First Business Financial Services, Inc. — Q3 2017 Form 10-Q
Business context and period. The company is a Wisconsin-based commercial bank serving businesses and individuals primarily in Wisconsin and the greater Kansas City area, with trust and investment services and specialty lending. This unaudited filing covers the quarter and nine months ended September 30, 2017; balance-sheet comparisons are with December 31, 2016. Amounts below are in U.S. dollars unless noted.
Financial performance and position
- Q3 earnings: Revenue (net interest income plus non-interest income) was $19.2 million, up 1.5% year over year. Net income was $2.6 million versus $2.7 million; diluted EPS was $0.30 versus $0.31. Pretax income was $3.5 million, compared with a $0.4 million pretax loss in Q3 2016; the prior-year quarter included a $3.0 million income tax benefit.
- Nine-month results: Revenue was $58.4 million, down 3.7%; net income was $7.9 million versus $10.9 million, and diluted EPS was $0.90 versus $1.26. The 2016 comparison included $3.6 million of historic tax credits and related impairment expense.
- Net interest and profitability: Q3 net interest income was $14.9 million, down 2.7%; nine-month net interest income was $45.3 million, down 2.8%. Net interest margin was 3.52% for Q3 (3.50% prior year) and 3.56% for the nine-month period (unchanged). Q3 return on average assets/equity was 0.58%/6.22%; nine-month figures were 0.59%/6.36%.
- Fees and expenses: Q3 non-interest income rose 19.2% to $4.3 million, led by trust fees and SBA gains; nine-month non-interest income fell 6.5% to $13.1 million, principally due to lower SBA and mortgage loan-sale gains. Non-interest expense was $14.2 million in Q3 (down 9.7%, partly reflecting the prior-year tax-credit impairment) and $42.0 million for nine months (up 0.2%). The reported efficiency ratio was 66.56% for Q3 and 67.55% year to date, versus 63.63% and 62.35% respectively.
- Credit costs and asset quality: Provision for loan and lease losses was $1.5 million in Q3 and $5.7 million year to date. Nine-month net charge-offs were $6.7 million, or 0.61% annualized of average loans, versus $3.1 million and 0.28% a year earlier. Non-accrual loans rose to $33.2 million from $25.2 million at year-end; non-performing assets increased to $35.8 million, or 2.01% of assets, from $26.7 million, or 1.50%. The allowance was $19.9 million, 1.36% of gross loans, versus 1.44% at year-end.
- Balance sheet and funding: Total assets were $1.786 billion, little changed from year-end. Net loans and leases increased 1.2% to $1.447 billion. Deposits declined 7.5% to $1.424 billion, while FHLB advances and other borrowings increased to $167.9 million from $59.7 million. Stockholders’ equity was $166.8 million. Cash and cash equivalents were $73.2 million.
- Cash flow, dividends, and capital: For nine months, operating cash flow was $19.4 million, investing cash outflow $13.3 million, and financing cash outflow $10.5 million; cash decreased $4.3 million. Dividends declared were $0.39 per share year to date. At September 30, the company and bank were described as well capitalized; consolidated total capital and common equity Tier 1 ratios were 11.91% and 8.86%, respectively.
Material changes and management commentary
- The company consolidated its three former bank charters into one effective June 1, 2017, and rebranded Alterra Bank as First Business Bank. Management expects the consolidation and a planned core-system conversion to improve efficiency and create capacity for growth; it cited these initiatives as potential contributors to earnings growth in 2018 and beyond.
- Management attributed lower year-to-date revenue mainly to rebuilding the SBA platform, which reduced SBA loan-sale gains, and to a shift toward lower-yielding conventional commercial loans. Trust and investment fee income increased 23.8% year to date, and management expected gradual SBA production growth in 2018.
- Management’s stated operating goals include maintaining net interest margin at 3.50% or better and returning the efficiency ratio to a long-term target range of 58%–62%. These are management objectives, not formal earnings guidance. Management noted competitive deposit pricing and anticipated possible modest increases in deposit costs as rates rise.
- Credit-related charges included $4.6 million of estimated losses on a Wisconsin commercial and industrial impaired loan and $5.0 million of charge-offs related to remaining energy-sector exposure, partly offset by reversal of a $1.8 million specific reserve after repayment of a Kansas City construction loan. The construction-loan payoff was received in October and was expected to reduce non-performing loans by $2.5 million in Q4.
- The SBA recourse provision was $2.1 million for nine months, including $1.3 million in Q3; the reserve was $2.7 million at quarter-end. Management cited potential guaranty-eligibility issues in certain credits and warned that recourse provisions may remain volatile, although it expects volatility to diminish as the rebuilt platform originates loans and the legacy portfolio runs off.
- Liquidity: management reported $450.2 million of immediate on-balance-sheet liquidity and said available liquidity exceeded its policy minimum. The Bank declared a $4.5 million dividend on October 25, bringing year-to-date declarations to $14.5 million.
Risks, contingencies, and other items
- Key risks identified include borrower defaults and delinquencies, economic and competitive conditions, interest-rate and market changes, growth execution, regulatory and tax changes, cybersecurity or fraud, and compliance with SBA requirements.
- The company has continuing obligations on sold SBA loans, including possible repurchase or reimbursement if SBA origination, funding, or servicing requirements were not met. The $2.7 million reserve reflects management’s estimate of inherent losses.
- Management said ordinary-course legal proceedings were not expected to have a material adverse effect. No material changes to previously disclosed risk factors or contractual obligations were reported.
- Interest-rate risk is the primary market risk; management said sensitivity had not changed materially since year-end. The company reported no significant subsequent events requiring adjustment and no material changes in internal control during the quarter.
Most important facts for investors to verify
- Whether non-accrual loans, non-performing assets, and net charge-offs stabilize or continue to rise; review borrower concentrations and the adequacy of the $19.9 million loan-loss allowance.
- How the $2.7 million SBA recourse reserve develops, including guaranty-eligibility issues, losses on sold loans, and the pace and profitability of rebuilt SBA production.
- Whether deposits, funding mix, and borrowing costs remain manageable as deposits fell and borrowings increased; monitor actual liquidity and FHLB funding costs.
- Whether management delivers its 3.50%-or-better net interest margin objective and 58%–62% efficiency-ratio goal, and whether charter consolidation and system conversion produce the anticipated efficiencies.
- How much of year-over-year earnings comparisons reflects ongoing operations versus the unusual 2016 tax-credit impairment and related tax-credit benefit.