Old Second Bancorp, Inc. — Q3 2013 Form 10-Q
Business context and period. Old Second is an Illinois-based bank holding company providing commercial and retail banking, trust, and wealth-management services. This unaudited report covers the three and nine months ended September 30, 2013; balance-sheet comparisons are against December 31, 2012. Dollar amounts below are in millions unless noted.
Key financial results
| Metric | Q3 2013 | Q3 2012 | 9M 2013 | 9M 2012 |
|---|---|---|---|---|
| Net interest income | $14.3 | $14.6 | $41.6 | $45.4 |
| Net interest margin, tax-equivalent | 3.25% | 3.44% | 3.17% | 3.52% |
| Provision (release) for loan losses | $(1.8) | — | $(6.1) | $6.3 |
| Noninterest income | $8.4 | $10.3 | $29.5 | $31.2 |
| Noninterest expense | $21.5 | $24.9 | $65.2 | $71.9 |
| Income (loss) before taxes | $2.9 | $0.1 | $11.9 | $(1.6) |
| Income tax benefit | $70.0 | — | $70.0 | — |
| Net income (loss) | $72.9 | $0.1 | $81.9 | $(1.6) |
| Diluted EPS | $5.08 | $(0.08) | $5.52 | $(0.37) |
- Tax-driven earnings: The $70.0 million tax benefit included a $74.1 million reversal of the deferred-tax-asset valuation allowance. The reversal followed management’s conclusion that realization of a significant portion of the assets was more likely than not. Pretax earnings were $2.9 million in Q3 and $11.9 million for nine months; reported net income is therefore not a measure of recurring operating earnings.
- Cash flow: Nine-month operating cash flow was $19.7 million, investing cash flow $18.4 million, and financing cash flow $(86.5) million. Cash and cash equivalents declined $48.4 million to $80.1 million.
- Balance sheet and liquidity: Total assets were $2.03 billion, down $13.0 million from year-end 2012. Deposits were $1.67 billion, down $44.1 million. Available-for-sale securities were $373.5 million and held-to-maturity securities $258.1 million. Management described securities and borrowing capacity as substantial liquidity sources and said it saw no current need to grow deposits to fund loan or investment opportunities.
- Loans and credit: Loans were $1.08 billion, down $72.4 million from year-end. Nonperforming loans fell to $47.8 million from $82.6 million at year-end 2012 and $105.8 million a year earlier. Net charge-offs were $3.0 million for nine months, including $3.7 million in Q3. The allowance was $29.5 million, or 2.74% of loans; coverage of nonperforming loans was 61.9%.
- OREO: Other real estate owned declined to $49.1 million from $72.4 million at year-end. Nine-month OREO-related expense, net of lease revenue and gains, was $8.9 million; Q3 included a $0.6 million net gain on sales.
- Debt and capital: Reported borrowings totaled $179.6 million, including $58.4 million of junior subordinated debentures, $45.0 million of subordinated debt, and $55.0 million of FHLB advances. Stockholders’ equity was $142.0 million, up from $72.6 million, principally reflecting the tax valuation-allowance reversal. The Bank’s Tier 1 leverage and total risk-based capital ratios were 11.08% and 17.08%, respectively; both exceeded its board-set thresholds.
Material changes and management commentary
- Compared with the first nine months of 2012, net interest income fell $3.9 million and tax-equivalent margin declined 35 basis points to 3.17%. Management attributed the pressure chiefly to lower loan balances and yields, a shift toward lower-yielding securities, competitive loan pricing, and a low-rate environment. Lower funding costs partially offset the decline.
- Noninterest income fell year over year, particularly mortgage-loan sale gains and OREO lease revenue. Management also reported sharply lower mortgage revenue in Q3 versus Q2 as loan-sale volume declined about one-third.
- Asset-quality measures continued to improve, but management cautioned that real-estate markets remained challenging and that actual loan and property losses could exceed estimates. Real-estate-related lending represented 89.3% of the loan portfolio.
- In September, $237.2 million fair value of securities was transferred from available-for-sale to held-to-maturity; the company reported positive intent and ability to hold them to maturity. Net unrealized securities losses in equity increased $11.1 million from year-end to $12.4 million. Management said the losses primarily reflected interest-rate movements, not credit deterioration.
- The OCC terminated the Bank’s Consent Order on October 17, 2013, after the quarter-end. The Federal Reserve Written Agreement with the holding company remained in effect and imposed restrictions including prior approval requirements for dividends, certain debt actions, and stock repurchases.
- The company remained out of compliance with one financial covenant in its correspondent-bank credit agreement at September 30. The lender’s stated remedies include terminating credit commitments, increasing certain interest rates, declaring the $0.5 million term debt due, and pursuing collateral remedies.
- Interest payments on $58.4 million of junior subordinated debentures had been deferred since 2010; accrued unpaid interest was $15.7 million. Deferred Series B preferred dividends were $12.3 million. Common dividends cannot resume until deferred debenture interest and preferred dividends are paid, and regulatory restrictions also apply. The Series B dividend rate is scheduled to rise from 5% to 9% in 2014.
- Outlook: No numerical earnings or margin guidance was provided. Management said its commercial and industrial and selected commercial real-estate lending efforts had built loan pipelines and expected continued focus on that strategy to mitigate loan runoff during the remainder of 2013. Management also noted the sensitivity of results to interest rates, credit quality, deposit behavior, and property-sale proceeds.
Important facts for investors to verify
- How much of reported earnings is repeatable without the $70.0 million tax benefit, and whether the remaining deferred-tax valuation allowance changes.
- Whether loan quality continues to improve, including nonperforming loans, charge-offs, impaired loans, reserve adequacy, and real-estate concentrations.
- Whether loan production can offset runoff and margin pressure, and whether mortgage-banking income stabilizes.
- Liquidity and deposit trends, securities values and classifications, and the ability to refinance or replace short-term FHLB advances.
- Status of the Federal Reserve Written Agreement, the outstanding lender covenant breach, and any resulting waivers or lender actions.
- Accrued deferred interest and preferred dividends, restrictions on distributions, and the effect of the Series B rate increase in 2014.