Arrow Financial Corporation — 2018 Third-Quarter 10-Q
Business context and reporting period. Arrow is a New York-based bank holding company operating two banks and related insurance, investment-advisory and other businesses. This unaudited report covers the quarter and nine months ended September 30, 2018; comparisons are with the same 2017 periods unless noted. Amounts below are in U.S. dollars; financial statement figures are generally in millions.
Financial performance and position
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Net income | $9.26m | $7.42m | $27.52m | $21.26m |
| Diluted EPS | $0.64 | $0.52 | $1.90 | $1.48 |
| Net interest income, GAAP | $21.00m | $19.65m | $62.36m | $57.34m |
| Net interest margin, GAAP | 3.02% | 3.00% | 3.09% | 3.01% |
| Noninterest income | $7.35m | $7.14m | $22.15m | $20.89m |
| Noninterest expense | $16.03m | $15.55m | $48.17m | $46.66m |
| Provision for loan losses | $0.59m | $0.80m | $1.96m | $1.58m |
- Q3 net income grew 24.9%; nine-month income grew 29.5%. Q3 return on average assets was 1.28% and return on average equity was 13.96%; nine-month figures were 1.30% and 14.32%.
- At September 30, total assets were $2.95bn, loans $2.13bn, deposits $2.41bn and stockholders’ equity $264.8m. Loans increased 9.0% from year-end 2017 and 11.4% year over year; deposits rose 7.2% from year-end.
- The allowance for loan losses was $20.0m, or 0.94% of loans. Nonperforming loans were $5.8m (0.27% of loans), and nonperforming assets were $7.0m (0.24% of assets). Q3 net charge-offs were $223,000, compared with $547,000 a year earlier.
- Nine-month operating cash flow was $33.6m; investing cash use was $181.6m and financing cash provided was $167.5m. Cash and cash equivalents ended the period at $92.3m, up $19.5m from the start of the year.
- Borrowings at period-end included $62.5m of federal funds/repo funding, $131.0m of overnight FHLB advances, $45.0m of FHLB term advances and $20.0m of junior subordinated obligations. Capital ratios remained strong: Arrow’s CET1 ratio was 12.89%, total risk-based capital 14.90% and Tier 1 leverage 9.67%; the company and both banks qualified as well-capitalized.
- Book value per share was $18.34 and tangible book value per share, a non-GAAP measure, was $16.69. The quarterly efficiency ratio was 55.79%; nine-month ratio was 56.12%.
Material changes and management commentary
- Growth in loan balances and higher market rates lifted interest income, while the shift toward loans from lower-yielding securities supported asset yields. Higher funding costs partly offset this: Q3 interest expense rose 79.5%, and the cost of interest-bearing liabilities increased 28 basis points year over year. Management cited deposit repricing, growth and a funding mix shift.
- The Tax Act reduced the federal statutory rate from 35% to 21%. Effective tax rates fell to 21.1% for Q3 from 29.0%, and to 19.9% for the first nine months from 29.1%.
- Nine-month fiduciary income and customer-service fees rose; insurance commissions and gains on loan sales declined. The loan-sale decline reflected the strategy of retaining more loans. New accounting rules moved equity-security fair-value gains into earnings; the company recorded $355,000 of such gains in the first nine months.
- Deposits included $45m of brokered funding. Average deposit costs continued to rise, and municipal deposits are seasonal. Management stated that liquidity was adequate: unused FHLB borrowing capacity was about $233m, available Federal Reserve discount-window capacity about $487m, and the reported basic liquidity ratio including FHLB capacity was 9.3% of assets versus a 4% internal minimum.
- Interest-rate modeling showed net interest income sensitivity of -2.7% in year one and +2.2% in year two under a hypothetical 200-basis-point increase; under a 100-basis-point decrease, the changes were +1.2% and +2.0%. Management cautioned that model assumptions and actual customer, market and balance-sheet behavior may differ.
Outlook, risks, contingencies and unusual items
- The filing gives no specific earnings or growth guidance. Management described loan demand as generally strong but noted potential pressure from higher rates, weaker demand or economic conditions, and competition for deposits. It said auto-loan demand may soften and mortgage originations may slow if rates rise substantially.
- Key risks include credit deterioration, especially in commercial real estate and consumer auto lending; rising funding costs and interest-rate volatility; liquidity and deposit competition; securities-market value changes; cyber and physical security incidents; regulatory changes; and general economic weakness. Management reported no significant portfolio-quality deterioration but gave no assurance against future increases in problem assets.
- Arrow expects to adopt the lease standard on January 1, 2019 and estimates that assets and liabilities will each increase by $7m–$9m, with no material operating-expense impact. It plans to adopt CECL in Q1 2020 and expects the standard likely to increase the loan-loss allowance and reduce equity; the amount is not yet clear. Management expects to remain well-capitalized under current regulatory calculations.
- Arrow held 27,771 Visa Class B shares linked to antitrust litigation. A settlement was announced, but approval and adequacy of the litigation escrow were uncertain; the company assigned no economic value to the shares. Off-balance-sheet commitments included $335.6m to extend credit and $4.0m of standby letters of credit; management did not expect material losses. Management reported no material pending legal proceedings.
- The board declared a Q4 cash dividend of $0.26 per share, payable December 14, 2018. A 3% stock dividend was distributed September 27, 2018. The interim financial statements were reviewed by KPMG, not audited; the review found no material modifications needed for GAAP conformity.
Important facts for investors to verify
- Whether loan growth—particularly in auto and residential lending—can continue without worsening delinquencies, charge-offs or required reserves.
- How deposit pricing, brokered funding and other borrowing costs affect future net interest margin and earnings as rates change.
- The extent and timing of any CECL transition adjustment, and whether the estimated $7m–$9m lease-related balance-sheet increase is realized.
- Whether the Visa settlement receives court approval and whether escrow funds cover claims and expenses; no value is currently recognized.
- That comparisons using tax-equivalent margins, efficiency ratios and tangible book value rely on non-GAAP measures; review the filing’s reconciliations and definitions.