on the core.

The resilience of the core community banking segment is the second pillar supporting the franchise. Despite the strategic pullback, the underlying business continues to function. The most telling metric is the Net Interest Margin (NIM) expanding to 3.79% in the third quarter. This expansion, driven by falling funding costs, demonstrates that the bank's core deposit base and lending relationships are still generating a solid spread. It suggests the fundamental "relationship banking" moat-built on local decision-making and trust-remains viable. This is the engine that must power the recovery, as it is the only part of the business that is both growing and profitable.

The critical test, however, comes down to capital allocation. Management has faced a difficult choice: return cash to shareholders or fortify the balance sheet. The record shows a preference for the former, with a dividend increased to $0.32 quarterly and a $25 million buyback authorized even while reporting negative earnings and a 91% payout ratio. This created a potential cash drain at a time when the bank needs every dollar to weather credit losses. The upcoming Q4 2025 earnings release scheduled for January 22, 2026, will show whether this discipline has shifted. The market will be watching to see if the bank prioritizes balance sheet repair-perhaps by cutting or suspending the dividend and buyback-over maintaining shareholder returns. This is the ultimate stress test for management's commitment to the long-term value of the franchise.

The bottom line is that Midland's moat is not gone; it is being defended. The bank is choosing to fight a defensive battle to clean up its balance sheet, a move that may temporarily weaken its financials but aims to preserve the core business. The value investor's patience will be tested, but the setup is now clear: the bank's future depends on whether management can successfully grow the resilient core while navigating the costly wind-down of its riskier ventures.

Financial Health: The Cost of Repair and the Path to Stability

The financial impact of Midland's strategic retreat is now clear in the numbers. The bank took a decisive step to clean up its balance sheet, but the cost was a sharp drop in profitability. In the third quarter of 2025, a $20.5 million provision for credit losses caused net income available to common shareholders to fall to just $5.3 million. This is the direct price of acknowledging and setting aside capital for the credit risks tied to its exiting equipment finance and other specialty lending portfolios. While the core business showed resilience with a Net Interest Margin expanding to 3.79%, the provision wiped out much of that gain, highlighting the near-term earnings pressure of the cleanup.

The path to stability is being charted through capital strength. Management has set a clear target: a Common Equity Tier 1 (CET1) capital ratio of 10.0%. The bank is moving in that direction, with the ratio improving to 9.37% in Q3 2025. This increase is a positive signal that the bank is bolstering its financial cushion as it exits riskier assets. The goal is to build a wider moat of capital safety, which will be essential for weathering any future credit storms and supporting the long-term growth of the core community banking franchise.

Yet, the credit quality challenges that necessitated this repair remain a tangible concern. The preliminary results for the first quarter of 2025 laid out the foundation for the cleanup, showing a loan book under strain. At that time, the bank reported $43.5 million in loans 30-89 days past due and $140 million in nonperforming loans. These figures represent the legacy issues that are being actively managed through sales and tighter underwriting. The fact that the bank is still reporting such levels of past-due and nonperforming loans underscores the depth of the problem it is facing and the importance of the capital build-up. The current trajectory of the CET1 ratio toward 10% is the bank's primary tool for regaining the stability needed to turn these numbers around.

The bottom line is a balance sheet in transition. The bank is paying a premium in the short term-through provisions and lower earnings-to fortify its capital and credit quality. The improvement in the CET1 ratio is a tangible step toward the target, but it must be sustained while the bank continues to manage a loan book with significant delinquencies. For the value investor, this is the setup: a company sacrificing current earnings for a stronger, more durable financial foundation. The margin of safety will be determined by whether this capital build-up is sufficient to absorb the remaining credit risks and support a return to sustainable, core-driven profitability.

Valuation and the Margin of Safety: A Peer-Comparative Lens

The market's verdict on Midland's strategic retreat is written in its stock price. As of January 2026, the trailing P/E ratio sits at a severe -17.2. This negative multiple is a stark reflection of the company's recent financial reality: significant losses from the credit cleanup are being priced in. For a value investor, this creates a potential margin of safety, but it is a margin that must be scrutinized against the backdrop of the bank's specific challenges and its peers' valuations.

