First Merchants Corporation — Q1 2020 Form 10-Q
Reporting period: Three months ended March 31, 2020; unaudited. First Merchants is a community bank holding company operating in Indiana, Illinois, Ohio and Michigan. The September 2019 MBT acquisition materially expanded the business and affects year-over-year comparability. Dollar amounts below are USD millions unless stated otherwise.
Financial performance and condition
- Profit: Net income available to common shareholders was $34.3 million, down 11.7% from $38.8 million. Diluted EPS was $0.62 versus $0.78. Pretax income declined to $37.8 million from $45.8 million. The effective tax rate fell to 9.2% from 15.2%, partly reflecting a $1.2 million CARES Act tax benefit related to NOL carrybacks.
- Revenue and margins: Net interest income increased 10.6% to $93.9 million, while fully taxable-equivalent net interest income rose to $97.8 million from $87.8 million. FTE net interest margin compressed to 3.46% from 3.84%; management attributed this to lower asset yields following rate cuts, partly offset by lower funding costs. Management expected further margin compression in Q2. Noninterest income rose 59.2% to $29.8 million, including $4.6 million of securities gains versus $1.1 million a year earlier. Noninterest expense increased 16.9% to $66.2 million, primarily reflecting MBT-related scale and higher FDIC assessments.
- Credit costs: Provision for loan losses jumped to $19.8 million from $1.2 million, primarily due to increased qualitative reserves for anticipated COVID-19 economic effects. The allowance was $99.5 million, 1.15% of loans, versus $80.3 million and 0.95% at year-end. Net charge-offs were $0.6 million. Nonaccrual loans were $15.6 million, while nonperforming loans totaled $16.3 million.
- Assets and loans: Total assets were $12.69 billion, up $236.3 million from December 31, 2019. Loans were $8.61 billion, up $147.5 million, or 1.7%; commercial and farmland real estate and commercial and industrial loans grew, while construction loans declined. Investment securities totaled $2.70 billion at carrying value; available-for-sale fair value gains increased with lower interest rates.
- Funding, debt and liquidity: Deposits were $9.87 billion, up $30.5 million from year-end. Borrowings rose $107.4 million to $840.1 million, including $481.0 million of FHLB advances. Cash and cash equivalents declined to $127.7 million from $177.2 million. Operating cash flow was $71.5 million; investing used $189.1 million and financing provided $68.1 million, producing a $49.5 million net cash decrease. The Bank reported $611.3 million of remaining FHLB borrowing capacity.
- Capital and shareholder returns: The Bank remained well capitalized: CET1 was 12.23%, total risk-based capital 13.22%, and leverage ratio 10.24%. The Corporation’s tangible common equity to tangible assets ratio was 9.91%, down from 10.16% at year-end. The company repurchased 1.63 million shares for $55.9 million, reaching the program’s $75 million cap; the quarterly dividend was $0.26 per share.
Material changes and outlook
- COVID-19 and associated shutdowns, unemployment and market disruption increased uncertainty around borrower repayment, collateral values, credit losses, revenue and operations. Management said the pandemic’s impact was minimal through March 31, but its duration and ultimate effects could not be predicted.
- As of May 6, 2020, the Bank had funded more than 3,800 Paycheck Protection Program loans totaling $871 million. These loans carry a 1% rate, are government-guaranteed, and management expected most to be forgiven in whole or part. The Bank had also borrowed $240 million through the PPP Liquidity Facility.
- By May 6, the Corporation had received requests for more than 1,700 commercial loan modifications totaling $861 million and over 550 consumer modifications totaling $56 million. Modifications completed in Q1 were immaterial; COVID-related requests rose after quarter-end.
- The company elected to defer CECL adoption under temporary CARES Act relief and used the incurred-loss model for Q1. Before deferral, management estimated CECL would increase the allowance by 55%–65% relative to the December 31, 2019 allowance and require an approximately $18 million reserve for unfunded commitments. The timing of adoption depended on the end of the national emergency or December 31, 2020, whichever came first.
- Additional near-term headwinds include the March Federal Reserve rate cuts and Durbin Amendment interchange-fee restrictions taking effect July 1, 2020. The Bank became subject to CFPB supervisory authority on April 1 after exceeding $10 billion in assets for four consecutive quarters. Management also noted a $1.2 million community contribution for COVID-19 relief.
Risks, contingencies and unusual items
- Key risks include pandemic duration and severity, weakening borrower credit, interest-rate and margin pressure, liquidity and market volatility, and potential adverse effects on regulatory capital. The filing also identifies PPP processing litigation and SBA-guarantee risks if loan eligibility, origination, funding or servicing is found deficient.
- Unfunded loan commitments and standby/commercial letters of credit totaled $2.93 billion; commitments may not be fully drawn. The filing states that ordinary-course litigation and regulatory examinations were not expected to have a material adverse effect. It references a DOJ fair-lending Settlement Agreement and Agreed Order but does not provide its details in the supplied text.
- Goodwill was $543.9 million; management concluded it was not impaired at March 31 after assessing COVID-19-related conditions. Securities with unrealized losses were assessed as temporarily impaired, with no other-than-temporary impairment recorded.
- Derivative agreements had a net-liability termination value of $82.0 million; $79.6 million of collateral had been posted. No relevant default or capital-condition breach was reported at quarter-end.
Important facts for investors to verify
- How COVID-19-related loan modifications, delinquencies and PPP exposures developed after the May 6 update, and whether borrower stress translates into higher provisions or charge-offs.
- Whether the $99.5 million allowance and management’s incurred-loss estimates adequately capture credit deterioration, and the eventual CECL adoption date and impact.
- Whether net interest margin compresses further, as management expected, and how lower rates and interchange-fee restrictions affect earnings.
- How liquidity, deposit trends, wholesale funding and capital ratios evolve as lending commitments are drawn and the economic downturn progresses.
- Whether PPP loan forgiveness, SBA guarantees and loan-processing compliance proceed without material losses, litigation or reputational harm.