Arrow Financial Corporation — Q3 2016 Form 10-Q
Business context and reporting period. Arrow is a New York bank holding company operating Glens Falls National Bank and Saratoga National Bank, along with insurance, investment-advisory and other subsidiaries. This unaudited quarterly report covers the three and nine months ended September 30, 2016; balance-sheet comparisons are primarily with December 31, 2015 and September 30, 2015. Amounts below are in U.S. dollars.
Financial performance and condition
- Quarterly earnings: Net income was $6.74 million, up 13.6% from $5.93 million in Q3 2015. Diluted EPS was $0.50 versus $0.45. Return on average assets was 1.06% versus 1.00%, and return on average equity was 11.75% versus 11.24%.
- Nine-month earnings: Net income was $19.93 million, up 10.2% from $18.09 million. Diluted EPS was $1.48 versus $1.36. ROA was 1.07% versus 1.05%; ROE was 11.93% versus 11.73%. Share and per-share data reflect a 3% stock dividend distributed September 29, 2016.
- Revenue and margins: Q3 net interest income was $17.88 million, up 7.8%; tax-equivalent net interest income, a non-GAAP measure, was $19.00 million, up 7.5%. Tax-equivalent net interest margin was 3.15%, versus 3.14%. Nine-month GAAP net interest income was $53.19 million, up 9.4%, and tax-equivalent margin was 3.19%, versus 3.18%. Q3 noninterest income was essentially flat at $7.11 million; nine-month noninterest income decreased 1.2% to $21.18 million. The efficiency ratio improved to 57.48% for Q3 and 56.86% year to date, on the company’s non-GAAP calculation.
- Expenses, provision and taxes: Q3 noninterest expense increased 1.6% to $15.08 million; nine-month expense increased 2.7% to $44.34 million. Loan-loss provision was $0.48 million for Q3, down from $0.54 million, but $1.55 million for the nine months, up from $0.88 million. Effective tax rates were 28.5% for Q3 and 30.0% year to date.
- Balance-sheet growth: Total assets were $2.58 billion, up 5.5% from year-end 2015 and 6.7% year over year. Loans were $1.71 billion, up 8.5% from year-end and 11.1% year over year. Deposits were $2.21 billion, up 9.0% from year-end. Stockholders’ equity was $229.2 million, up 7.1% from year-end; tangible book value per share was $15.23, a non-GAAP measure.
- Cash flow: For the first nine months, operating activities provided $25.17 million, investing activities used $82.29 million, and financing activities provided $108.12 million. Cash and cash equivalents increased $50.99 million to $102.06 million. Loan growth used $133.62 million in investing cash flow; deposit growth provided $182.76 million in financing cash flow.
- Debt and liquidity: At September 30, borrowings included $38.59 million of federal funds and repurchase agreements, $55 million of FHLB term advances and $20 million of junior subordinated obligations; there were no FHLB overnight advances. Arrow reported $276.3 million of unused FHLB borrowing capacity and $360.8 million available under Federal Reserve discount-window facilities, with no advances outstanding under the latter. Its reported basic liquidity ratio was 10.7%, above its 4% internal minimum target.
- Capital: Arrow’s September 30 regulatory ratios were 12.80% CET1, 13.98% Tier 1 risk-based, 14.99% total risk-based and 9.44% Tier 1 leverage. The company and both subsidiary banks exceeded required minimums and qualified as well-capitalized.
- Credit quality: Nonperforming loans were $6.76 million, or 0.40% of loans, compared with $9.06 million, or 0.59%, a year earlier. Nonperforming assets were $7.78 million, or 0.30% of assets. The allowance for loan losses was $16.98 million, or 0.99% of loans. Commercial and commercial real estate loans rated substandard totaled $33.72 million, up from $27.29 million at year-end, primarily because three commercial borrowers were downgraded.
Material changes and management commentary
- Management attributed earnings growth mainly to higher net interest income as average earning assets, particularly loans, increased. For Q3, average earning assets were $2.40 billion, 7.5% above Q3 2015; loan growth also helped offset a slight increase in funding costs.
- Loan growth was broad-based: from year-end 2015, commercial real estate loans rose 11.4%, consumer loans 12.7% and residential real estate loans 4.8%; commercial loans increased 0.5%. Consumer growth was driven largely by indirect automobile lending, including an expanded dealer network.
- Q3 noninterest income was little changed. Higher customer-service fees and loan-sale gains were offset by lower insurance commissions and other operating income. Insurance commissions were affected by the 2015 sale of the youth-sports insurance business of Loomis & LaPann; the buyer is to make post-closing payments through 2018.
- Management described credit quality and local economic conditions as generally strong, but noted increased adversely rated commercial real estate loans and higher substandard commercial-related balances. It said the allowance was appropriate and did not anticipate significant near-term increases in problem assets, while making no assurance about future outcomes.
Outlook, risks and contingencies
- No specific earnings guidance is provided in the filing. Management expects loan demand and funding costs to remain sensitive to interest rates, deposit competition and local economic conditions. It cautioned that deposit liabilities may reprice faster than earning assets if rates rise, potentially pressuring near-term margins.
- Interest-rate simulations as of September 30 estimated a 3.28% decline in net interest income under a hypothetical +200-basis-point shock and a 0.94% decline under a modeled downward-rate scenario. These are scenario estimates, not forecasts, and depend on assumptions about repricing, prepayments, deposit behavior and other factors.
- Key disclosed risks include economic and interest-rate changes, competition, real-estate and consumer-credit conditions, cybersecurity and service interruptions, regulatory changes, and shifts in customer behavior. Management reported no liquidity problems and said it regularly stress-tests liquidity and contingent funding plans.
- Off-balance-sheet exposures included $300.44 million of commitments to extend credit and $3.48 million of standby letters of credit. The company noted that commitments may expire undrawn and do not necessarily represent future cash needs.
- Arrow disclosed a possible indirect contingent exposure related to Visa litigation as a former member bank, while stating its view that Visa’s litigation escrow should cover remaining direct liabilities. A challenge to a Visa/Mastercard merchant settlement remained pending. The filing reported no material pending legal proceedings beyond routine business litigation.
- The company is evaluating the expected-credit-loss accounting standard, effective for Arrow in 2020; the filing does not provide a clear estimate of its impact. Management expected no material effect from the other newly discussed standards identified in the filing.
- After quarter-end, the board approved a new 2017 stock repurchase authorization of up to $5 million. Arrow also declared a fourth-quarter dividend of $0.250 per share, payable December 15, 2016.
Most important facts for investors to verify
- Whether strong loan and deposit growth can continue without weakening underwriting or increasing funding costs, particularly in indirect auto and commercial real estate lending.
- Whether the allowance remains adequate as substandard commercial-related loans increased, and how delinquencies, nonperforming loans and net charge-offs evolve.
- How interest-rate changes affect deposit pricing, loan yields and net interest margin; review the model assumptions behind the disclosed sensitivity analysis.
- Whether the reported liquidity sources and capital buffers remain available and sufficient under stressed conditions, including seasonal municipal-deposit fluctuations.
- The effects of the Loomis business sale, pending payment-card litigation matters and the future adoption of expected-credit-loss accounting.