Prosperity Bancshares, Inc. — FY2018 Form 10-K Summary
Business context and reporting period
Prosperity Bancshares, Inc. is a Texas-based financial holding company whose principal subsidiary, Prosperity Bank, provides commercial and consumer banking services in Texas and Oklahoma. At December 31, 2018, the Bank operated 242 full-service banking locations and had 3,036 full-time equivalent associates. The filing covers the fiscal year ended December 31, 2018; fourth-quarter data are included but the filing is an annual report, not a standalone quarterly filing.
Financial performance and key metrics
| Metric | 2018 | 2017 | Change |
|---|---|---|---|
| Total assets | $22.69 billion | $22.59 billion | 0.5% increase |
| Net interest income | $629.6 million | $616.9 million | 2.1% increase |
| Provision for credit losses | $16.4 million | $14.3 million | 14.1% increase |
| Noninterest income | $116.0 million | $116.6 million | 0.5% decrease |
| Noninterest expense | $326.2 million | $313.1 million | 4.2% increase |
| Net income | $321.8 million | $272.2 million | 18.2% increase |
| Diluted EPS | $4.61 | $3.92 | 17.6% increase |
| Return on average assets | 1.42% | 1.22% | 20 basis-point increase |
| Return on average common equity | 8.15% | 7.26% | 89 basis-point increase |
| Tax-equivalent net interest margin | 3.18% | 3.19% | 1 basis-point decrease |
| Efficiency ratio | 43.71% | 42.76% | Less favorable by 95 basis points |
Interest income increased 7.4% to $727.2 million, supported by higher loan and securities yields and 3.3% growth in average loans. Interest expense increased 61.4% to $97.6 million as the average rate on interest-bearing liabilities rose from 0.46% to 0.75%. Average cost of funds increased to 0.52% from 0.33%, while average cost of deposits increased to 0.42% from 0.27%.
Fourth-quarter 2018 net income was $83.3 million, or $1.19 diluted EPS, compared with $67.1 million, or $0.97 diluted EPS, in fourth-quarter 2017. Fourth-quarter provision expense was $1.0 million compared with $2.0 million in the prior-year quarter.
Balance sheet, credit quality, debt and liquidity
- Total loans increased 3.5% to $10.37 billion; loans represented 45.7% of total assets and 60.1% of deposits.
- Loan growth was concentrated in commercial real estate, which increased 6.7% to $3.54 billion, and construction, land development and other land loans, which increased 7.5% to $1.62 billion. Approximately 75.6% of loans consisted of commercial real estate, 1-4 family residential, construction, land development and other land loans.
- Total deposits declined 3.2% to $17.26 billion. Noninterest-bearing deposits increased 0.8% to $5.67 billion and represented 32.8% of period-end deposits.
- Investment securities declined 2.7% to $9.41 billion and represented 41.5% of total assets. Cash and cash equivalents increased to $411.1 million from $392.3 million.
- Federal funds purchased and other borrowings increased to $1.03 billion from $505.2 million. Securities sold under repurchase agreements declined to $284.7 million from $324.2 million. The Company had $5.92 billion of available capacity under its FHLB line at year-end, with $1.03 billion outstanding.
- Total shareholders’ equity increased 6.0% to $4.05 billion. Cash dividends declared increased to $1.49 per share from $1.38 per share; the 2018 payout ratio was 32.33%.
- Nonperforming assets declined to $19.0 million, or 0.18% of loans and other real estate, from $37.5 million, or 0.37%. Nonperforming loans declined to $17.2 million from $26.3 million.
- The allowance for credit losses increased 2.9% to $86.4 million, or 0.83% of total loans. Net charge-offs declined to $14.0 million from $15.6 million, and net charge-offs to average loans improved to 0.14% from 0.16%.
- The Company reported strong regulatory capital: CET1 of 16.32%, total risk-based capital of 16.99% and leverage of 10.23%. The Bank’s corresponding ratios were 16.24%, 16.90% and 10.18%; the Bank remained classified as well-capitalized.
Cash flow and capital allocation
- Net cash provided by operating activities was $320.1 million, compared with $390.7 million in 2017.
