Business Context and Reporting Period
This unaudited Form 10-Q covers Cornerstone Bancshares, Inc. and its wholly owned Cornerstone Community Bank for the quarter and six months ended June 30, 2015. The filing provided is for Cornerstone Bancshares, although the request metadata identifies SmartFinancial, Inc.; the companies were pursuing a merger expected to create the combined SmartFinancial, Inc.
The Bank operates primarily in the Chattanooga, Tennessee market through five full-service offices and a loan production office in Dalton, Georgia. It originates commercial real estate, construction, commercial, consumer and residential loans and funds those activities primarily through deposits and borrowings.
Key Financial Metrics
| Metric | Three Months Ended June 30, 2015 | Six Months Ended June 30, 2015 |
|---|---|---|
| Interest income | $4.583 million | $9.133 million |
| Net interest income before provision | $3.977 million | $7.934 million |
| Provision for loan losses | $(88,000) credit | $262,000 provision |
| Net interest income after provision | $4.066 million | $7.673 million |
| Noninterest income | $(76,000) | $296,000 |
| Noninterest expense | $3.473 million | $6.676 million |
| Net income | $318,000 | $798,000 |
| Net income available to common shareholders | $(75,000) | $12,000 |
| Basic and diluted EPS | $(0.01) | $0.00 |
Tax-equivalent net interest margin was 3.98% for the quarter and 4.02% for the six months. The tax-equivalent net interest spread was 3.83% and 3.89%, respectively.
At June 30, 2015, total assets were $435.5 million, gross loans were $309.9 million, net loans were $306.3 million, securities were $74.5 million, deposits were $331.6 million and stockholders’ equity was $40.7 million. The allowance for loan losses was $3.6 million, or 1.16% of gross loans.
Six-month operating cash flow was $2.280 million. Investing activities used $3.211 million, primarily because net loan originations exceeded collections and the Bank purchased premises and equipment. Financing activities provided $18.769 million, mainly from a $22.9 million increase in deposits. Cash and cash equivalents increased $17.838 million to $33.366 million.
Borrowings at June 30, 2015 included $23.993 million of federal funds purchased and repurchase agreements and $31.0 million of Federal Home Loan Bank advances and other borrowings. The Bank reported capital ratios of 9.45% Tier 1 leverage, 11.33% common equity Tier 1, 11.33% Tier 1 risk-based and 12.35% total risk-based capital.
Material Changes Versus Comparable Periods
- Second-quarter net income declined 22.3% to $318,000 from $409,000; six-month net income declined 2.9% to $798,000 from $822,000.
- Net interest income before loan-loss provision increased 3.1% in the quarter and 3.5% year to date, supported by lower funding costs. Interest expense declined 16.4% in the quarter and 17.2% year to date.
- The Bank recorded an $88,000 loan-loss credit in the second quarter versus a $350,000 provision in the prior-year quarter. Year-to-date provision expense fell 49.1% to $262,000.
- Noninterest income was negative in the quarter because $474,000 of losses on sales of foreclosed assets exceeded service fees and securities-sale gains. Year-to-date noninterest income declined 8.1%.
- Noninterest expense increased 12.6% in the quarter and 8.7% year to date. Other operating expense increased approximately $696,000 year to date, including approximately $395,000 of merger expenses and approximately $167,000 of additional legal expense related to charged-off loans and collection efforts.
- Gross loans increased approximately 4.9% from December 31, 2014, led by construction and land development and commercial real estate lending. Management expected continued loan growth during the remainder of 2015.
- Total assets increased 4.8% from year-end 2014. Deposits increased approximately $22.9 million, while securities declined approximately $12.7 million and Federal Home Loan Bank borrowings declined $5.0 million.
- Nonperforming assets declined to $8.1 million from $10.9 million at December 31, 2014 and $15.8 million at June 30, 2014. Nonaccrual loans declined to $890,000 and foreclosed assets declined to $7.2 million.
Outlook, Risks, Contingencies and Unusual Items
- The merger with SmartFinancial had been approved by shareholders and bank regulators. Cornerstone preferred shareholders approved an amendment permitting redemption of the outstanding preferred stock before completion. The filing does not provide a definitive closing date.
- Management expected loan growth to continue but anticipated downward pressure on loan yields from refinancing and market conditions. Management believed the net interest margin could remain near the June 30, 2015 level, while noting continued local competition for loans and deposits.
- Management targeted a net reduction of approximately $3 million in foreclosed assets during the remainder of 2015 and expected nonaccrual loans to remain relatively flat. It also cautioned that additional loans could transition to foreclosed assets and that future loan-loss provisions could increase.
- Material risks include credit deterioration, real estate values, construction and land-development exposure, liquidity needs, interest-rate changes, competition, regulatory requirements, cybersecurity and operational risks, the realization of deferred tax assets, merger integration and potential dilution or capital requirements.
- Available-for-sale securities had $218,000 of gross unrealized losses at June 30, 2015. Management attributed the losses primarily to interest-rate conditions and did not consider the securities other-than-temporarily impaired.
- Off-balance-sheet commitments included $40.8 million of commitments to extend credit and $239,000 of standby letters of credit. Management stated that pending legal claims were not expected to have a material effect.
- The filing states that disclosure controls were effective and that no material changes occurred in internal control over financial reporting during the quarter.
Investor Verification Items
- Confirm the issuer identity and merger status because the filing is issued by Cornerstone Bancshares, while the request metadata identifies SmartFinancial, Inc.
- Verify the timing, consideration, preferred-stock treatment, reverse-stock-split adjustment and integration costs associated with the SmartFinancial merger.
- Monitor loan growth, construction and land-development exposure, nonaccrual loans, foreclosed assets, charge-offs and the adequacy of the $3.6 million allowance.
- Assess whether elevated non-core funding, including $106.8 million of large time deposits, remains stable and supports planned asset growth.
- Evaluate the sustainability of the 4.02% year-to-date net interest margin as loan and investment yields face pressure.
- Reconcile the reported $318,000 quarterly net income with the $(75,000) loss available to common shareholders after preferred dividends and preferred-stock accretion.
- Review the impact of merger-related and legal expenses on future operating efficiency and profitability.