FIRST MERCHANTS CORP quarterly report, Q1 FY2012

First Merchants Corporation — Q1 2012 Form 10-Q

Reporting period: Three months ended March 31, 2012; balance-sheet comparisons are with December 31, 2011. The company is an Indiana-based community banking and financial services holding company. Unless stated otherwise, amounts below are in millions of dollars.

Financial performance

Metric	Q1 2012	Q1 2011
Interest income	$43.5	$46.4
Interest expense	$7.4	$10.9
Net interest income	$36.1	$35.5
Provision for loan losses	$4.9	$5.6
Other income	$22.7	$11.9
Other expenses	$34.0	$33.9
Income before tax	$19.9	$7.9
Net income	$14.4	$5.5
Net income available to common shareholders	$13.2	$4.5
Diluted EPS	$0.46	$0.17

Net interest margin was 3.96% on a fully taxable-equivalent basis, versus 3.95% a year earlier. Average earning assets increased $45.0 million; asset yields fell 37 basis points while funding costs fell 38 basis points. Operating cash flow was $10.5 million, compared with $44.8 million in Q1 2011. Investing activities provided $61.6 million and financing activities used $84.4 million; cash and cash equivalents ended the quarter at $61.0 million.

Financial position, liquidity and capital

Total assets were $4.236 billion, up $63.3 million from year-end. Net loans were $2.723 billion, compared with $2.643 billion; deposits were $3.280 billion, compared with $3.135 billion.
Total borrowings were $397.7 million, down from $489.4 million. The company repaid $79 million of maturing FDIC-guaranteed senior notes on March 30. FHLB advances were $131.5 million, with $184.5 million of remaining borrowing capacity.
Available-for-sale securities totaled $547.3 million. Management identifies core deposits, loan repayments, securities sales and maturities, and additional funding sources as liquidity sources.
Tangible common equity to tangible assets was 7.07%, versus 6.84% at year-end. Consolidated total risk-based capital was 16.39%, Tier 1 risk-based capital 14.14%, and Tier 1 leverage 10.61%. The company and bank exceeded well-capitalized regulatory thresholds.

Material changes and unusual items

On February 10, the bank acquired selected assets and assumed substantially all deposits and certain liabilities of SCB Bank from the FDIC. The transaction generated a $9.1 million pretax gain, contributing approximately $0.21 per common share after tax. The acquired assets included a loan portfolio; its remaining balance was approximately $89.7 million at quarter-end. No FDIC loss-sharing agreement applied.
SCB’s acquired assets were recorded at provisional fair values; the company said its analysis was ongoing and recorded values could be adjusted. The acquired loans were purchased at a $19.2 million fair-value discount.
Common earnings rose substantially year over year, but the FDIC transaction gain was a significant nonrecurring contributor. Excluding it, the filing does not provide a single adjusted earnings figure.
Other income also benefited from a $576,000 bank-owned life insurance death benefit and $789,000 of realized securities gains. No investment-securities OTTI loss was recognized in Q1 2012, versus a $400,000 credit impairment loss in Q1 2011.
Salaries and benefits rose $2.2 million year over year, partly offset by lower FDIC assessments and credit-related expenses.

Credit quality, risks and outlook

The allowance for loan losses was $70.4 million, or 2.50% of loans, versus $70.9 million and 2.60% at year-end. Q1 provision was $4.9 million; net charge-offs were $5.4 million, down from $7.6 million a year earlier. Management considered the allowance adequate.
Non-accrual loans increased to $74.5 million from $69.6 million; nonperforming assets were $96.8 million, down from $100.2 million. Management attributed the increase in non-accrual loans to acquired SCB loans. Impaired loans increased to $94.4 million from $79.8 million.
Management highlights sensitivity to interest rates, economic conditions, loan and investment performance, competition, regulation, acquisition integration, and liquidity and credit risks. Its 12-month interest-rate simulation estimated net interest income of $158.4 million under an immediate +200-basis-point scenario (+4.24% versus base) and $149.6 million under a -100-basis-point scenario (-1.53%); management cautions that model assumptions may not match actual results.
The company had a $55 million Bank of America facility maturing in February 2015. It reported compliance with financial covenants at March 31, but disclosed that it had failed the minimum return-on-average-assets covenant at December 31, 2011. The lender applied a 3% default rate to the term loan through March 31 and did not accelerate it.
Off-balance-sheet loan commitments and standby/commercial letters of credit totaled $652.8 million; actual funding needs may be lower because commitments can expire unused or be partially drawn. Certain derivative agreements could require settlement or collateralization following specified defaults or capital-status changes.
No specific earnings or revenue guidance was provided. Management said Q1 results are not necessarily indicative of full-year results. It reported no material changes to previously disclosed risk factors and no legal proceedings.

Most important facts for investors to verify

How much of reported earnings growth is sustainable after separating the $9.1 million acquisition gain and other unusual income items.
Final fair-value adjustments and ongoing performance of the acquired SCB loan portfolio, including acquired non-accrual loans and deposits.
Trends in non-accrual and impaired loans, charge-offs, collateral values, and the adequacy of the $70.4 million loan-loss allowance.
Ability to maintain net interest margin and manage the modeled sensitivity to rising or falling rates.
Liquidity and funding needs, including large undrawn commitments, debt maturities, covenant compliance, and the terms of the Bank of America facility.
Valuation and potential credit risk in pooled trust preferred securities, which had $5.8 million amortized cost and only $174,000 fair value.