First Business Financial Services, Inc. — Q3 2016 Form 10-Q
Business context and reporting period. The company is a Wisconsin bank holding company serving businesses and individuals through First Business Bank, First Business Bank–Milwaukee and Alterra Bank, with operations in Wisconsin and the Kansas City area. This unaudited filing covers the quarter and nine months ended September 30, 2016; comparisons are with the corresponding 2015 periods or December 31, 2015, as applicable. Dollar amounts below are in millions unless noted.
Financial performance and position
| Metric | Q3 2016 / Sept. 30, 2016 | Comparable period / prior date |
|---|---|---|
| Total assets | $1,772.4 | $1,782.1 at Dec. 31, 2015 |
| Net interest income | $15.3 for Q3; $46.6 for nine months | Q3: $14.6; nine months: $43.7 |
| Net income | $2.5 for Q3; $10.8 for nine months | Q3: $4.4; nine months: $12.4 |
| Diluted earnings per share | $0.29 for Q3; $1.24 for nine months | Q3: $0.50; nine months: $1.43 |
| Net interest margin | 3.50% for Q3; 3.56% for nine months | 3.61% and 3.67%, respectively |
| Net loans and leases | $1,438.2 | $1,414.6 at Dec. 31, 2015 |
| Deposits | $1,566.2 | $1,577.2 at Dec. 31, 2015 |
| Borrowings and junior subordinated notes | $39.9 combined | $44.7 at Dec. 31, 2015 |
| Stockholders’ equity | $159.9 | $150.8 at Dec. 31, 2015 |
Profitability and margins. Q3 net interest income rose 4.7%, but higher credit-loss provision and tax-credit investment impairment drove a pretax loss of $0.4 million. A $2.9 million income-tax benefit resulted in reported net income of $2.5 million. For the first nine months, revenue (net interest income plus non-interest income) increased 8.7% to $60.6 million, while net income fell 13.1%. Annualized return on average assets and equity were 0.56% and 6.38% in Q3, versus 1.02% and 11.93% a year earlier. The efficiency ratio improved to 63.63% in Q3 and 62.47% for nine months, but remained above management’s long-term 58%–62% goal.
Credit quality. Provision for loan and lease losses was $3.5 million in Q3 and $6.8 million for nine months, versus $0.3 million and $1.5 million, respectively, in 2015. At September 30, the allowance was $20.1 million, or 1.37% of gross loans, up from 1.14% at year-end. Non-accrual loans were $25.7 million (1.76% of gross loans), and non-performing assets were $27.2 million (1.54% of total assets), both higher than year-end. Management attributed deterioration primarily to certain Alterra relationships; Alterra accounted for $14.4 million, or 53%, of non-performing assets and 95.3% of Q3 provision. Nine-month net charge-offs were $3.1 million, compared with $0.5 million a year earlier.
Cash flow and liquidity. For the first nine months, operating cash flow was positive $16.8 million, investing cash flow was negative $42.5 million, and financing cash flow was negative $19.1 million; cash and cash equivalents declined $44.8 million to $68.8 million. The company reported immediate on-balance-sheet liquidity of $290.3 million, down from $331.5 million at year-end, and said available liquidity exceeded its policy minimum. Wholesale deposits were $449.2 million, or 28.7% of deposits, below its stated 30%–40% target operating range. Management reported the company and banks were well capitalized; consolidated total capital, Tier 1 and CET1 ratios were 11.44%, 9.02% and 8.45%, respectively.
Material changes and management commentary
- Loan and lease balances grew 1.7% net of allowance from year-end, led by non-owner-occupied commercial real estate. CRE represented about 64.6% of gross loans, a significant concentration.
- Management temporarily slowed SBA loan production while strengthening the platform’s infrastructure, policies, processes, controls, training and reporting. SBA loan sales gains fell to $0.35 million in Q3 from $0.93 million a year earlier, though nine-month gains increased to $3.85 million from $2.27 million.
- In Q3, the company recognized $3.6 million of historic tax credits and a corresponding $3.2 million impairment of the investment, for a net $0.43 million benefit to after-tax earnings. Management expected the 2016 effective tax rate to return to levels commensurate with full-year taxable income.
- The company announced closure of four offices and moderation of selected marketing and professional expenses to align costs with anticipated near-term revenue growth. Management cited a long-term efficiency-ratio goal of 58%–62% and a net interest margin objective of 3.50% or better.
- Management reported effective disclosure controls and no material change in internal control over financial reporting during the quarter. It reported no significant subsequent events through issuance and no legal proceedings expected to materially affect the company.
Outlook, risks and contingencies
The filing provides no earnings or revenue forecast. Management expected loan activity to replace normal amortization and support continued growth, while acknowledging slower SBA production and commercial lending trends. It expects to manage funding and deposit costs to support its margin objective. Key uncertainties include further credit deterioration and charge-offs, particularly at Alterra; CRE concentration; and SBA compliance. If the SBA identifies deficiencies in loan origination, funding or servicing, it may deny or reduce guarantees or seek repurchase or recovery. The company established a $0.375 million reserve for potential recourse on sold SBA loans; it also noted uncertain potential outcomes from its SBA review. Other material risks include deposit and wholesale funding availability, interest-rate changes, local economic conditions, regulatory requirements and possible impairment of Alterra-related goodwill. Management’s July 2016 goodwill assessment found fair value above carrying value; future adverse developments could prompt reassessment.
Most important facts for investors to verify
- Whether Alterra credit trends, non-performing assets and specific reserves stabilize, and whether subsequent charge-offs or provisions increase.
- Progress and findings from the SBA documentation and compliance review, the adequacy of the recourse reserve, and the effect of reduced SBA originations on fee income.
- Whether the $3.6 million tax-credit benefit and related impairment are nonrecurring as described, and how the full-year effective tax rate compares with management’s expectation.
- Whether deposit growth, wholesale funding, liquidity and capital remain adequate as loans grow and funding costs or market rates change.
- Whether CRE concentration, the efficiency ratio and net interest margin develop consistently with management’s stated objectives.