First Business Financial Services, Inc. — Q2 2016 Form 10-Q
Business context and reporting period. The company is a Wisconsin bank holding company serving businesses, business owners and professionals through banks in Wisconsin and Kansas, with commercial lending, equipment finance, SBA lending, trust and other services. This unaudited filing covers the quarter and six months ended June 30, 2016; balance-sheet comparisons are to December 31, 2015. Amounts below are in millions unless noted.
Financial performance and position
| Metric | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Net interest income | $15.741 | $14.188 | $31.279 | $29.118 |
| Non-interest income | $5.823 | $4.126 | $10.416 | $7.974 |
| Total revenue (net interest plus non-interest income) | $21.564 | $18.314 | $41.695 | $37.092 |
| Provision for loan and lease losses | $2.762 | $0.520 | $3.287 | $1.204 |
| Net income | $3.716 | $3.858 | $8.262 | $8.050 |
| Diluted EPS | $0.43 | $0.45 | $0.95 | $0.93 |
| Net interest margin | 3.59% | 3.61% | 3.59% | 3.70% |
| Efficiency ratio | 61.49% | 65.28% | 61.95% | 63.85% |
- Q2 revenue grew 17.7% and six-month revenue grew 12.4%. Net interest income rose with loan growth; non-interest income benefited substantially from stronger-than-expected SBA loan production.
- Profitability was mixed: Q2 net income declined 3.7% year over year as the much higher loan-loss provision and operating costs outweighed revenue growth. Six-month net income increased 2.6%. Q2 annualized ROAA was 0.81% and ROAE 9.43%, down from 0.93% and 10.73%, respectively.
- At June 30, total assets were $1.819 billion, up 2.1% from year-end. Net loans and leases were $1.434 billion, deposits $1.608 billion, and stockholders’ equity $158.4 million. Gross loans and leases grew to $1.453 billion; commercial real estate represented about 65% of the portfolio.
- Cash and cash equivalents were $131.6 million. Management-defined immediate on-balance-sheet liquidity was $344.7 million. Deposits rose $30.7 million from year-end; wholesale deposits were $477.1 million, or 29.7% of deposits.
- Borrowings, including subordinated and junior subordinated notes, totaled $43.6 million. The company reported compliance with senior-line debt covenants. Consolidated regulatory capital ratios were 11.44% total capital, 9.08% Tier 1 and 8.50% common equity Tier 1; the banks were classified as well capitalized.
- Six-month operating cash flow was $15.6 million, investing cash outflow $25.1 million and financing cash inflow $27.6 million. Cash and cash equivalents increased $18.0 million to $131.6 million.
Material changes, outlook and risks
- Credit costs increased materially. The Q2 provision reflected $2.2 million of new specific reserves and net charge-offs tied to two loan relationships, plus an $816,000 increase in specific reserves on an energy-sector loan. Management said it isolated the issues, modified reporting structures and reinforced lending policies; it did not believe the credit issues were systemic.
- Six-month net charge-offs were $1.449 million versus $334,000 a year earlier. The allowance was $18.2 million, or 1.25% of gross loans, compared with 1.14% at year-end. Non-accrual loans were $22.7 million; non-performing assets were 1.33% of total assets. Two C&I loans modified as troubled debt restructurings defaulted during the half, with recorded investment of $5.7 million.
- Direct energy-sector exposure was $7.1 million, or 0.49% of gross loans and leases; $5.8 million was non-performing. The related allowance was 20.43% of carrying value, versus 8.13% at year-end. The company reported no remaining unfunded energy commitments.
- Management attributed margin pressure in part to higher wholesale deposit costs and fading purchase-accounting accretion. Excluding purchase-accounting effects, six-month net interest margin improved to 3.53% from 3.47%. Management expects to manage funding to support a stable margin, while noting purchase-accounting effects may remain a source of volatility.
- Management said loan activity should replace normal amortization and support growth in future quarters, while emphasizing it would not relax underwriting standards. It expects the efficiency ratio to trend toward its long-term objective of 60%. These are management expectations, not specific earnings guidance; the filing provides no numerical earnings forecast.
- Key stated risks include competition, adverse economic conditions, borrower defaults, growth-management challenges, interest-rate and market fluctuations, regulatory or tax changes, and systems or network-security failures. CRE concentration and the effect of further credit deterioration also merit attention.
- The filing reported no material changes to previously disclosed risk factors, no significant subsequent events requiring disclosure, and no legal proceedings expected to have a material adverse effect. Management concluded disclosure controls were effective as of June 30, 2016.
Important facts for investors to verify
- Whether the elevated provision, charge-offs and new non-accrual credits persist, and how the allowance develops relative to loan growth and losses.
- Performance and collateral coverage of the energy exposure, the two defaulted restructured C&I loans, and other individually impaired credits.
- How sustainable SBA loan-sale gains are; management described Q2 production and gains as unusually strong and greater than expected.
- Deposit mix, wholesale funding costs and the ability to sustain net interest margin as purchase-accounting accretion declines.
- Progress toward the 60% efficiency-ratio objective given higher staffing and operating expenses, and continued capital and liquidity levels.