First Business Financial Services, Inc. — 2016 Form 10-K
Business context and reporting period. The filing reports the fiscal year ended December 31, 2016, with comparative annual results for 2015 and 2014 and quarterly data for 2016. First Business Financial Services is a Wisconsin bank holding company operating through three commercial banks in Wisconsin and Kansas City. Its business-focused offerings include commercial and real estate lending, SBA lending, asset-based lending, equipment finance, deposits, treasury management, and trust and investment services. The company reported $1.781 billion in assets and $1.452 billion in gross loans and leases at year-end.
Financial performance and condition
| Metric | 2016 | 2015 |
|---|---|---|
| Net interest income | $63.3 million | $58.6 million |
| Non-interest income | $18.0 million | $17.0 million |
| Total revenue (net interest income plus non-interest income) | $81.3 million | $75.7 million |
| Provision for loan and lease losses | $7.8 million | $3.4 million |
| Non-interest expense | $56.4 million | $47.4 million |
| Net income | $14.9 million | $16.5 million |
| Diluted earnings per share | $1.71 | $1.90 |
| Net interest margin | 3.64% | 3.66% |
| Return on average assets / equity | 0.82% / 9.40% | 0.97% / 11.36% |
- Balance sheet and credit: Assets were nearly flat year over year. Gross loans and leases increased 1.4% to $1.452 billion; commercial real estate loans were $945.9 million, or 65.1% of the portfolio. Deposits declined 2.4% to $1.539 billion, while stockholders’ equity rose to $161.7 million, or 9.1% of assets.
- Asset quality: Non-accrual loans and leases increased to $25.2 million, or 1.74% of gross loans, from $22.3 million, or 1.56%, in 2015. Non-performing assets were $26.7 million, or 1.50% of assets. The allowance was $20.9 million, equal to 1.44% of gross loans and 83.0% of non-accrual loans. Net charge-offs rose to 0.22% of average loans from 0.10%.
- Funding, debt, and liquidity: Year-end deposits were $1.539 billion; wholesale deposits were $416.7 million, or 27.1% of deposits. Total borrowings, including junior subordinated notes, were $69.7 million, up from $44.7 million. Cash and cash equivalents were $77.5 million, down from $113.6 million. Management reported $544.7 million of immediate on-balance-sheet liquidity, including eligible pledged loans. The company said it and each bank met applicable capital requirements and were well-capitalized; consolidated ratios included 8.68% common equity Tier 1, 9.26% Tier 1, and 11.74% total capital.
- Cash flow: Operating activities provided $26.2 million; investing activities used $44.3 million and financing activities used $17.9 million. The resulting decrease in cash and cash equivalents was $36.0 million.
- Dividends: The annual dividend declared increased to $0.48 per share from $0.44; the board retains discretion over future dividends.
Material changes versus 2015
- Revenue increased 7.5%, led by 8.0% growth in net interest income. Average loans and leases increased 8.3%, and recurring loan fees collected in lieu of interest rose to $5.1 million from $3.3 million.
- Net income fell 9.7% and diluted EPS declined from $1.90 to $1.71. Management attributed the decline chiefly to deterioration in certain Alterra credits, higher loan-loss provision, and investment in the SBA platform.
- The $7.8 million loan-loss provision was more than double 2015’s $3.4 million and included specific reserves and net charge-offs related principally to five Alterra loan relationships. Management reported enhanced credit policies, controls, training, staffing, and reporting.
- Non-interest expense rose 19.1%, including a $3.7 million tax-credit-investment impairment, a $2.1 million SBA recourse provision, and a $794,000 one-time fee to terminate Alterra’s core-system vendor agreement. Compensation expense also increased 10.5% as staffing grew.
- The effective tax rate declined to 12.6% from 33.7%, primarily reflecting tax credits and lower pre-tax income. Management reported approximately $4.2 million of gross tax-credit benefits associated with the investment impairment; the filing describes an approximately $450,000 net after-tax benefit for the historic-credit investment.
Outlook, risks, contingencies, and unusual items
- Outlook: No specific earnings or revenue guidance is provided. Management expects SBA production to ramp during 2017 after platform investment, with the initiatives expected to support earnings growth in 2018 and beyond. It targets an efficiency ratio of 58%–62% over time; the 2016 reported adjusted ratio was 61.12%, but management said normalized fees and expenses would place it in the mid-60% range.
- Charter and systems consolidation: The company planned to combine its three bank charters into one, with regulatory and board approvals obtained and implementation expected in the second quarter of 2017. Management expected administrative flexibility and efficiency over time, but said the plan was not designed to eliminate near-term operating expense. Core-system centralization and a change in certain third-party providers add execution and operational risk.
- Funding strategy: Management planned to reduce brokered certificates of deposit to below 10% of assets and use FHLB advances as needed, partly to reduce FDIC assessment costs. Wholesale funding is rate-sensitive and may become less available or more expensive.
- Principal risks: Credit and collateral risk, especially commercial real estate concentration; further deterioration in Alterra credits; SBA-guaranty eligibility and recourse exposure; dependence on wholesale funding; interest-rate and margin risk; geographic concentration; competition; regulatory and compliance costs; cybersecurity and third-party technology risks; and potential goodwill impairment. The filing reported $10.7 million of goodwill related to Alterra and no impairment identified in its 2016 assessments.
- Commitments and contingencies: Outstanding commitments to extend credit were $539.1 million and standby letters of credit were $11.8 million. The SBA recourse reserve was $1.75 million at year-end. Management did not expect losses from funding commitments and did not anticipate material losses from pending litigation.
- Other notable matters: No securities were deemed other-than-temporarily impaired. Available-for-sale securities recorded $912,000 in pre-tax unrealized losses through other comprehensive income, principally reflecting higher interest rates. The 2016 financial statements received an unqualified audit opinion; management and the auditor reported effective internal control over financial reporting.
Most important facts for investors to verify
- Whether the Alterra credit deterioration and specific problem loans stabilize, and how non-performing loans, charge-offs, and the allowance develop.
- Whether the planned charter consolidation and core-system transition are completed on schedule, and whether expected efficiencies materialize without service disruption or added cost.
- Whether SBA lending resumes growth while maintaining underwriting quality and limiting guaranty-repurchase or recourse losses.
- Whether deposit growth and the planned shift from brokered deposits to FHLB advances preserve liquidity and control funding and FDIC insurance costs.
- How much of 2016 revenue and earnings depended on elevated loan fees and tax credits, and whether underlying operating performance supports management’s longer-term efficiency and growth objectives.
- Whether CRE concentration, interest-rate sensitivity, and the effect of higher rates on both funding costs and securities values remain within management’s stated risk tolerance.