Old Second Bancorp, Inc. — Q2 2017 Form 10-Q
Business context and period. Old Second is an Illinois-based community banking and financial services company offering commercial and retail banking, trust, and wealth management services. This unaudited report covers the quarter and six months ended June 30, 2017; balance-sheet comparisons are to December 31, 2016. Amounts below are rounded to millions unless stated otherwise.
Financial performance and condition
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Net interest income | $19.0m | $15.4m | $36.7m | $30.6m |
| Provision for loan losses | $0.75m | None | $0.75m | None |
| Noninterest income | $7.3m | $7.3m | $14.3m | $13.6m |
| Noninterest expense | $18.0m | $16.7m | $36.0m | $33.0m |
| Income before taxes | $7.6m | $5.9m | $14.2m | $11.2m |
| Net income | $5.5m | $3.8m | $10.0m | $7.2m |
| Diluted EPS | $0.18 | $0.13 | $0.33 | $0.24 |
- Margins and operating efficiency: Tax-equivalent net interest margin was 3.81% for Q2, up from 3.22% a year earlier; GAAP margin was 3.60%, versus 3.19%. The reported efficiency ratio was 62.87%, compared with 68.92% in Q2 2016.
- Balance sheet at June 30: Total assets were $2.34bn, up $92.3m from year-end; loans were $1.54bn, up $60.8m; available-for-sale securities were $568.2m, up $36.4m. Deposits were $1.91bn, up $43.4m. Stockholders’ equity was $191.1m, up $15.9m.
- Cash flow, six months: Operating activities provided $34.3m, compared with $7.7m in 2016; investing activities used $88.7m versus $74.3m; financing activities provided $58.1m versus $66.6m. Cash and cash equivalents ended at $51.1m, up $3.8m from year-end.
- Debt and funding: Reported borrowings totaled $213.0m, including $36.4m in repurchase agreements, $75.0m in FHLB advances, $57.6m in junior subordinated debentures, and $44.0m in senior notes. The company reported $94.3m of excess collateral available to secure FHLB borrowing.
- Capital: The Bank’s Tier 1 leverage ratio was 10.23% and total risk-based capital ratio was 13.30%, above management’s stated 8% and 12% objectives. The consolidated common equity tier 1 ratio was 8.55%.
Material changes and management commentary
- Q2 net income increased about 42% year over year. Management attributed improved results principally to higher net interest income from loan growth and securities repositioning, alongside stronger trust income and a smaller mortgage-servicing-rights valuation loss.
- Loan growth reflected the 2016 Talmer Chicago branch acquisition, organic growth, and a $16.7m home-equity portfolio purchase from TCF in Q2 2017. Management said it was reducing commercial real estate concentration and increasing commercial and lease financing. Real estate-related loans remained 77.8% of the portfolio.
- The reported Q2 provision was $750,000, attributed to loan growth and collateral shortfalls on a few credits. Net charge-offs were $655,000 for the quarter; nonperforming loans were $15.6m, or 1.0% of loans, down from $16.0m and 1.1% at year-end. Classified loans declined to $22.5m from $26.5m.
- OREO was $11.7m, down slightly from year-end and from $16.3m a year earlier. The company recorded $710,000 of OREO valuation write-downs in the first half; approximately 48% of OREO had been held for five years or more.
- Q2 noninterest expense rose 7.7% year over year. Management cited $294,000 of one-time executive relocation and recruitment costs, higher employee insurance costs, and nine additional full-time-equivalent employees associated with the Talmer acquisition. First-quarter expenses also included other identified one-time or higher-than-expected items.
Outlook, risks, and unusual items
- No numerical earnings or revenue guidance was provided. Management described local growth opportunities and continued loan growth efforts, while cautioning that competitive lending pressure and underwriting standards constrain loan yields. Interim results are not necessarily indicative of full-year results.
- Management characterized interest-rate risk as moderate and within policy limits. Its model estimated annual pretax income increases of 1.4%, 2.9%, and 5.8% for immediate rate increases of 0.5%, 1.0%, and 2.0%, respectively; a 1.0% decline was estimated to reduce income 5.9%. The filing cautions that these simulations are not forecasts and exclude management actions.
- Rising rates, deposit pricing, competition, loan and securities prepayments, economic conditions, and the substantial real-estate exposure could affect results and asset quality. Management warned actual credit losses or OREO disposal losses may exceed estimates.
- The company expects adoption of the new purchased callable debt premium-amortization standard to reduce net interest margin by approximately 10 basis points per quarter going forward. Adoption is planned on a modified retrospective basis.
- A $25.8m interest-rate swap became effective June 15, 2017 to hedge floating-rate exposure on Trust II debentures; management stated the resulting total rate on that debt was 4.34%, compared with 6.77% before conversion and hedge.
- Management stated that ordinary-course legal matters are not expected to have a material adverse effect. It reported no material change in risk factors and no material changes to internal control over financial reporting; disclosure controls were assessed as effective.
Important facts for investors to verify
- Whether loan growth and higher-yielding securities sustain net interest income as funding costs rise and competitive pressures constrain loan pricing.
- Credit quality trends behind the $750,000 provision, $655,000 of quarterly net charge-offs, and the concentration of real-estate-related loans.
- Recoverability and carrying values of OREO, particularly long-held properties, and whether additional valuation adjustments or sale losses arise.
- The recurring versus one-time components of increased compensation and other operating costs, and the durability of the improved efficiency ratio.
- The impact of securities repositioning, interest-rate changes, and planned accounting-standard adoption on future margins and earnings.
- Capital and liquidity headroom, including the continued availability of FHLB collateral and the terms of senior and subordinated debt.