ARROW FINANCIAL CORP quarterly report, Q2 FY2011

Arrow Financial Corporation — Q2 2011 Form 10-Q

Reporting period: Three and six months ended June 30, 2011. Arrow is a New York bank holding company with banking, insurance and investment-advisory businesses. Financial statements are unaudited; the independent accountant performed an interim review, not an audit. Unless stated otherwise, dollar amounts below are in millions.

Financial performance and position

MetricQ2 2011Q2 2010Six months 2011Six months 2010
Net income$5.849$5.714$11.130$11.129
Diluted EPS$0.51$0.50$0.98$0.98
Net interest income, GAAP$14.581$15.655$29.135$31.366
Net interest margin, tax-equivalent3.35%3.70%3.37%3.75%
Noninterest income$6.228$5.028$11.848$9.046
Noninterest expense$12.171$12.002$24.490$23.542
  • Profitability: Q2 net income rose 2.4%; first-half net income was essentially unchanged. Q2 return on average assets was 1.20% and return on average equity was 14.51%, versus 1.22% and 15.38% a year earlier. First-half figures were 1.15% and 14.15%, respectively.
  • Revenue and margins: Q2 tax-equivalent net interest income fell 5.9% as the 62-basis-point decline in earning-asset yield exceeded the 33-basis-point decline in funding cost. First-half tax-equivalent net interest income fell 6.3%. Higher insurance commissions and fiduciary income offset much of the pressure. The six-month efficiency ratio was 57.98%, up from 56.74%.
  • Balance sheet at June 30: Assets were $1,901.8; deposits $1,541.9; gross loans $1,120.1; and stockholders’ equity $163.6. Compared with June 2010, assets increased 3.0% and deposits 7.1%, while loans declined 2.2%.
  • Credit: Allowance for loan losses was $14.8, or 1.32% of loans. Nonperforming loans were $5.9 (0.52% of loans), up from $4.9 at year-end 2010; nonperforming assets were $5.9 (0.31% of assets). First-half net charge-offs were $0.259, down from $0.353 a year earlier. Management attributed the increase in nonperforming assets mainly to two residential loans and noted it did not expect losses on them.
  • Cash flow and liquidity: First-half operating cash flow was $24.2, investing cash flow $31.5, and financing cash flow negative $29.5. Cash and cash equivalents increased $26.2 to $57.3. The company reported no material liquidity constraints. Available facilities included $30.0 of correspondent-bank lines, $72.5 of FHLB overnight capacity and $244.6 of Federal Reserve discount-window capacity, with no discount-window advances outstanding.
  • Borrowings and capital: Period-end borrowings included $60.4 of repurchase agreements, $2.2 of other short-term borrowings, $90.0 of FHLB advances and $20.0 of trust preferred obligations. FHLB advances declined $40.0 from year-end. Arrow’s Tier 1 leverage, Tier 1 risk-based and total risk-based capital ratios were 8.67%, 14.76% and 16.02%; the company and both banks were classified as well-capitalized.

Material changes and notable items

  • Insurance commissions rose to $1.815 in Q2 from $0.728, primarily reflecting insurance-agency acquisitions, including Upstate Agency in February 2011. On August 1, 2011, after quarter-end, Arrow completed another agency acquisition; its financial impact is not included in Q2 results.
  • Loans declined $25.4 from year-end: commercial and commercial real estate balances grew, while residential real estate and auto balances decreased. Arrow sold $28.1 of residential mortgage originations in the first half.
  • First-half equity increased $11.3, reflecting earnings, securities-related other comprehensive income and shares issued in an acquisition, partly offset by dividends and share repurchases. The quarterly dividend was $0.25 per share; the board authorized a new $5.0 share-repurchase program.
  • Q2 FDIC assessment expense declined 45.5% year over year following the shift to an asset-based assessment method.

Outlook, risks and contingencies

  • No earnings or revenue guidance is provided. Management expects continued pressure on net interest margins as asset yields may decline faster than deposit costs; it did not anticipate substantial near-term rate increases. The interest-rate model estimated net interest income would rise 0.47% under a 200-basis-point increase and fall 0.62% under a 100-basis-point decrease, subject to modeling assumptions and not a forecast.
  • Management identified interest-rate risk as its most significant market risk. Other risks include a weakening regional economy, deterioration in loan quality, real-estate market weakness, competitive pressures, and regulatory changes under Dodd-Frank and proposed capital and liquidity standards. Management cautioned that actual results may differ materially from forward-looking statements.
  • Arrow reported a $0.294 liability for its estimated share of remaining covered Visa litigation obligations; the amount is subject to change. It also had approximately $8.3 of standby letters of credit, most expiring within one year, some without collateral. Management reported no material pending legal proceedings.
  • Management stated that securities with unrealized losses were considered temporarily impaired and that it did not intend, and was not more likely than not required, to sell them before recovery. A $0.017 other-than-temporary impairment was recorded on a held-to-maturity security in Q2.

Key investor verification points

  • Track whether net interest margin and net interest income continue to contract, and how deposit costs respond to market rates.
  • Review trends in nonperforming loans, residential delinquencies, the allowance and charge-offs, including the two residential loans cited by management.
  • Assess the earnings contribution, integration costs and goodwill/intangible effects of insurance-agency acquisitions, including the August 2011 acquisition.
  • Confirm liquidity availability, municipal-deposit seasonality and the pace of FHLB borrowing repayment.
  • Monitor the Visa litigation estimate, standby-letter-of-credit exposure, and the effects of evolving regulatory capital, liquidity and fee rules.