- Net cash used in investing activities was $119.0 million, primarily reflecting net loan growth and securities activity.
- Net cash used in financing activities was $182.4 million, including $104.1 million of dividend payments, a $607.6 million decrease in interest-bearing deposits and $530.0 million of net proceeds from other short-term borrowings.
- Cash and cash equivalents increased by $18.8 million during 2018.
- The Company had $2.49 billion of commitments to extend credit and $66.3 million of standby letters of credit at year-end. These commitments may expire unused and do not necessarily represent future cash funding requirements.
Material changes versus prior comparable period
- Net income rose primarily because of lower corporate tax rates following the Tax Cuts and Jobs Act and higher interest income, partly offset by higher funding costs.
- The effective tax rate declined to 20.2% from 33.0%. The 2017 period included a $1.4 million one-time non-cash deferred-tax remeasurement charge.
- Net interest income increased despite a slight margin contraction because of loan growth and higher asset yields. Funding costs rose substantially as market rates increased.
- Noninterest expense increased, principally because salaries and employee benefits rose 7.9% to $207.5 million. The increase included higher compensation and stock-based compensation expense.
- Deposit balances declined while borrowings increased, changing the funding mix and increasing interest-rate and liquidity sensitivity.
- Asset quality improved materially, with lower nonperforming assets, nonperforming loans and charge-offs.
- No acquisitions were completed in 2018. The most recent acquisition was Tradition Bancshares, completed January 1, 2016.
Outlook, management commentary, risks and unusual items
Management intends to pursue internal loan and deposit growth, disciplined acquisitions, new banking centers, community banking, cost control and cross-selling while maintaining conservative underwriting and sound asset quality. The filing does not provide formal earnings, revenue, margin or loan-growth guidance.
The Company’s primary market risk is interest-rate volatility. Its simulation indicated that a 200-basis-point increase in rates would increase projected 12-month net interest income by 2.4%, while a 100-basis-point decline would reduce it by 1.8%; management cautions that model results are inherently uncertain. The Company does not use derivatives such as interest-rate swaps to reduce interest-rate risk.
- Material exposure exists to commercial real estate, construction and land-development lending, as well as real estate collateral generally.
- Texas and Oklahoma economic conditions, including oil-price volatility, could affect borrowers, collateral values, loan demand and credit losses.
- Higher deposit pricing or reduced deposit availability could increase funding costs and pressure margins and liquidity.
- Future acquisitions may be delayed, restricted or denied by regulators, may be difficult to integrate, or may not be accretive to earnings.
- Goodwill totaled $1.90 billion. Management identified no impairment at year-end, but adverse changes in profitability, cash flows or valuation assumptions could result in a future charge.
- ASU 2016-13, the current expected credit loss standard, becomes effective January 1, 2020 and could increase allowance levels and reduce capital through a transition adjustment. The Company was still evaluating the effect at year-end.
- ASU 2016-02, the new leases standard, became effective January 1, 2019; management anticipated recognizing an approximately $18.0 million lease liability with a corresponding right-of-use asset.
- Management stated that ordinary-course litigation is not expected to have a material adverse effect. Disclosure controls and internal control over financial reporting were determined to be effective, and Deloitte & Touche issued unqualified audit opinions.
Investor verification checklist
- Verify the sustainability of 2018 earnings growth after separating the benefit of the lower tax rate from underlying operating performance.
- Monitor deposit trends, deposit pricing, FHLB borrowings and the effect of funding costs on net interest margin.
- Review commercial real estate and construction concentrations, including geographic and oil-and-gas borrower exposures.
- Assess whether improved nonperforming asset trends persist and whether the allowance remains adequate as CECL implementation approaches.
- Evaluate the carrying value and impairment sensitivity of the $1.90 billion goodwill balance.
- Confirm the impact of the 2019 lease-accounting adoption and the expected 2020 CECL adoption on capital, earnings and regulatory ratios.
- Review the $2.56 billion of off-balance-sheet commitments and the Company’s capacity to fund them during adverse deposit or credit conditions.