ARROW FINANCIAL CORP quarterly report, Q2 FY2017

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Arrow Financial Corporation — Q2 2017 Form 10-Q

Business context and reporting period. Arrow is a New York-based bank holding company operating two banks and related insurance, investment-advisory and other businesses. This unaudited quarterly report covers the three and six months ended June 30, 2017; balance-sheet comparisons are primarily with December 31, 2016 and June 30, 2016. KPMG performed an interim review, not an audit.

Financial performance and condition

  • Quarterly earnings: Net income was $7.208 million, up 8.4% from $6.647 million; diluted EPS was $0.53 versus $0.49. Return on average assets was 1.08% and return on average equity was 12.08%.
  • First-half earnings: Net income was $13.839 million, up 4.9%; diluted EPS was $1.02 versus $0.98. Annualized ROA was 1.05% versus 1.07%, and ROE was 11.76% versus 12.02%.
  • Net interest and margins: Q2 GAAP net interest income was $19.227 million, up 7.1%; tax-equivalent net interest income was $20.176 million, up 6.9%. Tax-equivalent net interest margin was 3.17%, down 3 basis points year over year. For the first half, GAAP net interest income was $37.688 million, up 6.7%, and tax-equivalent margin was 3.16%, down 2 basis points.
  • Revenue, expenses and taxes: Q2 noninterest income was $7.057 million, down 1.9%, while noninterest expense rose 5.1% to $15.637 million. Higher fiduciary income and loan-sale gains were offset by no securities gains and lower other operating income. Q2 efficiency ratio was 57.16%, essentially unchanged; first-half ratio rose to 58.07% from 56.98%. Effective tax rates were 29.5% for Q2 and 29.2% for the first half, lower than the comparable 2016 periods.
  • Balance sheet and funding: Total assets were $2.722 billion, up 4.5% from year-end 2016. Loans were $1.879 billion, up 7.2% since year-end and 12.3% year over year; deposits were $2.220 billion, up 4.9% since year-end. Cash and cash equivalents were $66.1 million. Borrowings included $122 million of FHLB overnight advances, $55 million of FHLB term advances, $40.9 million of federal funds and repurchase agreements, and $20 million of junior subordinated obligations.
  • Cash flow: For the first half, operating activities provided $18.6 million, investing activities used $110.6 million (including $126.5 million of net loan growth), and financing activities provided $100.7 million, primarily from deposit growth. Cash and cash equivalents increased $8.7 million to $66.1 million.
  • Capital and shareholder returns: Stockholders’ equity was $240.8 million. Regulatory ratios included CET1 of 12.68%, total risk-based capital of 14.77%, and leverage of 9.35%; management reported the company and both banks were well-capitalized. Book value per share was $17.84 and tangible book value per share was $16.04. First-half cash dividends were $6.7 million; treasury-stock purchases were $1.9 million. A third-quarter dividend of $0.25 per share was declared after quarter-end.

Material changes versus comparable periods

  • Loan growth and a shift from lower-yielding securities toward loans supported higher net interest income; higher funding costs partly offset that benefit. Q2 interest expense increased 32.3% year over year.
  • First-half operating expenses increased 6.3%, led by salaries and benefits, which rose 9.4%; management cited added staffing, normal raises and higher medical claims.
  • Nonperforming assets were $8.8 million, up 6.7% year over year and 21.9% from year-end. Nonperforming loans were $7.1 million, or 0.38% of loans, versus $5.5 million at year-end. The allowance was $17.4 million, or 0.93% of loans, compared with 0.97% at year-end.
  • First-half operating cash flow increased from $15.0 million in 2016 to $18.6 million in 2017, while net cash used in investing increased as loan growth accelerated.

Outlook, risks and unusual items

  • The filing gives no broad earnings or EPS guidance. Management expected elevated residential mortgage originations to continue during 2017, while noting that higher interest rates could weigh on loan demand, asset yields and margins. It also flagged possible weakening in auto demand and regional commercial real estate or business conditions.
  • Management reported no significant loan-quality deterioration overall and considered the allowance appropriate. Q2 provision for loan losses was $422,000, versus $669,000 a year earlier; the provision reflected charge-offs, loan growth, auto-loan qualitative factors and one impaired commercial real estate loan, partly offset by lower classified commercial real estate loans.
  • Management reported no liquidity problems. The basic liquidity ratio, including FHLB collateralized capacity, was 10.4% of assets, or $174 million above its 4% internal minimum. Available capacity included approximately $248 million at the FHLB and $399 million at the Federal Reserve discount window; neither facility had advances outstanding at quarter-end.
  • Interest-rate simulations estimated a 2.63% decrease in net interest income over 12 months under a 200-basis-point rate increase and a 0.08% increase under the modeled rate decrease. These are scenario estimates, not forecasts; management cautioned that deposit repricing could precede asset repricing.
  • Management cited seasonal and competitive variability in municipal deposits, which typically represent 28%–34% of deposits. Rising rates could increase deposit costs and pressure margins. Other risks include credit quality, competition, regulatory changes, and broader economic and market conditions.
  • Arrow adopted new share-based-payment accounting in 2017; related stock-option tax benefits increased first-half earnings by approximately $112,000, or less than $0.01 per share. Management did not expect material effects from several pending accounting standards, but had not quantified the future CECL allowance impact and anticipated a significant change to its allowance methodology.
  • Available-for-sale securities had $1.493 million of gross unrealized losses at June 30; management attributed these mainly to market-rate and spread movements, considered them temporary, and reported no other-than-temporary impairment in the first half. A contingent exposure related to Visa litigation remained; management considered Visa’s escrow substantially sufficient and assigned no economic value to Arrow’s restricted Visa Class B shares.
  • The company reported no material pending legal proceedings, no defaults on senior securities, and no material changes to previously disclosed risk factors. Disclosure controls were deemed effective.

Important facts for investors to verify

  • Whether loan and deposit growth can continue without materially increasing funding costs or weakening underwriting quality.
  • Trends in nonperforming loans, delinquencies, auto-loan credit tiers, commercial real estate exposures, and the adequacy of the allowance as loans expand.
  • Margin sensitivity to interest-rate changes, including actual deposit repricing and the timing of asset repricing versus the company’s modeled scenarios.
  • Whether rising salary, benefit and technology expenses affect the efficiency ratio and earnings growth.
  • Future effects of CECL adoption, the Visa litigation and escrow position, and seasonal or competitive changes in municipal deposits and available liquidity.