CHOICEONE FINANCIAL SERVICES INC quarterly report, Q2 FY2023

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Business context and reporting period

ChoiceOne Financial Services, Inc. is a Michigan-based bank holding company. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2023; comparative results are for the corresponding 2022 periods. Unless noted otherwise, dollar amounts are in millions.

Financial performance and position

  • Earnings: Second-quarter net income was $5.2 million, down 7.2% year over year; diluted EPS was $0.69 versus $0.75. First-half net income was $10.8 million, down 2.7%; diluted EPS was $1.44 versus $1.49.
  • Interest income and margins: Q2 interest income rose to $23.3 million from $17.7 million, but interest expense increased to $7.2 million from $1.4 million. Net interest income declined to $16.1 million from $16.3 million. GAAP net interest margin was 2.79%, versus 2.94%; first-half margin was 2.88%, versus 2.95%. First-half net interest income increased to $33.1 million from $32.6 million.
  • Other income and expenses: Q2 noninterest income was $3.5 million, up 1.6%; noninterest expense was $13.6 million, up 3.2%. First-half noninterest income was $7.2 million, down 1.7%, while expenses were $27.6 million, up 2.7%. Management cited wage and benefit inflation; lower loan-sale gains weighed on first-half fee income.
  • Credit: The company recorded a net provision benefit of $0.3 million in Q2 and $0.2 million in the first half, reflecting improved economic forecasts, partly offset by provision for unfunded commitments. Net charge-offs were $0.1 million in the first half versus $0.3 million in 2022. Nonperforming loans, including specified troubled modifications, were $1.7 million at June 30, versus $1.3 million at year-end. The loan allowance was $14.6 million, or 1.15% of loans, compared with $7.6 million, or 0.64%, at year-end; the accounting change to CECL materially affects comparability.
  • Cash flow and liquidity: First-half operating cash flow was $25.2 million, investing cash outflow was $66.9 million, and financing cash inflow was $74.6 million. Cash and cash equivalents were $76.8 million at June 30, up from $43.9 million at December 31. Deposits totaled $2.09 billion, down from $2.12 billion; the balance included $51.4 million of brokered deposits. Management said deposit outflows stabilized, with monthly growth in May and June.
  • Funding and debt: Borrowings were $160.0 million, up from $50.0 million at year-end, primarily reflecting a $160 million Federal Reserve Bank Term Funding Program (BTFP) borrowing at a 4.71% rate fixed through May 2024. Subordinated debentures were $35.4 million. Available borrowing capacity from the FHLB and Federal Reserve was reported at $791.7 million.
  • Balance sheet and capital: Total assets were $2.48 billion, up from $2.39 billion at year-end. Gross loans were $1.26 billion, up from $1.19 billion; commercial real estate was 52% of the loan portfolio. Shareholders’ equity was $179.2 million, versus $168.9 million. At the bank, regulatory capital ratios were 12.7% total capital, 12.2% CET1, and 8.7% Tier 1 leverage; each exceeded the stated well-capitalized thresholds.
  • Securities and comprehensive income: Available-for-sale securities were $521.2 million and held-to-maturity securities were $420.5 million. Combined unrealized losses were approximately $148.4 million at June 30. The company attributed losses primarily to interest rates and market conditions, reported no AFS credit-loss allowance, and said it did not intend to sell affected securities before recovery. First-half other comprehensive income was $10.9 million, improving from a $62.5 million loss in 2022.

Material changes versus prior comparable periods

  • Higher market rates lifted loan and securities yields, but sharply higher deposit and borrowing costs offset much of the benefit. Q2 tax-equivalent net interest margin fell 16 basis points year over year.
  • Core loans grew $145.8 million, or 13.5%, from June 2022; Q2 core-loan growth was $14.8 million. Growth was concentrated in commercial real estate and residential real estate.
  • Noninterest expense increased, while first-half gains on loan sales fell $0.7 million year over year as higher mortgage rates slowed refinancing activity.
  • Deposits declined and the company added BTFP funding and brokered deposits. First-half financing cash flow shifted to a $74.6 million inflow from $38.9 million in 2022.
  • CECL adoption on January 1, 2023 increased the loan allowance by about $7.2 million and added a $3.3 million allowance for unfunded commitments; the transition reduced retained earnings after tax.

Outlook, commentary, risks, and unusual items

  • The filing provides no formal earnings or revenue guidance. Management said deposit costs were expected to continue rising as deposits reprice, while rates paid were expected to lag the federal funds rate. It also described plans to use brokered deposits, FHLB advances, Federal Reserve discount-window advances, and BTFP funding for short-term needs.
  • Management expects the securities portfolio to generate approximately $179 million of cash flows over the next two years as lower-yielding assets mature. It considers the portfolio’s unrealized losses temporary and expects fair values to recover as securities approach maturity.
  • Key risks include deposit competition and liquidity needs, rising funding costs and interest-rate exposure, commercial real estate concentration, credit losses, and uncertainty in economic forecasts. Management reported $700.3 million of uninsured deposits, or 34.4% of deposits, and stated available borrowing capacity exceeded that amount.
  • Interest-rate hedges included swaps with $401 million total notional value. The company terminated $200 million of cash-flow swaps in March 2023 for a $4.2 million cash payment; the loss is being amortized into interest income over the remaining 13 months.
  • Management reported effective disclosure controls and no material change in internal control over financial reporting during the quarter. No material pending legal proceedings were reported.

Important facts for investors to verify

  1. Whether deposit stabilization continues and how deposit pricing, brokered funding, and the $160 million BTFP borrowing affect future net interest margin and earnings.
  2. Loan growth, particularly commercial real estate exposure, asset-quality trends, troubled modifications, and the assumptions behind the CECL allowance and unfunded-commitment reserve.
  3. The size and duration of securities’ unrealized losses, the company’s ability and intent to hold securities, and the performance of its interest-rate hedges.
  4. Whether cash, borrowing capacity, and regulatory capital remain adequate under deposit outflows or adverse credit and rate scenarios.
  5. That prior-period comparisons reflect different credit-loss accounting: CECL took effect January 1, 2023, while 2022 results used the prior incurred-loss approach.