Arrow Financial Corporation — Q2 2018 Form 10-Q
Business and period: Arrow is a New York-based bank holding company operating two banks, alongside insurance, fiduciary and investment-related businesses. This filing covers the quarter and six months ended June 30, 2018; financial amounts below are in U.S. dollars.
Financial performance and position
- Q2 earnings: Net income was $9.73 million, up 35.0% year over year; diluted EPS was $0.69 versus $0.52. Return on average assets was 1.38% and return on average equity was 15.22%.
- First-half earnings: Net income was $18.26 million, up 32.0%; diluted EPS was $1.30 versus $0.99. ROA was 1.32% and ROE was 14.51%.
- Net interest: Q2 GAAP net interest income increased 9.0% to $20.96 million; GAAP net interest margin was 3.11%, compared with 3.02%. First-half net interest income rose 9.8% to $41.36 million and margin was 3.12%, compared with 3.01%. Tax-equivalent margins were 3.18% for Q2 and 3.19% for the first half; these are non-GAAP measures.
- Other income and costs: Q2 noninterest income rose 12.1% to $7.91 million, led by fiduciary fees; noninterest expense increased 3.5% to $16.19 million. The reported non-GAAP efficiency ratio improved to 55.38% from 57.16%. First-half noninterest income rose 7.6% to $14.80 million and expense rose 3.3% to $32.15 million.
- Taxes: Q2 and first-half effective tax rates were both 19.3%, versus 29.5% and 29.2%, respectively, in 2017. The filing attributes the decline principally to the Tax Act’s reduction in the federal statutory rate.
- Balance sheet at June 30: Total assets were $2.85 billion; loans were $2.06 billion, up 5.5% from year-end 2017; deposits were $2.30 billion, up 2.7%. Stockholders’ equity was $259.5 million, up 4.0% from year-end.
- Cash flow, first half: Operating cash flow was $21.0 million, investing cash flow was negative $103.5 million, and financing cash flow was positive $70.4 million. Cash and cash equivalents declined $12.1 million to $60.7 million.
- Debt and funding: Period-end borrowings included $60.2 million of federal funds/repos, $136 million of overnight FHLB advances, $45 million of FHLB term advances and $20 million of junior subordinated obligations. Deposits were the principal funding source; brokered deposits totaled $45 million.
- Liquidity and capital: Management reported a 9.0% basic liquidity ratio, including FHLB collateralized borrowing capacity, and $142 million above its 4% internal minimum. Unused FHLB borrowing capacity was approximately $263 million and Federal Reserve discount-window capacity approximately $456 million. Arrow’s CET1, Tier 1 risk-based, total risk-based and leverage ratios were 13.01%, 14.04%, 15.06% and 9.65%, respectively; the company and both banks were reported well-capitalized.
Material changes versus comparable periods
- Q2 loan interest and fees increased $2.6 million year over year, supporting higher net interest income; average earning assets grew 5.9%. Funding costs also rose: Q2 interest expense increased 54.7%, and the cost of interest-bearing liabilities rose to 0.50% from 0.34%.
- Loan growth was strongest in consumer and residential real estate. Total loans increased $179.2 million, or 9.5%, from June 30, 2017. Consumer loans were primarily automobile lending; management cited dealer-network expansion and strong originations.
- Credit indicators improved: nonperforming loans were $4.16 million, or 0.20% of loans, versus $7.14 million and 0.38% a year earlier. The allowance was $19.64 million, or 0.95% of loans. Q2 net charge-offs were $46,000.
- Noninterest income included a $223,000 Q2 gain on equity securities, reflecting the 2018 accounting treatment of fair-value changes in earnings. First-half fiduciary income rose, while insurance commissions and gains on loan sales declined year over year.
- Available-for-sale securities had $6.64 million of gross unrealized losses at June 30; held-to-maturity securities had $5.78 million. Management attributed losses principally to market rates and spreads, considered them temporary, and reported no other-than-temporary impairment in the first half.
Outlook, commentary and risks
- The filing provides no formal earnings or revenue guidance. Management described local business and real estate conditions as generally stable and said it did not then anticipate significant increases in problem assets, while cautioning that it could not assure this outcome.
- Management expects to continue retaining a greater share of mortgage originations, but noted that substantially higher rates or economic weakness could slow originations and loan growth. It also identified possible weakening in automobile demand and commercial lending conditions.
- Rising rates may increase deposit and borrowing costs; municipal deposits are seasonal and may be sensitive to competition. The filing notes that the cost of deposits increased during the quarter and that future effects of Federal Reserve policy were uncertain.
- Interest-rate simulations showed net interest income changes of negative 2.24% in year one and positive 1.20% in year two under a 200-basis-point increase; under a 100-basis-point decrease, the modeled changes were positive 0.53% and negative 1.25%. These are hypothetical model results, not forecasts.
- Arrow plans to adopt the expected-credit-loss standard (CECL) in Q1 2020 and said adoption will likely reduce shareholders’ equity, while expecting to remain well-capitalized under current regulatory calculations. The company was assessing the impact.
- After quarter-end, the board declared a $0.26-per-share third-quarter cash dividend. The 2018 repurchase authorization was up to $5 million; approximately $389,000 had been used under the program by June 30.
- Arrow disclosed an indirect contingent exposure related to Visa litigation through its 27,771 Visa Class B shares, but assigned them no economic value because settlement is uncertain. Management reported no material pending or threatened legal proceedings.
Important facts for investors to verify
- Whether loan growth, particularly indirect auto lending, continues without deterioration in delinquencies, charge-offs or underwriting quality.
- Whether rising deposit and wholesale funding costs outpace loan-yield increases and pressure net interest margin.
- The composition, persistence and funding cost of brokered and large time deposits, including seasonal municipal deposit movements.
- Interest-rate exposure assumptions and actual performance relative to the filing’s modeled sensitivity results.
- The eventual CECL implementation effect on allowance levels, retained earnings and regulatory capital.
- Whether reported earnings growth is sustained when the Tax Act benefit and the nonrecurring large-estate fiduciary revenue contribution are considered.