ConnectOne Bancorp, Inc. — Q2 2018 Form 10-Q
Business context and reporting period. ConnectOne is a New Jersey-based community commercial bank operating 22 offices. This unaudited filing covers the three and six months ended June 30, 2018; balance-sheet comparisons are to December 31, 2017. Amounts below are in millions unless otherwise stated.
Key financial results
| Metric | Q2 2018 | Q2 2017 | First half 2018 | First half 2017 |
|---|---|---|---|---|
| Net interest income | $38.9 | $35.1 | $77.1 | $68.2 |
| Provision for loan losses | $1.1 | $1.5 | $18.9 | $2.6 |
| Noninterest income | $1.4 | $1.4 | $2.8 | $4.4 |
| Noninterest expense | $17.1 | $25.3 | $34.2 | $43.6 |
| Net income | $17.5 | $7.7 | $21.8 | $19.6 |
| Diluted EPS | $0.54 | $0.24 | $0.67 | $0.60 |
| Tax-equivalent net interest margin | 3.31% | 3.45% | 3.29% | 3.42% |
Q2 net interest income grew 10.0% on a tax-equivalent basis, reflecting 14.5% growth in average earning assets, primarily loans. Margin contracted 14 basis points. First-half tax-equivalent net interest income rose 11.8%, while margin fell 13 basis points. Management attributed margin pressure to higher deposit funding costs, the January 2018 subordinated-debt issuance, lower securities yields, and the Tax Act’s effect on the tax-equivalent adjustment.
Q2 2018 effective tax rate was 20.8%; the first-half rate was 18.8%, including a $0.6 million share-based compensation tax benefit. Management projected an approximately 21% combined federal and state effective rate for 2018, excluding those benefits, but said the estimate could change.
Financial position, cash flow, and capital
| Metric | June 30, 2018 | December 31, 2017 |
|---|---|---|
| Total assets | $5,275.4 | $5,108.4 |
| Gross loans | $4,364.0 | $4,174.8 |
| Total deposits | $3,905.4 | $3,795.1 |
| Borrowings | $629.0 | $670.1 |
| Subordinated debentures | $128.4 | $54.7 |
| Stockholders’ equity | $578.6 | $565.4 |
| Cash and cash equivalents | $176.2 | $149.6 |
- Loans increased $189.2 million, or 4.5%, from year-end, led by commercial real estate growth of $124.7 million. Deposits rose $110.3 million, or 2.9%.
- First-half operating cash flow was $54.3 million; investing activities used $166.0 million, primarily reflecting loan growth; financing activities provided $138.3 million. Cash increased $26.6 million.
- Management reported liquid assets of $418.7 million, equal to 7.9% of assets and 9.2% of deposits and borrowings. It reported approximately $1.0 billion of available and unused credit at June 30, 2018, alongside $753 million of outstanding commitments to extend credit.
- The Bank’s regulatory capital ratios were 10.43% Tier 1 leverage, 11.02% CET1, 11.02% Tier 1 risk-based, and 12.42% total risk-based; management said the Bank met applicable capital requirements. Tangible common equity ratio was 8.40%; tangible book value per share was $13.38.
Material changes, credit quality, and unusual items
- The first-half provision was $18.9 million and net charge-offs were $17.1 million, primarily due to a $17.0 million taxi medallion portfolio charge-off in Q1. Management attributed the charge-off to falling medallion transfer values and a lower cash-flow valuation. The allowance for loan losses was $33.6 million, or 0.77% of loans, at June 30.
- Nonaccrual loans declined to $49.7 million from $65.6 million at year-end, mainly because of the taxi medallion charge-off. Nonperforming assets were $50.8 million, or 0.96% of total assets. Total TDRs rose to $33.6 million from $20.5 million; $20.8 million were on nonaccrual. Of 35 first-half loan modifications, 27 taxi medallion loans totaling $11.2 million remained on nonaccrual after modification.
- The sharp year-over-year Q2 reduction in noninterest expense primarily reflects a $9.7 million taxi-medallion held-for-sale valuation allowance recorded in Q2 2017. The first-half 2017 comparison likewise included a $12.3 million allowance. First-half 2018 noninterest income was lower principally because 2017 included $1.6 million of securities-sale gains.
- Unrealized losses on available-for-sale securities, net of tax, increased to $6.1 million from $0.9 million at year-end, which management primarily attributed to market conditions and interest rates. Management did not consider the losses other-than-temporary; it cautioned that future impairment conclusions involve judgment.
- Subordinated notes issued in January 2018 added $75 million of principal, with a 5.20% fixed coupon through January 2023 and a subsequent floating-rate period. Higher funding costs contributed to margin pressure.
- After quarter-end, the company agreed to acquire Greater Hudson Bank in an all-stock transaction valued at approximately $76.3 million. Closing was expected early in Q1 2019, subject to shareholder, regulatory, and other customary approvals.
Outlook, risks, and contingencies
Management said its interest-rate-risk models were within Board guidelines. A modeled instantaneous +200-basis-point rate shock was estimated to increase one-year net interest income by 0.84%, while a -100-basis-point shock was estimated to reduce it by 1.41%. The corresponding economic value of equity estimates were a 13.23% decline and a 3.66% increase, respectively. These are model estimates, not guidance.
New Jersey legislation introduces a temporary corporate surtax and requires combined filing for affiliated companies beginning in 2019. Management expects the changes to increase tax expense but could not yet quantify the full impact because implementing regulations were pending; it was evaluating tax strategies. Other disclosed risks include competition, interest-rate and margin changes, credit losses and loan provisions, economic conditions, securities-market movements, regulatory changes, and legal or regulatory proceedings. Management reported no material legal proceedings and no material change to internal controls.
The company is preparing for the expected 2020 adoption of the current expected credit loss standard (CECL), including work on data and modeling; it could not estimate the adoption impact. Management also expects lease accounting adoption in 2019 to increase reported assets and liabilities, with the effect still under evaluation. No specific earnings or growth guidance was provided.
Most important facts for investors to verify
- Whether taxi medallion exposure, collateral values, charge-offs, and provisions stabilize, and whether the allowance remains adequate.
- Loan growth, asset quality, TDR performance, and concentrations in commercial real estate and New Jersey markets.
- Whether deposit pricing and subordinated-debt costs continue to compress net interest margin as rates and competition change.
- The eventual tax impact of New Jersey’s surtax and combined-filing rules, and the company’s projected 2018 effective tax rate.
- Available liquidity and funding capacity relative to commitments, deposit trends, and planned loan growth.
- Regulatory and shareholder approvals, execution, and integration risks for the Greater Hudson Bank acquisition.
- Future effects of CECL and lease-accounting adoption, as management had not quantified the full impacts.