First Merchants Corporation — Q2 2018 Form 10-Q
Business context and reporting period. First Merchants is an Indiana-based community banking company operating through First Merchants Bank, with 117 banking locations across Indiana, Illinois and Ohio. This unaudited report covers the quarter and six months ended June 30, 2018. Comparisons with 2017 are affected by the Arlington Bank and Independent Alliance Banks acquisitions, completed in May and July 2017, respectively.
Key financial results
| Metric | Q2 2018 | Q2 2017 | Six months 2018 | Six months 2017 |
|---|---|---|---|---|
| Net interest income | $84.6 million | $63.1 million | $164.5 million | $124.1 million |
| Provision for loan losses | $1.7 million | $2.9 million | $4.2 million | $5.3 million |
| Other income | $18.2 million | $18.4 million | $37.8 million | $33.3 million |
| Other expenses | $53.5 million | $47.3 million | $107.2 million | $90.4 million |
| Net income available to common shareholders | $39.6 million | $24.1 million | $76.3 million | $47.3 million |
| Diluted EPS | $0.80 | $0.57 | $1.54 | $1.13 |
Quarterly diluted EPS rose 40.4%. Management attributed earnings growth to core banking performance, the full-period contribution from the 2017 acquisitions and tax reform. Effective tax rates were 16.7% for Q2 and 16.0% year to date, versus 23.0% and 23.3% in 2017, primarily reflecting the reduction in the federal corporate tax rate.
- Net interest margin: Fully taxable-equivalent margin was 3.99% in Q2 2018 versus 3.95% a year earlier; it was 3.96% for both six-month periods. Q2 net interest spread declined 3 basis points, as funding costs rose 33 basis points while asset yields rose 30 basis points.
- Balance sheet and funding: Total assets were $9.73 billion at June 30, up $367.2 million from year-end 2017. Loans were $7.08 billion, up $329.9 million; deposits were $7.50 billion, up $331.3 million. Total borrowings were $839.1 million, up $4.7 million. Cash and cash equivalents were $133.9 million, down from $154.9 million at year-end.
- Cash flow: For the first six months, operating activities provided $81.7 million, investing activities used $420.1 million, and financing activities provided $317.4 million. Net cash decreased $21.0 million.
- Credit quality: Allowance for loan losses was $77.5 million, or 1.09% of loans, versus $75.0 million and 1.11% at year-end. Non-accrual loans declined to $20.1 million from $28.7 million; nonperforming assets were $29.8 million versus $40.1 million. Six-month net charge-offs increased to $1.7 million from $0.8 million a year earlier.
- Capital: The Corporation reported CET1 of 11.21%, total risk-based capital of 13.81% and a tangible common equity-to-tangible assets ratio of 9.36%. The Bank met the regulatory definition of well-capitalized.
- Equity and securities: Stockholders’ equity was $1.34 billion. Accumulated other comprehensive loss widened to $24.9 million from $2.9 million at year-end, including the effect of unrealized securities losses. Available-for-sale securities were $1.10 billion; held-to-maturity securities were $522.8 million.
Material changes and management commentary
Loan growth and acquisitions lifted average earning assets and net interest income, while higher deposit and wholesale funding costs pressured spread. Q2 noninterest income was slightly lower year over year, largely because life-insurance benefit gains fell by $2.1 million; customer fees and securities-sale gains partly offset the decline. Expenses rose with the enlarged franchise, notably salaries, occupancy, equipment, marketing, data processing and acquisition-related intangible amortization. Lower professional-service expenses partly offset these increases.
Management described credit metrics as improving and considered the allowance adequate. It cautioned that loan performance remains exposed to economic conditions and collateral values. Available-for-sale securities had $20.4 million of gross unrealized losses at quarter-end; management attributed these primarily to interest-rate changes and said it did not intend, and was not more likely than not required, to sell affected securities before recovery.
Outlook, risks and contingencies
- The filing provides no specific earnings, revenue or margin guidance. Management’s forward-looking statements are subject to interest-rate and pricing movements, economic and credit deterioration, changes in asset values, competition, regulation, acquisition integration, liquidity and capital needs, and the availability of earnings and excess capital to support dividends.
- Interest-rate sensitivity modeling estimated a 7.17% increase in 12-month net interest income under an immediate 200-basis-point rise and a 5.59% decrease under a 100-basis-point decline, relative to the modeled base case. These are scenarios, not forecasts; results depend on assumptions about rates and customer behavior.
- The Corporation had $446.7 million of remaining FHLB borrowing capacity. Off-balance-sheet loan commitments and standby/commercial letters of credit totaled $2.71 billion; commitments may expire unused or be partially drawn.
- Adoption of the expected-credit-loss standard (CECL), planned for 2020, could materially affect the allowance and earnings; the impact had not yet been determined. Management also expected lease accounting adoption in 2019 to change other assets and liabilities, with the size of the adjustment still under evaluation.
- Management stated routine litigation and regulatory examinations were not expected to have a material adverse effect. No material change to previously disclosed risk factors was reported. The 2018 Economic Growth Act raised the stress-test asset threshold to $250 billion; the company said it would not be subject to the Dodd-Frank stress tests upon reaching $10 billion in assets.
Important facts for investors to verify
- How much of earnings and loan growth reflects sustainable organic activity versus the acquired businesses and purchase-accounting accretion?
- Whether deposit pricing and funding costs continue to rise faster than asset yields, and how that affects net interest margin.
- Whether improving non-accrual and nonperforming-asset trends persist, particularly given higher six-month net charge-offs and continued loan growth.
- The sensitivity of securities values, accumulated other comprehensive loss and earnings to further rate changes, as well as the assumptions behind management’s interest-rate scenarios.
- The eventual CECL allowance transition impact, lease-accounting adjustment, and any effect of regulatory implementation of the Economic Growth Act.