First Merchants Corporation — FY 2018 Form 10-K
Reporting period: Fiscal year ended December 31, 2018. The filing also presents unaudited fourth-quarter results. First Merchants is an Indiana-based financial holding company operating through one community-banking segment, with 116 banking locations across Indiana, Illinois and Ohio.
Financial performance and condition
- Earnings: Net income available to common shareholders was $159.1 million, up 65.7% from $96.1 million in 2017. Diluted EPS rose to $3.22 from $2.12. Fourth-quarter net income was $41.7 million, or $0.85 diluted EPS, versus $24.4 million, or $0.49, in Q4 2017.
- Revenue and margins: Net interest income was $338.9 million, up from $277.3 million; fully taxable equivalent (FTE) net interest income was $349.6 million. Noninterest income increased 7.7% to $76.5 million. FTE net interest margin edged down to 4.00% from 4.02%, as funding costs rose faster than asset yields. Return on average assets was 1.64% versus 1.17%; return on average equity was 11.84% versus 8.65%.
- Expenses and taxes: Noninterest expense rose 7.0% to $220.0 million, partly reflecting the first full year of operating expenses from the 2017 acquisitions. The effective tax rate fell to 15.4% from 28.1%; 2017 included a $5.1 million tax charge from TCJA deferred-tax revaluation, while 2018 benefited from the release of a $7.0 million state deferred-tax valuation allowance.
- Loans and credit: Year-end loans were $7.22 billion, up $470.8 million year over year. The allowance for loan losses was $80.6 million, or 1.11% of loans, versus $75.0 million and 1.11% in 2017. Provision expense declined to $7.2 million from $9.1 million; net charge-offs increased to $1.7 million from $0.1 million. Nonperforming assets fell to $29.4 million from $40.1 million; nonaccrual loans were $26.1 million. Criticized commercial loans not deemed impaired totaled $259.6 million, down from $270.0 million.
- Deposits, debt and liquidity: Deposits increased 8.1% to $7.75 billion. Total borrowings declined to $671.0 million from $834.4 million, including lower FHLB advances and federal funds purchased. Cash and cash equivalents were $139.2 million. Available-for-sale securities totaled $1.14 billion, and remaining FHLB borrowing capacity was $629.2 million. Cash flows were $180.2 million provided by operating activities, $575.6 million used in investing activities and $379.7 million provided by financing activities; cash decreased $15.7 million during the year.
- Capital and shareholder returns: Corporation regulatory capital ratios were 14.61% total risk-based capital, 12.80% Tier 1 and 11.98% CET1. Tangible common equity to tangible assets was 9.97%, up from 9.30%. Common dividends were $0.84 per share, compared with $0.69 in 2017.
Material changes versus 2017
- Loan and deposit growth, alongside a full-year contribution from the 2017 Arlington Bank and IAB acquisitions, supported higher net interest income and earnings. Year-end assets rose 5.5% to $9.88 billion.
- Higher market rates lifted loan and asset yields, but deposit and borrowing costs increased more quickly; FTE net interest spread contracted 9 basis points and net interest margin declined 2 basis points.
- Noninterest expense rose with the larger franchise, particularly salaries and employee benefits. Acquisition and conversion expenses were concentrated in 2017, when $12.2 million was recorded.
- Unrealized losses on securities increased: accumulated other comprehensive loss widened to $21.4 million from $2.9 million, primarily reflecting securities valuation changes. Management reported no other-than-temporary impairment in 2018.
Outlook, risks and unusual items
- Management expected the Corporation and Bank to exceed $10 billion in assets in 2019. The filing warns that crossing the threshold could bring additional consumer-protection oversight and higher FDIC assessments; debit interchange fee limits under the Durbin Amendment were expected to materially reduce fee income.
- At year-end, the company had a cumulative negative interest-rate gap of $1.7 billion over one year. Its model estimated 12-month net interest income would rise 7.89% under an immediate 200-basis-point increase and fall 3.80% under a 100-basis-point decrease; management cautions that actual results may differ from model assumptions.
- In October 2018, First Merchants agreed to acquire MBT Financial for estimated consideration of approximately $290.9 million in stock. MBT had $1.3 billion of assets at year-end. The deal was expected to close in the first half of 2019, subject to remaining regulatory and customary conditions.
- Other key risks include economic and interest-rate changes, credit deterioration and real-estate exposures, deposit competition and wholesale-funding access, acquisition integration, cybersecurity and operational disruptions, and the judgment involved in loan-loss and goodwill valuations. The two commercial industry concentrations above 10% of total loans were lessors of residential buildings and lessors of nonresidential buildings.
- CECL was scheduled for adoption in 2020. Management anticipated a one-time allowance adjustment but said the amount and overall impact could not yet be determined. The financial statements received an unqualified audit opinion, and management and the auditor reported effective internal control over financial reporting.
Important facts for investors to verify
- Whether loan growth, funding costs and deposit mix support sustainable net interest income and margins.
- Credit performance in commercial real estate and the identified industry concentrations, including criticized loans, delinquencies and net charge-offs.
- The size and earnings effect of the CECL transition allowance adjustment.
- Completion, integration costs and expected benefits of the MBT acquisition, and the impact of crossing $10 billion in assets.
- Whether modeled interest-rate sensitivity and securities valuations remain consistent with actual market conditions.
- How much of 2018 earnings growth reflects lower taxes and other nonrecurring or acquisition-related effects.