1st Source Corporation — Q2 2017 Form 10-Q
Business context and period: Indiana-based bank holding company providing banking and financial services. This unaudited filing covers the quarter and six months ended June 30, 2017; balance-sheet comparisons are against December 31, 2016. Dollar amounts below are in millions unless stated otherwise.
Key financial results
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Net interest income | $45.9 | $42.3 | $89.6 | $83.6 |
| Provision for loan and lease losses | $2.7 | $2.0 | $3.7 | $3.0 |
| Noninterest income | $24.1 | $22.3 | $47.4 | $43.9 |
| Noninterest expense | $41.1 | $40.0 | $82.2 | $80.7 |
| Net income | $16.7 | $14.5 | $32.9 | $28.3 |
| Diluted EPS | $0.64 | $0.56 | $1.26 | $1.08 |
- Q2 net income increased about 15% year over year; first-half net income increased about 16%. Management attributed the improvement principally to higher net interest and noninterest income, partly offset by higher credit provision, operating expense and taxes.
- Fully taxable-equivalent net interest margin was 3.57% in Q2, up from 3.45% a year earlier; first-half margin was 3.55%, versus 3.45%. Higher loan and securities yields supported the improvement, while funding costs also rose.
- Return on average assets was 1.20% for the first half, versus 1.08% in 2016; return on average common equity was 9.60%, versus 8.70%.
- Cash flows for the first half: operating activities provided $57.7; investing activities used $237.3, mainly reflecting loan growth and investment in leased equipment; financing activities provided $147.3. Cash and cash equivalents ended at $76.0, down from $108.3 at year-end 2016.
Financial position, capital and liquidity
- Total assets were $5.69 billion, up 3.7% from year-end. Loans and leases grew 4.6% to $4.38 billion, with notable growth in auto/light truck, commercial/agricultural and construction equipment. Deposits rose 3.4% to $4.48 billion.
- Available-for-sale securities were $850.3; equipment owned under operating leases increased 21.7% to $144.5. The allowance for loan and lease losses was $91.9, or 2.10% of loans and leases, compared with 2.20% one year earlier.
- Total liabilities were $4.99 billion. Short-term borrowings were $306.6; long-term debt and mandatorily redeemable securities were $70.4; subordinated notes were $58.8. Shareholders’ equity was $699.2, and the equity-to-assets ratio was 12.29%.
- Regulatory capital ratios exceeded stated minimums: consolidated total capital ratio 14.88%, Tier 1 risk-based 13.58%, common equity Tier 1 12.43%, and Tier 1 leverage 12.28%.
- Management said funding sources were adequate. At quarter-end, the company reported approximately $265 million of short-term federal funds borrowing capacity, $75.1 million of additional FHLB borrowing capacity, and $505.3 million available from the Federal Reserve. The loan-to-asset ratio was 77.04%.
- Management estimated a $647 million potential liquidity exposure if collateral were required for public-fund deposits under Indiana rules; none was required at quarter-end, but that determination could change.
Material changes and management commentary
- Loan growth and stronger yields contributed to higher net interest income. Average earning assets rose 4.4% in Q2 year over year; average net loans and leases rose about 5.0%. Deposit and borrowing costs increased as rates rose.
- Noninterest income grew 8.3% in Q2. Equipment rental, trust and wealth advisory, service charges and debit-card revenue increased. Equipment rental growth was accompanied by higher leased-equipment depreciation.
- First-half net securities gains were $1.75 million, compared with a $0.20 million loss in the prior-year period. Q2 included $0.47 million in gains, partly offset by a $0.19 million other-than-temporary impairment loss on a marketable equity security.
- Noninterest expense increased 2.7% in Q2. Higher leased-equipment depreciation, professional fees and marketing were partly offset by lower salaries and insurance expense. Management also cited impairment write-downs on branches planned for closure in Q3 2017.
- Q2 net charge-offs were $0.94 million, compared with net recoveries of $0.11 million in Q2 2016; first-half net charge-offs were $0.37 million, versus net recoveries of $0.32 million. The provision rose year over year.
- Nonperforming assets were $29.9 million, down 1.8% from year-end but up 42.1% from June 2016. Repossessions rose to $13.1 million, mainly aircraft-related; nonperforming assets were 0.66% of net loans and leases.
- Management highlighted aircraft collateral concentration and softening values, particularly for private jets, as well as foreign borrower and geopolitical risks. Aircraft-related foreign outstandings totaled $226.6 million, including $98.4 million in Brazil and $115.4 million in Mexico.
Outlook, risks and contingencies
- The filing provides no specific earnings, revenue or margin guidance. Management’s outlook is qualified by uncertainty around interest rates, loan prepayments, competition, regulation, economic conditions and industries with credit concentrations. The company disclaims an obligation to update forward-looking statements.
- Credit risks include aircraft collateral values and foreign exposures, concentration in Northern Indiana and Southwestern Lower Michigan, and broader economic and geopolitical conditions. Management stated it considered these factors in its reserve assessment and believed reserve ratios remained appropriate.
- Off-balance-sheet commitments included $893.7 million of commitments to extend credit, $27.4 million of standby letters of credit and $1.6 million of commercial letters of credit. Commitment amounts do not necessarily represent future cash requirements.
- The bank’s tax-advantaged and other partnership investments, including legally binding future funding commitments, totaled $27.3 million; associated unfunded commitment liability was $18.6 million.
- Management did not expect the outcome of ordinary-course legal proceedings to materially adversely affect consolidated financial position or results. The filing reported no material changes to risk factors since the 2016 Form 10-K and no material changes in market risk.
- Disclosure controls were assessed as effective, with no reported material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether loan growth and improved net interest margin persist as deposit and borrowing costs respond to further rate changes.
- Credit quality trends, especially aircraft repossessions, aircraft collateral values, and Brazil/Mexico exposures; also track delinquencies, nonaccrual loans and reserve coverage.
- Whether equipment-rental revenue growth continues to exceed the associated depreciation and funding costs.
- The durability of securities gains and other noninterest income, including the effect of the prior-year partnership liquidation and 2017 equity-security sales and impairment.
- The impact of planned branch closures and related impairment charges, and whether the stated contingent liquidity exposure or borrowing availability changes.