Old National Bancorp — Q2 2011 Form 10-Q
Business context and reporting period
Unaudited results cover the three and six months ended June 30, 2011; balance-sheet comparisons are primarily with December 31, 2010 and June 30, 2010. Old National is a regional banking company operating mainly in Indiana, Illinois and Kentucky.
The January 1 acquisition of Monroe Bancorp expanded the company’s banking franchise and materially affected year-over-year comparisons. On June 1, Old National also acquired Integra Bank’s trust business. The subsequent FDIC-assisted acquisition of Integra Bank’s banking operations closed July 29, 2011, after quarter-end.
Financial and operating performance
- Q2 revenue and earnings: Net interest income was $62.3 million, up 13.0% year over year; noninterest income was $43.6 million, up 1.4%. Combined revenue was $105.9 million. Net income was $17.0 million versus $10.5 million; diluted EPS was $0.18 versus $0.12.
- First-half results: Net interest income was $123.7 million, up 12.2%; noninterest income was $86.4 million, up 0.5%. Combined revenue was $210.1 million. Net income was $33.4 million versus $20.6 million; diluted EPS was $0.35 versus $0.24.
- Margins and expenses: Fully taxable-equivalent net interest margin was 3.67% in Q2 versus 3.40% a year earlier, and 3.64% for the first half versus 3.37%. Noninterest expense rose 2.4% in Q2 to $79.8 million and 3.1% for the first half to $159.7 million. The first-half efficiency ratio improved to 73.92% from 76.16%.
- Credit costs: Provision for loan losses fell to $3.2 million in Q2 from $8.0 million, and to $6.5 million for the first half from $17.3 million. Annualized net charge-offs were 0.56% of average loans in Q2 versus 0.90%; first-half rates were 0.41% versus 0.80%.
- Cash flow and liquidity: Operating cash flow was $113.3 million for the first half, compared with $82.4 million. Investing activities provided $160.3 million and financing activities used $189.5 million. Cash and cash equivalents ended at $335.6 million, up $84.1 million from year-end.
- Balance sheet and funding: Total assets were $8.019 billion, total loans $4.117 billion, deposits $6.015 billion and shareholders’ equity $1.008 billion. Short-term borrowings were $305.2 million and other borrowings $440.5 million. The $150 million of subordinated bank notes matures in October 2011.
- Capital: The reported Tier 1 leverage ratio was 8.68%; Tier 1 risk-based capital was 13.39% and total risk-based capital 14.90%. Management said regulatory capital remained above well-capitalized requirements.
- Dividends and shares: The quarterly dividend was $0.07 per share, unchanged year over year. Shares outstanding at June 30 were 94.752 million, including approximately 7.6 million shares issued for Monroe.
Material changes versus comparable periods
- Assets rose 10.4% from year-end and 4.1% from June 2010, primarily reflecting Monroe. Total loans increased to $4.117 billion from $3.743 billion at year-end; acquired Monroe loans contributed significantly to the increase.
- Monroe-related purchase accounting added $6.7 million to Q2 net interest income through loan-mark accretion and other fair-value adjustments. The accretion supported net interest margin by 38 basis points in Q2 and 29 basis points year to date; management expected the benefit to decline each quarter and be nominal by 2013.
- Deposits increased $552.2 million from year-end, including $636.1 million acquired from Monroe, while wholesale funding was 11.0% of total funding versus 11.6% at year-end and 14.2% a year earlier. Noninterest-bearing deposits increased year over year; time deposits and other borrowings declined as a share of funding.
- Credit indicators worsened in reported totals, in large part because of Monroe acquired loans: nonaccrual loans were $118.4 million versus $70.9 million at year-end, nonperforming loans were 2.88% of loans versus 1.90%, and underperforming assets were $128.8 million versus $77.1 million. The allowance was $70.2 million, or 1.70% of loans, compared with 1.93% at year-end. The allowance-to-nonperforming-loans ratio fell to 59%.
- Net securities gains were lower than in 2010: $0.7 million in Q2 and $2.2 million for the first half, partly offset by $0.2 million and $0.5 million of credit impairment charges. The comparable first-half 2010 figures included $9.5 million of securities gains and $3.3 million of impairment charges.
Outlook, risks, contingencies and unusual items
- Management targeted a 65% efficiency ratio by the end of 2012 and said it remained focused on expense control and franchise growth. Monroe accounted for $14.9 million of first-half expenses, including $5.7 million of acquisition and integration costs.
- Management described overall credit quality as well-controlled, but noted weak loan demand and continued economic weakness in its markets. It said it would work to reduce underperforming loans and could consider troubled-loan sales, which might cause additional charge-offs.
- Investment risks include non-agency mortgage-backed securities with $103.5 million fair value and approximately $2.0 million net unrealized losses, including nine securities rated below investment grade. Nine pooled trust preferred securities had $9.7 million fair value and $17.6 million unrealized losses; all had experienced defaults. No pooled trust preferred impairment charge was recorded in the first half of 2011.
- Interest-rate models showed that an immediate 3% rate increase could reduce one-year net interest income by 3.61% and two-year cumulative net interest income by 0.39%. The modeled economic value of equity fell 19.63% under the same rate shock. Management stated results remained within its risk tolerance; model outputs are not guarantees.
- The July 29 Integra bank acquisition involved approximately $1.9 billion of assets and $1.6 billion of assumed liabilities, including $1.5 billion of deposits. FDIC loss-sharing provides 80% reimbursement on specified losses up to $275.0 million, no reimbursement on losses from $275.0 million to $467.2 million, and 80% above $467.2 million. Old National estimated $269.0 million of asset losses, of which $211.2 million was expected to be reimbursable as losses are realized. Coverage terms differ by asset type and extend up to ten years for single-family mortgages and five years for commercial loans.
- Legal matters include a trust-administration lawsuit scheduled for trial in February 2012 and a class action challenging checking-account practices. The company recorded no liability for the trust case, stating it did not consider its estimated exposure material based on information then available; it could not estimate the likelihood or amount of loss in the class action.
- Management identified estimates for loan-loss allowances, securities impairment, goodwill and intangibles, derivatives and taxes as areas requiring judgment. It cautioned that actual outcomes may differ. Disclosure controls were judged effective at a reasonable-assurance level; no material change in internal control over financial reporting was reported.
Most important facts for investors to verify
- How much reported earnings and margin depend on Monroe purchase-accounting accretion, and the expected pace of its decline.
- Whether acquired and legacy loan deterioration, nonaccrual balances and criticized/classified assets result in higher provisions or charge-offs; review allowance assumptions and coverage.
- The valuation and expected cash flows of below-investment-grade mortgage-backed and pooled trust preferred securities, including the substantial unrealized losses.
- The final Integra acquisition accounting, realized credit losses and FDIC reimbursements under the tiered loss-sharing terms.
- Execution against the 65% efficiency-ratio target, integration costs, and the October 2011 maturity of $150 million in subordinated bank notes.
- Developments in the disclosed litigation and the company’s sensitivity to interest-rate, liquidity and regional economic conditions.