The contrast with peers is telling. While Midland trades at a deep discount, its regional banking competitors command positive multiples. Northeast Bank (NBN) trades at a P/E of 11.0, and National Bank Holdings (NBHC) at 12.6. The fact that Midland's valuation is so much lower-by over 160 percentage points in each case-highlights the market's harsh assessment of its unique problems. This isn't a sector-wide discount; it's a penalty for the specific credit deterioration and strategic missteps in equipment finance and fintech partnerships. The market is pricing in a higher risk of further losses and a more uncertain path to stability than it is for its peers.

Yet, within this bleak picture, there are signs of underlying strength that a value investor must weigh. One such sign is the bank's balance sheet structure. In late 2022, before the full brunt of the credit issues hit, Midland maintained a loan-to-deposit ratio of 99%. This figure, while not recent, indicates a fundamental characteristic of the business: it has historically been able to fund its loan growth primarily from its own deposits. This is a critical advantage. It means the bank can grow its core lending business without immediately resorting to more expensive wholesale funding, which would pressure margins. The path to a return to positive earnings and a normalized valuation likely depends on management successfully growing this core deposit-funded lending engine.

The bottom line is a valuation that offers a wide discount for a clear reason. The negative P/E is not a value trap in the abstract; it is a direct consequence of the $20.5 million provision for credit losses and the strategic retreat. The margin of safety, if it exists, must be measured against the bank's ability to repair its capital, grow its resilient core, and avoid further impairments. The stark gap with peer valuations underscores the severity of the current challenges, but the deposit-funded business model provides a tangible foundation upon which a recovery could be built. For the patient investor, the price now reflects the pain of the cleanup, but the future value will be determined by the discipline shown in navigating it.

The Value Investor's Checklist: Catalysts, Risks, and What to Watch

For the patient investor, the current setup is one of high-stakes transition. The bank's strategic retreat is a necessary repair, but its success hinges on a series of near-term events and the consistent improvement of key financial metrics. The checklist is clear: watch for the resolution of accounting uncertainties, monitor for hidden credit risks, and track the core franchise's revival.

The primary catalyst is the completion of the accounting review for third-party lending arrangements. The company is completing its evaluation, subject to review by its independent registered public accounting firm, of these arrangements. This process is the critical path to filing the restated 2024 Annual Report. The market's patience is being tested; delays here could prolong uncertainty and keep the stock under pressure. The filing, when it comes, will provide audited, restated financials for the full year, offering a definitive picture of the credit and accounting issues. Until then, the preliminary results remain a guide, not a final verdict.

A key risk is that credit quality issues in legacy portfolios are more severe than currently provisioned. The bank has taken a $20.5 million provision for credit losses in Q3 2025, but this is a snapshot. The ongoing evaluation of third-party lending and the sale of GreenSky loans are steps to reduce exposure, but the full extent of potential future impairments remains unknown. If the accounting review uncovers deeper problems, it could necessitate further capital infusions or impairments, threatening the bank's capital ratio target and its ability to fund the core business. This is the hidden vulnerability that a value investor must watch.

The specific metrics to watch are the tangible signs of a recovering core franchise. First, a sustained expansion of the Net Interest Margin (NIM) above its recent level of 3.79% is essential. This margin is the bank's fundamental spread; its expansion to 3.48% in Q1 2025 showed early promise. A consistent climb back toward or above 3.79% would signal that the core deposit-funded lending engine is regaining its profitability and that management's focus on relationship banking is paying off.

Second, and more critically, watch for a consistent decline in nonperforming assets. The bank reported $43.5 million in loans 30-89 days past due in early 2025. While management notes no significant new substandard loans in Q1, the trajectory of these delinquencies and the overall nonperforming loan total will be the clearest signal that the credit clean-up is working. A steady reduction would demonstrate that the strategic retreat is effectively isolating and resolving the legacy risks, freeing up capital and management focus for the core business.

The bottom line is that the investment thesis is on hold until these catalysts play out and the key metrics turn. The value is in the potential for a disciplined turnaround, but it is not yet priced in. The patient investor's role is to monitor the resolution of the accounting review, the stability of the capital ratio, and the clear, measurable signs that the core franchise is regaining momentum.