CHOICEONE FINANCIAL SERVICES INC annual report, FY2019

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ChoiceOne Financial Services, Inc. — 2019 Form 10-K

Reporting period: Fiscal year ended December 31, 2019. Unless otherwise noted, amounts are U.S. dollars. ChoiceOne is a Michigan community banking holding company; 2019 results include Lakestone Bank & Trust following the October 1, 2019 merger with County Bank Corp. Consequently, comparisons with 2018 are not on a like-for-like basis.

Financial performance and position

  • Scale at year-end: Total assets were $1.386 billion, gross loans $802.0 million, net loans $798.0 million, deposits $1.155 billion, and shareholders’ equity $192.1 million. Assets, loans, deposits, and equity increased substantially, principally because of the County merger.
  • Revenue and earnings: Interest income was $32.5 million (2018: $24.5 million); noninterest income was $9.2 million (2018: $6.9 million). Net interest income rose to $27.8 million from $22.1 million. Net income was $7.17 million, down from $7.33 million; basic and diluted EPS were each $1.58, versus $2.03 and $2.02, respectively.
  • Merger-adjusted earnings: Management reported non-GAAP adjusted net income of $8.94 million, or adjusted diluted EPS of $1.97, excluding $1.769 million after tax of merger-related expenses. This is a company-defined non-GAAP measure, not a substitute for GAAP results.
  • Profitability and margins: Return on average assets was 0.85% (2018: 1.15%); return on average equity was 6.48% (9.55%). Tax-equivalent net interest margin was 3.71% (3.86%), while net interest spread was 3.47% (3.68%). Higher funding costs outpaced the increase in yields.
  • Credit costs and quality: No loan-loss provision was recorded in 2019; net charge-offs were $616,000, compared with net recoveries of $61,000 in 2018. The allowance was $4.06 million, or 0.51% of gross loans (1.14% in 2018), and covered 63% of reported nonperforming loans (123%). Nonperforming loans totaled $6.41 million, including $4.69 million on nonaccrual; management separately identified $14.0 million of loans with some repayment concerns.
  • Cash flow and liquidity: Net cash from operating activities was $9.2 million. Investing activities provided $36.4 million, including merger-related cash and security-sale proceeds; financing activities used $5.7 million. Cash and cash equivalents ended at $59.6 million, versus $19.7 million. Management said liquidity was sufficient; reported available capacity included approximately $95.5 million of correspondent federal-funds lines and $78.6 million of additional FHLB borrowing capacity.
  • Debt and funding: FHLB advances were $33.2 million at year-end (2018: $5.2 million); no federal funds were purchased at year-end (2018: $4.8 million). Deposits were the primary funding source. The company and both banks were classified as well-capitalized; year-end total risk-based capital ratios were 14.2% for the holding company, 13.2% for ChoiceOne Bank, and 15.0% for Lakestone Bank & Trust.

Material changes versus the prior comparable period

  • The County transaction added approximately $711.9 million of assets at acquisition, including $424 million of loans and $573.6 million of deposits. ChoiceOne issued about 3.604 million shares valued at approximately $108 million. The acquired business contributed $2.3 million of earnings from October 1 through year-end.
  • Year-end gross loans nearly doubled to $802.0 million, primarily from the merger; commercial real estate and residential real estate balances rose to $326.4 million and $218.0 million, respectively. Management said organic loan growth was minimal amid paydowns.
  • Net interest income increased, but the tax-equivalent spread narrowed 21 basis points as the average rate paid on interest-bearing liabilities rose 26 basis points while asset yields increased 5 basis points.
  • Noninterest expense rose $8.0 million to $28.5 million, reflecting Lakestone’s inclusion for the fourth quarter and merger costs. Noninterest income increased $2.25 million, including higher mortgage-sale gains and Lakestone-related income.
  • Reported net income declined modestly despite higher net interest income; merger expenses and the larger share count affected reported earnings and per-share comparisons. Goodwill rose to $52.9 million, including $39.1 million recognized in the County merger.

Outlook, risks, contingencies, and unusual items

  • Interest rates: Management stated that Federal Reserve rate cuts in March 2020 were expected to pressure interest income and spread. Its year-end simulation showed a 10% decline in modeled net interest income under an immediate 400-basis-point rate decrease; management also disclosed that modeled equity-value declines in the 300- and 400-basis-point-down scenarios slightly exceeded internal policy guidelines.
  • COVID-19: The filing said borrower impacts from the novel coronavirus were not yet clear and warned that payment-extension requests, borrower distress, collateral values, and operating disruptions could adversely affect results. The filing provides no quantified COVID-19 earnings or credit-loss estimate.
  • Pending acquisition: In January 2020, ChoiceOne agreed to acquire Community Shores Bank Corporation. Consideration is elective cash of $5.00 per share or 0.17162 ChoiceOne shares, subject to limits requiring 50%–75% of Community Shores shares to be exchanged for ChoiceOne stock. Regulatory and shareholder approvals and other customary conditions remained outstanding; management expected closing in the second half of 2020.
  • Dividends: Declared dividends totaled $1.40 per share in 2019, including a $0.60 special dividend paid in connection with the County merger. The payout ratio was 81%, versus 35% in 2018. Management expected regular quarterly dividends in 2020, but said amounts would depend on conditions, liquidity, and capital needs.
  • Other risks and contingencies: Key exposures include borrower credit and collateral risk, Michigan economic conditions, funding and interest-rate sensitivity, competition, regulation, cybersecurity, and environmental liability on foreclosed property. Management reported no significant pending litigation expected to materially affect consolidated financial condition. The auditor issued unqualified opinions on the financial statements and internal control; the acquired County/Lakestone operations were excluded from the internal-control assessment.

Important facts for investors to verify

  • Whether the County merger delivers expected integration benefits and cost savings, and how the pending Community Shores transaction affects capital, shares outstanding, and future earnings.
  • The quality and performance of acquired loans, the $14.0 million concern list, rising nonaccrual loans, and adequacy of the allowance given its lower loan-coverage ratio and acquired-loan fair-value marks.
  • The sustainability of net interest income and margins after rate cuts, including deposit repricing, the use and cost of FHLB funding, and interest-rate sensitivity assumptions.
  • Whether GAAP earnings, cash generation, and capital support the dividend level; distinguish the one-time special dividend from recurring distributions.
  • The assumptions behind management’s adjusted earnings measure, merger accounting and $39.1 million of goodwill, and the eventual impact of expected-credit-loss accounting (CECL), which management said it was evaluating.