First Merchants Corporation — FY 2017 Form 10-K
Business and reporting period. First Merchants is an Indiana-based financial holding company operating primarily through one community-banking segment, with 119 banking locations in Indiana, Illinois and Ohio. This filing covers the fiscal year ended December 31, 2017; comparisons below are primarily with FY 2016. Figures are in U.S. dollars.
Financial performance and position
| Metric | FY 2017 / Dec. 31, 2017 | FY 2016 / Dec. 31, 2016 |
|---|---|---|
| Net interest income | $277.3 million; FTE $294.6 million | $226.5 million; FTE $240.0 million |
| Net interest margin (FTE) | 4.02% | 3.89% |
| Net income | $96.1 million | $81.1 million |
| Diluted EPS | $2.12 | $1.98 |
| Total assets | $9.37 billion | $7.21 billion |
| Loans, gross | $6.75 billion | $5.14 billion |
| Deposits | $7.17 billion | $5.56 billion |
| Total borrowings | $834.4 million | $694.2 million |
| Stockholders’ equity | $1.30 billion | $901.7 million |
| Cash and cash equivalents | $154.9 million | $127.9 million |
- Total revenue, calculated as net interest income plus other income, was $348.3 million, up from $291.7 million. Other income was $71.0 million, up 8.9%; other expense was $205.6 million, up 15.9%.
- Average assets were $8.20 billion. Return on average assets was 1.17%, unchanged from 2016; return on average equity was 8.65%, versus 9.16%.
- Net cash provided by operating activities was $126.5 million; investing activities used $635.3 million, chiefly reflecting loan growth and securities purchases; financing activities provided $535.8 million. Cash increased $27.0 million during the year.
- At year-end, total risk-based capital was 13.69% and CET1 was 11.00% at the Corporation; the Bank’s corresponding ratios were 13.17% and 12.20%. The Bank met “well capitalized” requirements.
- Common dividends declared were $0.69 per share, versus $0.54 in 2016. The dividend payout ratio increased to 32.55% from 27.27%.
Material changes and notable items
- 2017 growth included the acquisitions of Arlington Bank, completed May 19, and Independent Alliance Banks (IAB), completed July 14. The deals added approximately $1.53 billion of assets and were funded with stock. First Merchants issued about 2.1 million shares for Arlington and 6.0 million shares for IAB; year-end shares outstanding rose to 49.16 million from 40.91 million.
- Excluding acquired assets, management reported organic asset growth of $604.7 million, or 8.4%; organic loan growth of $657.6 million, or 12.8%; and organic deposit growth of $501.0 million, or 9.0%.
- Net interest income increased with loan growth and acquired earning assets. The FTE margin expanded 13 basis points; management attributed higher asset yields in part to Federal Reserve rate increases. Purchased-loan fair-value accretion contributed $13.9 million, compared with $12.4 million in 2016.
- FY 2017 included $12.2 million of acquisition, merger and system-conversion expenses. The Tax Cuts and Jobs Act (TCJA) caused a $5.1 million deferred-tax remeasurement charge; the reported effective tax rate was 28.1%, versus 25.4% in 2016. Quarterly fourth-quarter net income was $24.4 million, with $15.2 million of income tax expense.
- Credit measures were mixed but generally improved: nonperforming assets plus loans 90 days past due were $41.0 million, down from $43.8 million; net charge-offs were $148,000. The allowance rose to $75.0 million, but declined as a share of loans to 1.11% from 1.28%; allowance coverage of nonaccrual loans increased to 261.2% from 220.1%. Criticized loans not deemed impaired rose to $254.3 million from $233.5 million.
- The investment portfolio totaled $1.57 billion at fair value. Unrealized losses were $6.6 million; management concluded there was no other-than-temporary impairment in 2017.
Outlook, risks and contingencies
- No specific earnings or revenue guidance is provided. Management expected the Corporation and Bank to exceed $10 billion of assets in 2019, based on acquisition strategy and historic growth. Crossing the threshold could bring stress-testing and enhanced supervisory requirements, higher FDIC assessments, CFPB examination authority and debit-interchange fee limits that management said could materially reduce fee income.
- Liquidity sources included core deposits, available-for-sale securities with a year-end market value of $999.9 million, and $664.2 million of remaining FHLB borrowing capacity. The Corporation reported a cumulative negative one-year interest-rate gap of $1.14 billion, or 12.15% of assets. Its model estimated net interest income would rise 8.19% under an immediate +200-basis-point scenario and fall 8.02% under a -100-basis-point scenario; management cautioned that model assumptions and actual outcomes may differ.
- Key risks include regional economic weakness, interest-rate and funding-cost changes, credit deterioration and the adequacy of loan-loss reserves, concentration in commercial real estate and commercial lending, acquisition integration, competition, cybersecurity and technology disruptions, regulatory changes, and valuation of goodwill and deferred tax assets. Goodwill was $445.4 million; the October 2017 impairment test found no impairment.
- Loan commitments to extend credit were $2.48 billion and standby letters of credit were $43.5 million. Management said many commitments may expire unused or be partially drawn. Routine litigation was not expected to have a material adverse effect; no material pending legal proceeding was reported.
- The TCJA reduced the federal corporate rate to 21%; the company said it had substantially completed its accounting for the tax-law effects but further refinements were possible. CECL adoption was planned for 2020; the eventual allowance and earnings impact could not yet be determined.
- The financial-statement auditor issued an unqualified opinion. Management and the auditor reported effective internal control over financial reporting, but the 2017 assessment and audit excluded the acquired Arlington and IAB operations, representing 17% of consolidated assets at year-end.
Most important facts for investors to verify
- How much of reported earnings and future profitability depends on acquisition integration, synergies and purchased-loan accretion, and whether acquisition costs and share issuance affect expected returns per share.
- Whether the allowance remains adequate as loans grow, particularly given $254.3 million of criticized loans and the decline in allowance-to-loan coverage.
- Deposit retention, deposit pricing and wholesale funding needs as rates change, alongside the reported negative one-year interest-rate gap and modeled scenario sensitivity.
- The timing and financial effects of crossing $10 billion in assets, including regulatory costs and potential interchange-fee reductions.
- The eventual impact of CECL, tax-law refinements and the accounting or valuation of $445.4 million of goodwill and acquired intangibles.
- Whether acquired-bank controls and reporting processes are fully incorporated into the company’s internal-control assessment after the temporary acquisition-related exclusions.