First Merchants Corporation — Q3 2018 Form 10-Q
Business context and reporting period. This unaudited quarterly report covers the three and nine months ended September 30, 2018. First Merchants is an Indiana-based community banking company operating through First Merchants Bank, with 116 banking locations across Indiana, Illinois and Ohio. Unless otherwise stated, amounts below are in millions of dollars.
Financial performance and condition
| Metric | Q3 / September 30, 2018 | Comparable period / December 31, 2017 |
|---|---|---|
| Net income available to common shareholders | Q3: $41.1; nine months: $117.4 | Q3 2017: $24.4; nine months 2017: $71.7 |
| Diluted earnings per share | Q3: $0.83; nine months: $2.37 | Q3 2017: $0.50; nine months 2017: $1.63 |
| Net interest income | Q3: $86.5; nine months: $251.0 | Q3 2017: $74.4; nine months 2017: $198.5 |
| Net interest margin, FTE | Q3: 4.05%; nine months: 3.99% | Q3 2017: 4.03%; nine months 2017: 3.98% |
| Total assets | $9,787.3 | $9,367.5 |
| Total loans, gross | $7,088.1 | $6,751.2 |
| Total deposits | $7,633.2 | $7,172.5 |
| Total borrowings | $732.7 | $834.4 |
| Stockholders’ equity | $1,361.4 | $1,303.5 |
- Revenue and earnings: Net interest income plus other income was $106.0 in Q3 and $308.3 for the first nine months, versus $93.1 and $250.5, respectively, in 2017. Q3 income before tax was $49.6; tax expense was $8.5, for a 17.1% effective tax rate. The nine-month effective rate was 16.4%, down from 23.7% in 2017, primarily reflecting the federal corporate tax rate reduction under the Tax Cuts and Jobs Act.
- Cash flow: Nine-month operating cash flow was $136.2, compared with $79.4 in 2017. Investing activities used $478.4 and financing activities provided $329.9. Cash and cash equivalents were $142.5 at quarter-end, down from $154.9 at year-end 2017.
- Credit and allowance: The allowance for loan losses was $78.4, or 1.11% of gross loans. Nine-month provision was $5.6 and net charge-offs were $2.2. Non-accrual loans declined to $20.4 from $28.7 at year-end; nonperforming assets were $30.2 versus $40.1. Management stated the allowance was adequate, while noting its estimate depends on judgment and economic conditions.
- Liquidity and capital: Available-for-sale securities were $1,149.2. The Bank reported $517.8 of remaining FHLB borrowing capacity. The Bank met the regulatory definition of well-capitalized; its total risk-based capital ratio was 13.43% and CET1 ratio was 12.46%. Tangible common equity to tangible assets, a non-GAAP measure, was 9.55%.
Material changes versus prior periods
- Q3 net income rose 68% year over year; nine-month net income rose 64%. Management attributed improvement to core banking performance, the full-period contribution of the 2017 Arlington Bank and IAB acquisitions, and tax reform. The 2017 comparison includes only partial-period results from those acquisitions, so it is not fully like-for-like.
- Loan growth of $332.7 since year-end was led by commercial and industrial, commercial real estate and construction lending. Deposits grew $460.6; interest-bearing deposits increased while noninterest-bearing deposits declined, which management linked in part to higher interest rates. Borrowings fell $101.7 as deposit growth was used to reduce funding balances.
- Interest costs rose faster than asset yields year over year in Q3: the FTE asset yield increased 32 basis points while funding costs increased 36 basis points. Nevertheless, FTE net interest margin edged up two basis points to 4.05%, aided by asset growth.
- Q3 noninterest expense declined 6.3% year over year, mainly because Q3 2017 included acquisition-related costs. Nine-month noninterest expense increased 8.8%, largely reflecting the expanded franchise and staffing following the acquisitions.
- Accumulated other comprehensive loss increased to $35.4 from $2.9 at year-end, principally reflecting unrealized securities losses amid higher interest rates. Management considered the declines temporary and stated it did not intend, and was not more likely than not required, to sell the affected securities before recovery.
Outlook, risks and unusual items
- The filing provides no specific earnings or revenue guidance. Management said liquidity and interest-rate sensitivity remained adequate; its model estimated 12-month net interest income would rise 7.57% under an immediate 200-basis-point rate increase and decline 4.53% under a 100-basis-point decrease. These are scenario estimates, not forecasts, and depend on assumptions about rates and customer behavior.
- On October 9, 2018, after quarter-end, First Merchants agreed to acquire MBT Financial Corp. for an estimated $290.9 million in stock. MBT had $1.3 billion in assets at June 30, 2018. Closing was anticipated in the first half of 2019, subject to shareholder and regulatory approvals and other conditions.
- Key risks identified include interest-rate and deposit-pricing changes, economic deterioration and credit losses, adverse loan or investment performance, competition, regulation, acquisition integration, and the availability of earnings and capital for dividends. The company reported no material change to previously disclosed risk factors and no material legal proceedings; ordinary-course claims and regulatory examinations remain possible.
- The company expects adoption of the new lease standard in Q1 2019 to increase other assets and other liabilities by approximately $25 million, with no material income-statement or regulatory-capital impact expected. CECL adoption was planned for Q1 2020; the size of any resulting allowance adjustment was not yet determinable.
Important facts for investors to verify
- Whether loan growth, deposit mix and deposit pricing sustain net interest margin as rates and funding costs change.
- Whether credit quality and loss provisioning continue to improve, and how management’s allowance assumptions compare with subsequent charge-offs and economic conditions.
- The extent to which reported earnings growth reflects organic performance versus acquisition contributions and the lower tax rate.
- MBT merger approvals, final consideration, integration plans and expected effects on capital, funding and earnings.
- The sensitivity of securities values and accumulated other comprehensive loss to interest rates, and the assumptions behind the disclosed rate scenarios.
- The ultimate impact of CECL implementation and the lease-standard balance-sheet adjustment.