EAGLE FINANCIAL SERVICES INC annual report, FY2018

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Eagle Financial Services, Inc. — 2018 Form 10-K

Business context and reporting period. The company is a Virginia bank holding company operating through Bank of Clarke County, a community bank serving Northern Virginia and the Shenandoah Valley. It provides commercial and retail banking, lending, deposit, trust and investment services. This annual report covers the fiscal year ended December 31, 2018; the filing also reports fourth-quarter results. Financial statement amounts below are in millions of dollars unless otherwise noted.

Financial performance and position

  • Profitability: 2018 net income was $9.0 million, up 15.6% from $7.8 million in 2017; diluted EPS was $2.60, versus $2.24. Pretax income fell to $10.3 million from $11.4 million, but income tax expense declined to $1.3 million from $3.6 million. The effective tax rate was 12.74%, aided by the lower federal tax rate and tax credits.
  • Revenue and margins: Net interest income increased 8.1% to $29.4 million; noninterest income rose 1.5% to $6.9 million. Net interest margin was 4.07%, compared with 4.10% in 2017. The efficiency ratio improved to 66.36% from 67.47%.
  • Expenses and credit costs: Noninterest expense grew 8.7% to $25.2 million. The company recorded a $777,000 provision for loan losses, compared with a $625,000 recovery in 2017.
  • Fourth quarter: Net income was $2.081 million, or $0.60 per diluted share, versus $1.710 million, or $0.49 per diluted share, in fourth-quarter 2017.
  • Balance sheet: Total assets were $799.6 million, up 4.4%; loans were $606.8 million, up 6.7%; deposits were $703.1 million, up 6.0%. Shareholders’ equity was $87.6 million, or 10.96% of assets.
  • Asset quality: Nonperforming assets declined to $2.2 million from $6.4 million; nonperforming loans were 0.35% of total loans versus 1.11%. The allowance for loan losses was $5.456 million, or 0.90% of loans, up from 0.78%.
  • Cash flow: Operating activities used $1.5 million, compared with $9.4 million provided in 2017. Investing activities used $53.7 million and financing activities provided $37.7 million. Cash and cash equivalents fell $17.5 million to $18.4 million.
  • Liquidity and borrowings: Management reported $242.3 million of liquid assets, equal to 34.03% of liabilities, down from $275.9 million and 39.61%. Year-end borrowings included $1.9 million of federal funds purchased; there were no Federal Home Loan Bank advances. Available borrowing capacity included $26.1 million on federal funds lines and $169.6 million with the FHLB.
  • Capital and shareholder returns: The Bank’s common equity Tier 1, total risk-based capital and leverage ratios were 13.99%, 14.88% and 10.92%, respectively, and it was classified as well capitalized. The company declared $0.94 per share in dividends and repurchased 39,333 shares at an average $32.06.

Material changes versus 2017

  • Growth in loans and securities helped lift interest income, but deposit interest expense more than doubled to $2.5 million as rates rose and deposit pricing increased. Net interest margin edged down.
  • The loan-loss provision shifted from a recovery to an expense, reflecting portfolio growth, higher specific reserves and a change in methodology that extended the historical loss look-back from five to seven years.
  • Noninterest expenses rose substantially, including an $866,000 net loss on other real estate owned and higher data-processing costs following the move to a service-bureau platform.
  • Unrealized losses on available-for-sale securities increased; the portfolio showed a $2.0 million net unrealized loss at year-end, compared with a $338,000 gain in 2017. Management attributed the losses principally to interest-rate changes and did not expect to sell the securities before recovery.

Outlook, risks and unusual items

  • The filing provides no specific earnings or growth guidance. Management’s stated strategy is to grow local lending funded primarily by core deposits and to sustain customer relationships, profitability and dividends.
  • Management cautioned that rising rates may pressure net interest income if interest-bearing liabilities reprice faster than earning assets. Its simulation showed a 12-month net interest income decline under each modeled rate shock, including 1.04% for an immediate 100-basis-point rise and 6.54% for a 200-basis-point decline. The economic-value-of-equity model showed a 26.40% decline under a 200-basis-point decline in rates; results depend on modeling assumptions.
  • Real estate-secured lending represented 91.84% of loans, exposing the Bank to local property values and economic conditions. Other stated risks include competition, cybersecurity and operational disruption, regulatory change, growth execution, and the subjectivity of loan-loss estimates.
  • A roughly 38-acre Northern Loudoun County property taken through foreclosure was initially recorded at $3.2 million after selling costs. Following a lower contracted sale price, the Bank recorded a $987,000 valuation allowance; the filing reports an $866,000 net loss on other real estate owned for 2018.
  • The company expects to adopt the current expected credit loss standard (CECL) beginning January 1, 2020; it had not yet estimated the financial impact. Adoption of lease accounting was expected to add an estimated $3.8 million right-of-use asset and corresponding lease liability.
  • Off-balance-sheet credit exposures included $21.6 million of commitments to extend credit, $105.9 million of unfunded credit lines and $6.4 million of letters of credit. Management did not anticipate material losses from these commitments. No material pending legal proceedings were reported.
  • Independent auditors issued unqualified opinions on the financial statements and internal control over financial reporting; no material weaknesses were identified.

Important facts for investors to verify

  • Whether loan growth, real-estate concentration and the improvement in nonperforming assets are sustainable, and whether the $5.456 million allowance adequately reflects emerging credit risks.
  • Whether deposits can be retained at acceptable costs as rates and local competition change, and how that repricing affects net interest margin and liquidity.
  • The final realized proceeds and any further costs or valuation changes associated with the foreclosed Northern Loudoun property.
  • The sensitivity assumptions behind the interest-rate simulations and the eventual effect of CECL adoption on reserves, earnings and capital.
  • That dividend capacity depends substantially on Bank distributions: $72.4 million of the holding company’s equity in the Bank’s net assets was restricted from distribution at year-end, despite $11.8 million of Bank retained earnings reported as available for dividends.
  • The reason for the $11.5 million decrease in other liabilities contributing to negative 2018 operating cash flow, and whether that cash-flow effect is temporary.