MERCANTILE BANK CORP quarterly report, Q2 FY2018

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Mercantile Bank Corporation — Q2 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 six months ended June 30, 2018; balance-sheet comparisons are with December 31, 2017. Unless otherwise noted, amounts are in U.S. dollars.

Financial performance and position

  • Q2 earnings: Net income was $9.4 million, or $0.57 per diluted share, versus $7.3 million, or $0.45, in Q2 2017. Net interest income was $29.2 million, up 7.5%; net interest margin was 3.92%, versus 3.85%. Provision for loan losses was $0.7 million.
  • First-half earnings: Net income was $20.3 million, or $1.22 per diluted share, versus $15.0 million, or $0.91, in the first half of 2017. Net interest income rose 12.8% to $59.4 million; the net interest margin increased to 3.99% from 3.79%. Provision was $0.7 million, down from $1.4 million.
  • Income and expenses: Q2 interest income was $34.3 million and interest expense $5.1 million. First-half noninterest income was $8.9 million, compared with $9.9 million; excluding a 2017 life-insurance claim, management said it increased 5.2%. Noninterest expense rose 7.3% in the first half to $42.6 million, largely due to salaries, benefits, and growth-related costs.
  • Taxes and unusual items: The effective tax rate was 19% in Q2 and the first half, versus 30.7% in each 2017 comparison, reflecting the federal corporate tax rate reduction from 35% to 21%. Successful collections on certain nonperforming commercial loans added about $1.7 million, or $0.10 per diluted share, to first-half 2018 net income. A 2017 bank-owned life-insurance death-benefit claim added about $1.1 million, or $0.06 per diluted share, to first-half 2017 net income. Management reports first-half diluted EPS growth of 31.8% excluding these items.
  • Assets and lending: Total assets were $3.29 billion, little changed since year-end. Loans increased $78.3 million, or 3.1%, to $2.64 billion; commercial loans were 85.8% of the portfolio. Residential mortgage loans grew 11.4% from year-end, while consumer loans declined. The allowance for loan losses was $21.2 million.
  • Credit quality: Nonperforming loans were $5.0 million, or 0.19% of loans, versus $7.1 million at year-end. Nonperforming assets totaled $5.8 million, or 0.2% of assets, versus $9.4 million. Allowance coverage of nonperforming loans was 426%, compared with 273% at year-end. Net loan recoveries were $0.5 million in Q2 and $1.0 million in the first half; management cautions that future recoveries cannot be reliably forecast.
  • Deposits, liquidity, and debt: Deposits rose $7.4 million to $2.53 billion. Cash and cash equivalents declined $74.4 million to $125.7 million, primarily as liquidity funded loan growth. Repurchase agreements were $94.6 million; Federal Home Loan Bank advances were $230 million; subordinated debentures were $45.9 million. The bank reported approximately $427 million of additional FHLB borrowing availability based on collateral. Wholesale funding was 11.1% of deposits and borrowed funds.
  • Cash flows: For the first six months, operating activities provided $21.4 million, investing activities used $82.2 million, and financing activities used $13.5 million. Cash and cash equivalents decreased $74.4 million, ending at $125.7 million.
  • Capital and securities: Shareholders’ equity was $374.9 million, up from $365.9 million at year-end. The bank was categorized as well capitalized; its total risk-based capital ratio was 12.9% and common equity Tier 1 ratio 12.2%. Available-for-sale securities were $331.1 million, with a $13.8 million pretax net unrealized loss, attributed by management to interest-rate changes and not considered other-than-temporary.

Material changes versus comparable periods

  • First-half net interest income increased as earning assets grew and loan yields improved, including the effect of higher rates on variable-rate commercial loans. The first-half margin rose 20 basis points year over year.
  • Funding costs increased: Q2 interest expense rose 37.3% and first-half interest expense rose 43.0%, as rates paid on deposits and borrowings increased. The margin eased from 4.06% in Q1 2018 to 3.92% in Q2, partly because first-quarter loan collections had temporarily lifted yield.
  • Loan balances expanded, while acquired loans continued to run off. Nonperforming loans declined $2.2 million from year-end; recoveries exceeded charge-offs in the first half.
  • First-half reported noninterest income declined year over year, mainly because 2017 included the life-insurance claim. Reported expenses increased, particularly employee compensation.
  • Accumulated other comprehensive loss widened, reflecting the decline in available-for-sale securities values as market interest rates rose.

Outlook, risks, and other matters

  • Management reported a strong commercial loan pipeline, approximately $198 million of new lending commitments expected largely to close and fund over the next 12–18 months, and $116 million of available construction and development loan commitments expected mostly to be drawn over that period. These are management expectations, not earnings guidance.
  • Management remained optimistic about residential mortgage banking activity, citing a strong pipeline and near-record pre-qualifications, while noting higher mortgage rates and limited housing inventory. It expects consumer-related loans to decline as repayments exceed new originations.
  • Management described intense competition for commercial loans and said it would maintain prudent underwriting rather than match terms it considers too aggressive. It believes up to half of the recent money-market deposit increase may be withdrawn by year-end.
  • Interest-rate exposure is a key market risk. Modeling estimated next-12-month net interest income would change by +2.8% with rates up 100 basis points and −5.4% with rates down 100 basis points; a 400-basis-point decline modeled a 17.1% decrease. Management cautions that model assumptions are uncertain.
  • Other risks include credit quality and collateral values, deposit competition and liquidity, economic conditions, regulation, and execution of growth plans. Unfunded commitments totaled $990.7 million, including $22.5 million of standby letters of credit; the filing states no reserve or liability was recorded for these instruments.
  • The company adopted the revenue-recognition standard in 2018 with no material financial impact. It was evaluating CECL, effective for the company after December 15, 2019, and expected to implement a framework later in 2018. Management reported no material change to previously disclosed risk factors, no material ongoing legal proceedings, and effective disclosure controls.
  • The board declared a $0.24-per-share dividend in July, payable September 19, 2018. No shares were repurchased in the first half of 2018.

Investor verification checklist

  • Verify whether loan growth and the stated pipeline convert to funded loans while underwriting standards and credit quality remain stable.
  • Track deposit pricing, money-market balances, wholesale funding, and available borrowing capacity as interest rates and competition evolve.
  • Assess whether higher funding costs continue to outpace asset-yield gains and pressure net interest margin.
  • Review loan-loss allowance assumptions, subsequent recoveries, troubled debt restructurings, and the effect of CECL adoption.
  • Monitor securities valuation losses and the bank’s capital ratios, dividend capacity, and any future share repurchases.
  • Distinguish recurring earnings from the commercial-loan collection benefit, tax-rate reduction, and prior-year life-insurance claim.