1ST SOURCE CORP annual report, FY2017

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1st Source Corporation — FY 2017 Form 10-K

Business context and reporting period. This annual report covers the year ended December 31, 2017, with year-end comparisons to 2016. 1st Source is an Indiana bank holding company operating primarily in Indiana and Michigan, with banking, trust and wealth advisory, insurance, and nationwide specialty equipment finance businesses. At year-end, it reported $5.89 billion of assets, $4.53 billion of loans and leases, $4.75 billion of deposits, and $718.5 million of shareholders’ equity.

Financial performance and condition

  • Earnings: Net income was $68.1 million, up 17.8% from $57.8 million in 2016. Diluted EPS rose to $2.60 from $2.22. Return on average assets was 1.21% (1.08% in 2016); return on average common equity was 9.69% (8.71%).
  • Net interest income and margin: Net interest income increased 9.4% to $185.6 million. Fully taxable-equivalent net interest margin improved to 3.57% from 3.43%. Average earning assets grew 4.9%; loan and lease yield rose 22 basis points to 4.50%, while the cost of interest-bearing liabilities increased 9 basis points to 0.69%.
  • Other income and expenses: Noninterest income rose 11.0% to $98.7 million, led by equipment rental income (+17.5%) and trust and wealth advisory fees (+9.0%); securities gains were $4.34 million versus $1.80 million. Noninterest expense increased 6.3% to $174.0 million, including higher leased-equipment depreciation, professional fees, marketing and collection costs.
  • Credit costs: The provision for loan and lease losses increased to $9.0 million from $5.8 million. Net charge-offs declined to $2.6 million from $5.4 million; the allowance was $94.9 million, or 2.10% of loans and leases, versus 2.11% a year earlier.
  • Loan quality and growth: Loans and leases grew 8.1% to $4.53 billion. Nonperforming assets were $31.3 million, up from $30.4 million; nonperforming loans and leases were 0.44% of loans, down from 0.49%. Repossessions reached $10.1 million, including aircraft, and auto and light truck nonaccrual loans increased to $8.0 million from $0.2 million. Potential problem loans declined to $5.45 million from $13.63 million.
  • Cash flow: Operating activities generated $117.3 million; investing activities used $462.2 million, mainly reflecting loan growth and securities purchases; financing activities provided $314.7 million. Cash and cash equivalents fell $30.3 million to $78.0 million.
  • Funding, debt and capital: Deposits rose to $4.75 billion from $4.33 billion. Short-term borrowings were $214.6 million, down from $291.9 million; long-term debt and mandatorily redeemable securities were $70.1 million, and subordinated notes were $58.8 million. The Bank was classified as well capitalized: total risk-based capital was 13.36%, common equity Tier 1 was 12.10%, and Tier 1 leverage was 10.98%.
  • Dividends: Cash dividends were $0.76 per share, up from $0.72; the payout ratio was 29.23%.

Fourth-quarter results

Q4 net income was $18.0 million and diluted EPS was $0.69, compared with $15.2 million and $0.58 in Q4 2016. Net interest income increased 12.5% to $48.8 million; the provision rose to $3.62 million from $0.74 million, and noninterest expense increased to $47.3 million from $41.8 million. Q4 results included the tax-reform benefit described below.

Material changes versus 2016

  • Earnings growth reflected higher net interest income, noninterest income, and loan balances, partly offset by higher provision and operating expenses.
  • The 2017 provision increase accompanied loan growth and losses in commercial and agricultural lending and foreign aircraft finance. Aircraft charge-offs were $1.87 million, compared with $6.12 million in 2016.
  • Equipment rental income and related leased-equipment depreciation both increased with portfolio expansion. The average equipment rental portfolio grew 20.0%.
  • Year-end accumulated other comprehensive income shifted from a $1.34 million gain to a $3.33 million loss, principally reflecting unrealized securities depreciation.

Outlook, commentary, risks and unusual items

  • Outlook: The filing provides no formal numerical earnings or growth guidance. Management described solar financing as promising for growth and credit quality; expected modest business-jet market growth in 2018 and a relatively stable, potentially favorable trucking industry. It cited continued pressure on agricultural borrowers from low commodity prices and weak farm incomes.
  • Tax reform: The December 2017 federal tax law reduced the corporate rate from 35% to 21%. Revaluation of deferred tax liabilities produced a one-time $2.61 million tax benefit and lowered the 2017 effective tax rate to 32.86% from 35.16%. The company said certain partnership-related tax calculations remained provisional pending further information.
  • Interest-rate sensitivity: The company’s model estimated that a 100-basis-point rate decline would reduce pretax net interest income by 6.45% over 12 months and 9.87% over 24 months; a 200-basis-point increase was modeled to raise it by 3.90% and 7.83%, respectively. Management cautioned that actual results could differ materially.
  • Key risks: Credit and collateral risk in specialty finance, including aircraft exposure in Mexico and Brazil; economic, political, fuel-price and industry-cycle shocks; rising funding costs and interest-rate exposure; competition; cybersecurity and third-party technology risks; regulatory change; and uncertainty in loan-loss and asset valuations. Foreign aircraft exposure was $233.4 million, largely in Brazil and Mexico.
  • Commitments and contingencies: Loan commitments to extend credit were $1.03 billion and standby letters of credit were $30.0 million. Management did not expect ordinary-course legal proceedings to materially affect the company. It reported a $0.39 million mortgage repurchase liability and $15.7 million of legally binding unfunded partnership commitments.
  • Assurance: The auditor issued unqualified opinions on the financial statements and internal control over financial reporting; management and the auditor concluded controls were effective at year-end.

Important facts for investors to verify

  • How much of 2017 earnings growth is sustainable after excluding the $2.61 million tax benefit and higher securities gains?
  • Whether the rise in auto nonaccrual loans and repossessions, and the aircraft and foreign-credit exposures, leads to further losses or higher allowance needs.
  • Whether loan growth and deposit funding can continue without materially higher deposit and borrowing costs, particularly under changing interest rates.
  • How the $1.03 billion in credit commitments, $689 million potential public-deposit collateral exposure, and partnership funding commitments affect liquidity under stress.
  • Whether management’s 2018 industry commentary—especially on agriculture, aircraft, trucking and solar finance—translates into realized growth and credit performance.