First Business Financial Services, Inc. — Q3 2020 Form 10-Q
Reporting period: Three and nine months ended September 30, 2020; balance-sheet comparisons are to December 31, 2019. First Business operates a commercial bank primarily in Wisconsin and the greater Kansas City area, with specialty finance and private wealth businesses.
Financial performance
| Metric | Q3 2020 | Q3 2019 | Nine months 2020 | Nine months 2019 |
|---|---|---|---|---|
| Net interest income | $18.6m | $16.8m | $54.6m | $51.4m |
| Provision for loan and lease losses | $3.8m | $1.3m | $12.5m | $0.6m |
| Non-interest income | $7.4m | $5.8m | $20.1m | $16.2m |
| Non-interest expense | $16.8m | $14.7m | $51.2m | $49.9m |
| Net income | $4.3m | $5.1m | $10.9m | $17.6m |
| Diluted EPS | $0.50 | $0.59 | $1.27 | $2.01 |
| Net interest margin | 3.14% | 3.40% | 3.30% | 3.57% |
Q3 top-line revenue (net interest income plus non-interest income) grew 15.3% to $26.0m; nine-month revenue rose 10.5% to $74.7m. Higher revenue did not prevent lower net income, principally because credit-loss provisions increased substantially. Management-reported adjusted pre-tax, pre-provision earnings rose 23.0% in Q3 and 20.6% year to date; these are non-GAAP measures. The efficiency ratio improved to 64.16% for Q3 and 64.29% year to date, from 66.41% and 67.29%, respectively.
- Q3 annualized return on average assets/equity was 0.68%/8.58%, versus 0.97%/10.68% a year earlier; nine-month figures were 0.62%/7.49%, versus 1.15%/12.77%.
- Commercial loan swap fees increased to $2.4m in Q3 and $5.8m year to date, from $0.4m and $1.9m. Management notes this revenue can vary by period.
- Operating cash flow was $5.4m for the nine months, versus $20.8m in 2019. Investing used $470.1m, largely reflecting net loan growth; financing provided $449.3m. Cash and cash equivalents ended at $51.7m.
Financial position, funding and credit
Total assets increased 24.1% to $2.602bn. Gross loans and leases were $2.178bn, including $332.3m of gross Paycheck Protection Program (PPP) loans; deposits were $1.821bn and stockholders’ equity was $200.8m. Deposits grew $291.0m and FHLB advances and other borrowings increased to $483.5m from $319.4m. Junior subordinated notes were $10.1m.
- Allowance for loan and lease losses rose to $30.8m from $19.5m, or 1.41% of gross loans (1.67% excluding net PPP loans). Nine-month net charge-offs were $1.2m.
- Non-accrual loans and leases increased to $36.1m from $20.6m; non-performing assets were $36.7m, or 1.41% of assets. Non-accrual loans were 1.95% of gross loans excluding net PPP loans.
- COVID-19 deferrals outstanding fell to $131.5m, or 7.1% of loans excluding gross PPP loans, from $323.2m at June 30. As of October 20, 95% of clients whose first deferral concluded during Q3 had resumed scheduled payments. Management expected modifications to continue through 2020.
- Loans to retail, hospitality, entertainment, and restaurant/food-service borrowers totaled $188.5m, or 10.2% of loans excluding net PPP loans. Management cited uncertainty about the pandemic’s eventual effects on borrowers and the portfolio.
- Reported on-balance-sheet liquidity was $556.1m, including short-term investments, unencumbered securities and unencumbered pledged loans; additional federal funds lines totaled $53.5m. In-market deposits were $1.667bn, and management said the increase was positively affected by PPP proceeds.
- At September 30, the Bank was classified as well capitalized. Its total capital ratio was 11.11%, common equity tier 1 ratio 9.86%, and tier 1 leverage ratio 8.72%. The company’s corresponding ratios were 11.42%, 8.64%, and 8.04%.
Changes, outlook and notable items
Loan growth included substantial PPP lending and commercial real estate growth; excluding net PPP loans, net loans and leases increased $118.9m, or 7.0%, from year-end. Deposit costs fell, helping offset lower asset yields and margin compression. Management attributed lower profitability mainly to increased COVID-related credit provisions, while higher swap fees, SBA loan-sale gains and net interest income supported revenue.
- Outlook: No specific earnings or quarterly guidance was provided. Management stated a long-term objective of net interest margin averaging at least 3.50%, expects modest positive operating leverage, and expects asset-based lending and accounts-receivable financing volumes to increase during the remainder of 2020 and 2021. It cautioned that growth may be muted by economic conditions.
- PPP and fees: PPP loans are 100% SBA-guaranteed, subject to lender compliance. The company had $6.9m of deferred PPP processing fees outstanding and had submitted $97.9m, or 29% of gross PPP loans, for forgiveness as of October 20.
- Unusual expense: A $744,000 pre-tax loss was recorded on early repayment of $59.5m of FHLB advances. The company said the action lowered funding costs and supported its funding position.
- Capital returns: The quarterly dividend was $0.165 per share, a 33% payout of Q3 diluted EPS. The stock repurchase program was suspended in March 2020 because of pandemic uncertainty.
- Risks and contingencies: Credit quality remains exposed to pandemic-related economic conditions, stressed industries, legacy SBA relationships, and possible further charge-offs or provisions. Other cited risks include interest-rate changes, competition, operational/cybersecurity issues and maintaining SBA guarantees. Management reported no anticipated material loss from pending legal proceedings, no material change to previously disclosed risk factors, and no significant subsequent event requiring disclosure.
- Goodwill testing as of August 1, 2020 found no impairment; estimated fair value exceeded book value by $89.4m, or 44.8%. The company, as a smaller reporting company, deferred CECL adoption to 2023 and was developing its methodology.
Key facts for investors to verify
- Whether loan performance, deferral expirations and exposures to hospitality and other stressed sectors result in additional non-accruals, charge-offs or reserve increases.
- How much of loan, deposit and liquidity growth reflects temporary PPP-related balances, and the timing and effects of PPP forgiveness and fee recognition.
- Whether core loan yields, net interest margin and fee income can hold up as rates remain low and volatile swap/SBA activity changes.
- Funding mix, liquidity availability and capital levels as loan growth continues and wholesale borrowings mature.
- The basis and reconciliation of management’s adjusted earnings and efficiency metrics, and the sustainability of the dividend and suspended buyback policy.