Mercantile Bank Corporation — Q3 2018 Form 10-Q
Business context and reporting period. Mercantile Bank Corporation is a Michigan-based bank holding company. This unaudited quarterly report covers the three and nine months ended September 30, 2018; balance-sheet comparisons are with December 31, 2017. Unless otherwise noted, amounts below are in U.S. dollars.
Financial performance and condition
- Revenue and earnings: Third-quarter interest income was $35.5 million and noninterest income was $4.7 million. Net income was $10.1 million, or $0.61 per diluted share, versus $8.3 million, or $0.51, a year earlier. For the first nine months, interest income was $104.8 million, noninterest income $13.6 million, and net income $30.5 million, or $1.83 per diluted share, compared with $23.3 million, or $1.41, in 2017.
- Net interest income and margin: Reported net interest income was $29.8 million for Q3 and $89.3 million for the first nine months, up 4.2% and 9.7%, respectively, year over year. Net interest margin was 3.87% for Q3 (3.83% in Q3 2017) and 3.95% year to date (3.80% in 2017).
- Expenses and taxes: Noninterest expense increased 7.1% to $21.7 million in Q3 and 7.3% to $64.2 million year to date, chiefly reflecting higher salaries and investment in staff, facilities, and technology. The effective tax rate was 19.0% in both 2018 periods, versus 30.8% for Q3 2017 and 30.7% year to date, following the federal corporate rate reduction from 35% to 21%.
- Loans and credit: Loans totaled $2.697 billion, up $138.9 million, or 5.4%, from year-end. Commercial loans were 85.5% of the portfolio. The allowance for loan losses was $21.7 million; management reported allowance coverage of nonperforming loans of 447%. Nonperforming loans were $4.9 million, or 0.18% of loans, compared with $7.1 million at year-end. Net loan recoveries were $0.1 million in Q3 and $1.1 million year to date.
- Deposits and liquidity: Deposits were $2.509 billion, down $13.6 million, or 0.5%, since year-end. Cash and cash equivalents fell to $80.0 million from $200.1 million, primarily as on-balance-sheet liquidity funded loan growth. The company reported $540 million of remaining FHLB borrowing availability. Wholesale funds were 11.2% of deposits and borrowed funds.
- Debt and capital: FHLB advances were $240 million, up $20 million from year-end; repurchase agreements were $112.4 million; subordinated debentures were $46.0 million. Shareholders’ equity was $379.5 million, up from $365.9 million. The bank’s total risk-based capital ratio was 12.8%, above the 10.0% well-capitalized threshold; its common equity Tier 1 ratio was 12.1%.
- Cash flow: For the first nine months, operating activities provided $34.9 million; investing activities used $144.5 million, mainly reflecting net loan funding; financing activities used $10.5 million. Cash and cash equivalents declined by $120.1 million over the period.
Material changes versus comparable periods
- Net income rose 21.4% in Q3 and 30.7% for the first nine months. Management attributed the improvement to higher net interest income and lower income-tax expense, with lower loan-loss provision also contributing. Higher noninterest expense partly offset gains.
- Net interest income benefited from loan growth, higher asset yields, and a shift toward loans from lower-yielding interest-earning deposits. Funding costs also rose: total interest expense increased 28.6% in Q3 and 37.4% year to date, reflecting higher rates on deposits and borrowings.
- Loan growth was driven in part by commercial lending and residential mortgages. Total deposits declined slightly, while their composition shifted: money-market balances increased and interest-bearing checking, savings, and larger time deposits decreased.
- Available-for-sale securities were $326.5 million, down $9.2 million from year-end. Unrealized losses increased as market interest rates rose; accumulated other comprehensive loss was $13.4 million versus $4.9 million at year-end.
Outlook, commentary, and risks
- Management described the commercial loan pipeline as strong and expected approximately $152 million of construction and development commitments to fund over the next 12–18 months. It also reported a high residential mortgage pre-qualification level, while identifying rising mortgage rates and limited housing inventory as headwinds. The filing provides no formal earnings or revenue guidance.
- Management expects interest-earning deposits to average approximately 1%–2% of average earning assets in future quarters and expects the securities portfolio to remain around 11% of total assets. It expects consumer loans to decline as scheduled repayments exceed anticipated originations.
- Interest-rate sensitivity simulations estimated next-12-month net interest income changes of +3.3% for a 100-basis-point rate increase and +12.9% for a 400-basis-point increase; a 200-basis-point decrease was estimated to reduce it by 7.8%. Management cautioned that model assumptions are uncertain and actual outcomes may differ.
- Material risks include interest-rate and liquidity exposure, competition for loans and deposits, borrower repayment and collateral values, economic conditions, regulatory changes, and the ability to manage growth. Unfunded credit commitments totaled $1.029 billion, including $855 million of lines available for draw; the company reported no related reserve or liability at quarter-end.
- After quarter-end, the board declared a regular $0.25-per-share dividend and a special $0.75-per-share dividend, payable December 19, 2018. The bank’s related special dividend to the holding company would reduce its September 30 total risk-based capital ratio by approximately 40 basis points on a pro forma basis.
- Other notable items: purchased-loan accounting increased 2018 net income by $0.3 million in Q3 and $2.7 million year to date; a 2017 bank-owned life-insurance claim increased 2017 nine-month net income by $1.2 million. Management said there were no material legal proceedings, no material changes to previously disclosed risk factors, and no material change in internal control over financial reporting.
Important facts for investors to verify
- Whether loan growth and the stated pipeline fund as expected, and how commercial real estate and commercial-and-industrial exposures perform.
- Credit quality trends, including the allowance methodology, troubled debt restructurings, charge-offs, recoveries, and the relatively low nonperforming-loan balance.
- Deposit pricing, deposit retention, reliance on FHLB advances and other wholesale funding, and the liquidity implications of the large unfunded commitment balance.
- How rising rates affect net interest margin, funding costs, mortgage banking, and the market value of securities; assess the reported rate-sensitivity model assumptions.
- The capital and liquidity effect of the post-quarter special dividend, alongside the increase in unrealized securities losses.
- Management’s implementation of the expected-credit-loss standard (CECL), which was still under evaluation and planned for adoption after December 15, 2019.