FIRST BUSINESS FINANCIAL SERVICES, INC. quarterly report, Q3 FY2018

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First Business Financial Services, Inc. — Q3 2018 Form 10-Q

Reporting period: Quarter and nine months ended September 30, 2018. The company is a Wisconsin-based commercial bank holding company operating primarily in Wisconsin and the greater Kansas City area, focused on business and commercial banking, specialty lending, and trust and investment services.

Financial performance and position

MetricQ3 2018 / Sept. 30, 2018Comparable period / prior year-end
Net income$5.3 million; diluted EPS $0.60Q3 2017: $2.6 million; $0.30
Nine-month net income / diluted EPS$12.2 million / $1.402017: $7.9 million / $0.90
Net interest incomeQ3: $17.1 million; nine months: $50.2 millionQ3 2017: $14.9 million; nine months 2017: $45.3 million
Net interest marginQ3: 3.75%; nine months: 3.73%Q3 2017: 3.52%; nine months 2017: 3.56%
Total assets$1.894 billion$1.794 billion at Dec. 31, 2017
Gross loans and leases$1.600 billion$1.503 billion at Dec. 31, 2017
Deposits$1.409 billion$1.394 billion at Dec. 31, 2017
Cash and cash equivalents$40.3 million$52.5 million at Dec. 31, 2017
Shareholders’ equity$177.5 million$169.3 million at Dec. 31, 2017
  • Revenue and profitability: Q3 top-line revenue (net interest income plus non-interest income) rose 14.3% to $22.0 million; nine-month revenue rose 9.2% to $63.7 million. Annualized Q3 ROAA was 1.11% and ROAE was 12.06%; nine-month figures were 0.86% and 9.53%.
  • Margins and expenses: The efficiency ratio was 69.55% for Q3 and 68.05% for the nine months, versus 66.56% and 67.55% a year earlier. Q3 compensation expense increased 28.4%, including a $486,000 increase in the performance-compensation accrual.
  • Credit costs: Q3 provision was a benefit of $546,000, compared with $1.5 million expense in Q3 2017. Nine-month provision was $4.5 million versus $5.7 million. The company attributed much of the current-period benefit to collateral liquidation that reduced provision by approximately $4.1 million.
  • Cash flows: Nine-month operating cash flow was $20.3 million; investing activities used $116.7 million, principally for net loan growth; financing activities provided $84.2 million, largely from increased FHLB advances. Cash and cash equivalents decreased $12.2 million over the period.
  • Borrowing and liquidity: Balance-sheet FHLB advances and other borrowings were $281.4 million, up from $207.9 million at year-end. Immediate on-balance-sheet liquidity was $344.3 million, down from $401.1 million. Wholesale funds were 35.4% of total bank funding, within the company’s stated 30%–40% operating range.
  • Capital: At September 30, the Bank’s total capital, Tier 1, common equity Tier 1, and leverage ratios were 11.70%, 10.45%, 10.45%, and 10.24%, respectively. The filing states the Bank remained well capitalized and the Corporation and Bank exceeded applicable capital adequacy minimums.

Material changes versus prior periods

  • Q3 and nine-month earnings per share both improved substantially year over year, supported by loan growth, higher loan yields, higher trust fees, and lower credit and SBA recourse provisions.
  • Gross loans grew 6.5% from year-end, led by commercial real estate and commercial and industrial lending. Multi-family CRE loans increased to $174.7 million from $137.0 million.
  • Funding costs rose with market rates: Q3 average interest-bearing deposit cost increased to 1.47% from 0.88%, while average FHLB advances rose to $292.5 million from $103.4 million in Q3 2017. The company reported that liability costs rose quickly, partly offsetting asset-yield gains.
  • Credit indicators weakened versus year-end: non-accrual loans and leases increased to $30.6 million from $26.4 million; non-performing assets rose to $32.1 million from $27.5 million. Non-performing assets were 1.69% of total assets versus 1.53%.
  • The allowance for loan and lease losses increased to $20.5 million, or 1.28% of gross loans, from $18.8 million, or 1.25%. Net charge-offs for the first nine months were $2.8 million, lower than the $6.7 million recorded in the same 2017 period.
  • Available-for-sale securities had $2.5 million of pre-tax unrealized losses recognized through other comprehensive income during the first nine months, primarily attributed to rising interest rates. No securities were deemed other-than-temporarily impaired.

Outlook, commentary, risks, and unusual items

  • Management expects loan activity to replace normal amortization and support modest growth in coming quarters, while maintaining underwriting standards. It believes successful funding-cost management and profitable loan growth can support a net interest margin of 3.50% or better; loan fees may cause quarterly margin volatility.
  • Management’s long-term efficiency-ratio goal is 58%–62%; the reported Q3 ratio was 69.55%. It plans expense management and continued investment in staff and revenue growth, including SBA lending and commercial banking.
  • Management expects deposit costs to continue rising amid competition and a rising-rate environment. It also highlighted funding concentration in wholesale sources and continued efforts to build in-market deposits.
  • Credit risks include legacy SBA relationships and impaired commercial credits. A $9.1 million asset-based loan entered impaired status; a $5.0 million partial repayment was received October 25, 2018, and management expected further collateral liquidation. The filing notes future charge-offs or higher provisions remain possible.
  • The SBA recourse reserve was $2.7 million at quarter-end. Q3 SBA recourse provision was $314,000, compared with $1.3 million a year earlier; management cited remediation efforts and runoff of the legacy portfolio.
  • The nine-month effective tax rate was 19.0%, compared with 26.3% in 2017, primarily reflecting the lower federal corporate tax rate and a $245,000 state historic tax credit benefit.
  • Management reported no significant subsequent events requiring adjustment, no material changes to previously disclosed risk factors, and no anticipated material loss from pending legal proceedings. Disclosure controls were reported effective.
  • No formal earnings guidance was provided. The company described its outlook and operating targets as management expectations, subject to interest-rate, competition, economic, credit, regulatory, cybersecurity, tax, and SBA compliance risks.

Most important facts for investors to verify

  1. Whether the rise in non-accrual loans, non-performing assets, and impaired legacy SBA credits leads to further losses or provision expense; review collateral recovery assumptions and the $20.5 million allowance.
  2. Whether loan yields and growth can continue to outpace deposit and wholesale funding cost increases, supporting the stated NIM objective of at least 3.50%.
  3. Whether in-market deposits strengthen and wholesale funding remains within the 30%–40% operating range as loan growth and liquidity needs evolve.
  4. Whether compensation and other operating costs moderate enough to move the efficiency ratio toward the 58%–62% long-term goal.
  5. How much of earnings growth is repeatable versus influenced by lower provisions, collateral recoveries, tax benefits, and variable loan-fee income.