Arrow Financial Corporation — Q3 2019 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2019. Arrow is a New York bank holding company operating Glens Falls National Bank and Saratoga National Bank, with insurance, investment-advisory and other subsidiaries. Amounts below are in millions unless otherwise noted. Interim financial statements were reviewed by KPMG, not audited.
Financial performance and condition
- Q3 earnings: Net income was $10.1 million, up 8.7% from $9.3 million a year earlier. Diluted EPS was $0.67 versus $0.62. Return on average assets was 1.32%; return on average equity was 13.82%.
- First nine months: Net income was $27.7 million, up 0.8% year over year; diluted EPS was $1.85 versus $1.84. ROA declined to 1.24% from 1.30%, and ROE to 13.21% from 14.32%.
- Interest income and margin: Q3 net interest income was $22.3 million, up 6.2%; GAAP net interest margin was 3.07%, up from 3.02%. For the nine months, net interest income rose 4.4% to $65.1 million, while margin declined to 3.04% from 3.09% (tax-equivalent margin: 3.09% versus 3.15%). Q3 margin benefited from loan growth and balance-sheet mix, while higher funding costs pressured year-to-date margin.
- Other income, expenses and taxes: Q3 noninterest income increased 4.6% to $7.7 million; nine-month noninterest income fell 3.1% to $21.5 million, including lower fiduciary and insurance income, partly offset by loan-sale gains. Noninterest expense rose 4.8% in Q3 to $16.8 million and 4.5% year to date to $50.4 million. Technology and equipment costs were higher; Q3 and year-to-date FDIC expense included $687,000 of assessment credits. The Q3 effective tax rate was 20.6%; the nine-month rate was 20.3%.
- Loans and deposits: At September 30, total loans were $2.336 billion, up 9.9% year over year; deposits were $2.615 billion, up 8.6%. Consumer lending, primarily auto loans, was a major growth driver. Management said deposits also included a net $70 million acquisition of brokered deposits during 2019 to diversify funding.
- Credit quality: The allowance for loan losses was $20.9 million, or 0.90% of loans, versus 0.94% a year earlier. Nonperforming loans were $4.7 million (0.20% of loans), down from $5.8 million (0.27%) a year earlier; nonperforming assets were $6.0 million. Q3 net charge-offs were $282,000, or 0.05% of average loans annualized. Management considered the allowance appropriate and described portfolio credit quality as strong.
- Cash flow: For the first nine months, operating cash flow was $32.7 million, investing cash use was $100.5 million and financing cash flow was $75.8 million. Cash and cash equivalents ended at $92.3 million, up $8.1 million from year-end 2018.
- Capital and liquidity: Stockholders’ equity was $292.2 million, up 10.4% year over year. The company reported a 12.93% CET1 ratio, 14.81% total risk-based capital ratio and 10.04% Tier 1 leverage ratio; it and both subsidiary banks qualified as well-capitalized. Available FHLB borrowing capacity was approximately $577 million and Federal Reserve discount-window capacity approximately $574 million; the basic liquidity ratio including FHLB collateralized capacity was 18.6% of assets. Management reported no significant liquidity constraints.
- Borrowings: At period-end, FHLB overnight advances were $48 million and term advances $30 million, versus $234 million and $45 million, respectively, at December 2018. Repurchase-agreement and federal-funds borrowings were $72.9 million; junior subordinated obligations were $20 million. Finance lease liabilities were $5.3 million following lease-accounting adoption.
Material changes and notable items
- Q3 earnings growth reflected higher loan interest income and net interest income. Loan balances increased $209.5 million year over year, while investment securities declined as the company shifted earning assets toward loans.
- Funding costs rose materially: Q3 interest expense increased 61.5% year over year and nine-month interest expense nearly doubled, reflecting higher deposit costs and funding needs. The nine-month cost of interest-bearing liabilities rose to 0.98% from 0.52%.
- The company adopted lease accounting on January 1, 2019, increasing reported assets by $7.9 million and liabilities by $8.0 million, with no retained-earnings adjustment or material income-statement impact.
- Arrow distributed a 3% stock dividend on September 27, 2019; share and per-share comparisons were restated. It paid $0.252 per share in Q3 and announced a Q4 dividend of $0.26 per share, payable December 13, 2019.
- A $5 million 2019 share repurchase authorization remained in effect through year-end; approximately $1.2 million had been used under the program by September 30. In October, the board approved a new $5 million program for 2020.
Outlook, risks and contingencies
- The filing provides no formal earnings or revenue guidance. Management noted market expectations for lower short-term rates through the remainder of 2019 and into 2020, and said the balance sheet was positioned for a range of rate environments. Its interest-rate model estimated that a 200-basis-point increase would reduce year-one net interest income by 2.90%, while a 100-basis-point decrease would increase year-one income by 0.70%; results are hypothetical and depend on assumptions.
- Management identified risks from economic and market changes, interest-rate and funding-cost movements, competition, technology and regulation, and potential weakening in commercial real estate, consumer-auto or residential markets. Loan growth and continued credit quality are not assured.
- Arrow planned to adopt the expected-credit-loss standard (CECL) in Q1 2020. It was testing methods and expected to use an 18-month forecast with a two-year reversion period; methods could change. The filing gives no clear quantified estimate of the adoption impact, but management expected to remain well-capitalized under current regulatory calculations.
- Off-balance-sheet commitments to extend credit totaled $341.0 million and standby letters of credit $3.2 million. These are not necessarily expected cash needs; management did not expect material losses from them. Management and counsel reported no pending or threatened legal matter expected to cause a material loss.
- Arrow held 27,771 Visa Class B shares with potential conversion value tied to antitrust litigation settlement arrangements; it recognized no economic value because settlement outcomes were uncertain. Newly entered customer interest-rate swaps had $39.6 million notional value and offsetting terms; management said they created no material income-statement exposure.
Most important facts for investors to verify
- Whether strong loan growth continues and whether auto-loan, commercial real estate and other credit performance remains sound.
- Whether deposit costs, brokered-deposit reliance and other funding costs constrain net interest margin as rates change.
- The future efficiency and earnings effects of higher technology and operating expenses, alongside the temporary FDIC assessment credits.
- CECL implementation progress, final methodology and the transition’s actual effect on the allowance and capital.
- Liquidity and capital levels, including the availability and terms of borrowing facilities and the company’s potential use of the community bank leverage ratio framework.
- Developments in the Visa litigation settlement and any resulting change in the value or conversion of the Class B shares.