Business context and reporting period
Independent Bank Corporation filed this unaudited Form 10-Q for the quarter ended June 30, 2016. The Michigan-focused bank reports two operating segments: Independent Bank and Mepco, its vehicle service contract payment-plan business. Comparisons below are with the same 2015 period unless noted.
Financial performance and position
| Metric | Q2 2016 | Six months 2016 |
|---|---|---|
| Net interest income | $19.6 million | $39.4 million |
| Non-interest income | $9.6 million | $17.4 million |
| Net income | $6.4 million | $10.5 million |
| Diluted earnings per share | $0.30 | $0.48 |
| Tax-equivalent net interest margin | 3.52% | 3.57% |
For Q2, net income rose from $5.6 million and diluted EPS from $0.24; for the first half, net income rose from $9.4 million and diluted EPS from $0.40. Reported net interest income increased 5.0% in Q2 and 7.1% year to date. The filing attributes growth mainly to higher average earning assets, partly offset by margin compression. Net interest margin declined from 3.62% to 3.52% in Q2 and from 3.60% to 3.57% year to date.
The provision for loan losses was a credit of $0.7 million in Q2 and $1.3 million for the first half, compared with credits of $0.1 million and $0.8 million, respectively, in 2015. Non-interest expense decreased 3.2% in Q2 to $20.9 million and 1.8% year to date to $42.9 million. Mortgage servicing results weakened materially: a $0.3 million Q2 loss and $1.3 million first-half loss, versus income of $1.5 million and $1.0 million in 2015.
At June 30, total assets were $2.45 billion; portfolio loans were $1.58 billion, up 4.4% from year-end; deposits were $2.13 billion, up $42.3 million. Cash and cash equivalents were $61.0 million, down from $85.8 million at December 31. First-half operating cash flow was $14.5 million, investing cash outflow $62.2 million, and financing cash inflow $22.9 million. Other borrowings were $11.8 million and subordinated debentures $35.6 million. Shareholders’ equity was $246.9 million.
The allowance for loan losses was $22.7 million, or 1.44% of portfolio loans. Non-performing loans were $10.9 million (0.69% of portfolio loans); non-performing assets were $16.5 million (0.67% of assets). Annualized first-half net charge-offs were negative 0.18%, reflecting net recoveries. The Bank was reported well-capitalized; its June 30 capital ratios included 15.12% total risk-based capital, 13.87% Tier 1 risk-based capital, 13.87% common equity Tier 1, and 9.87% Tier 1 leverage.
Material changes versus prior periods
- Higher net interest income and larger loan balances supported earnings growth, despite lower net interest margins.
- Non-interest income fell 12.8% in Q2 and 12.8% year to date. The main headwind was mortgage servicing, driven by valuation allowance changes and amortization; mortgage loan sale gains increased as margins improved despite lower originations and sales.
- Non-performing assets declined from $17.9 million at year-end, while non-performing loans edged up from $10.7 million. Performing troubled debt restructurings fell to $78.9 million from $81.5 million.
- Shareholders’ equity declined from $251.1 million, principally due to $15.5 million of share repurchases and dividends, partly offset by earnings and improved accumulated other comprehensive loss.
- The company adopted ASU 2016-09 in Q2, recording a $1.247 million cumulative equity adjustment and a $0.3 million tax benefit for the quarter. The filing says the adoption did not otherwise materially affect results or financial condition.
Outlook, commentary, risks and unusual items
- No specific earnings or revenue guidance was provided. Management said it expected short-term rate increases, if any, to be gradual, and expected rising rates to benefit net interest margin over the long term. Its simulations estimate net interest income would rise 4.25% under an immediate 100-basis-point rate increase and 7.34% under a 200-basis-point increase; these are scenarios, not forecasts.
- Management described Michigan economic conditions as generally improving but uneven. It cited ongoing sensitivity to regional economic and real-estate conditions, interest rates, loan growth, competition, and credit-loss estimates.
- The company began using PIMCO to manage about $150 million of securities and anticipates approximately $0.5 million of additional annual interest income after fees. It also signed a non-binding letter of intent to purchase about $15.5 million of Michigan residential mortgage loans, with closing expected in August 2016.
- Mepco counterparty collections remain a key risk. A first-quarter settlement generated $4.0 million cash and a $1.5 million promissory note; the remaining $1.45 million note balance was fully reserved at June 30, although the counterparty had made its first three payments. Net counterparty receivables were $3.0 million, down from $7.2 million at year-end. A major counterparty failure could cause significant losses.
- Uninsured deposits were approximately $495.5 million; $310.2 million of time deposits mature within 12 months. Management considered liquidity adequate but noted deposit-renewal and wholesale-funding availability risks. Parent-company cash and time deposits were approximately $14.4 million.
- Ordinary-course litigation had an immaterial accrued reserve; the company estimated reasonably possible additional losses of up to approximately $1.0 million. The filing reported no material changes to previously disclosed risk factors and no material internal-control changes.
- The company expects the new credit-loss standard (ASU 2016-13) to take effect January 1, 2020, but had not determined its impact. Management identified allowance for loan losses, Mepco counterparty contingencies, mortgage servicing-right valuation, and deferred tax assets as critical estimates.
Important facts for investors to verify
- Whether loan and deposit growth can continue without further net interest margin pressure, and whether expected rate changes benefit earnings as management anticipates.
- Mortgage servicing-right valuations and the drivers of the large year-over-year swing in servicing income.
- Credit quality trends, especially commercial real estate, resort lending, troubled restructurings, and the adequacy of the loan-loss allowance.
- Mepco’s ability to collect counterparty refunds and the recoverability of its fully reserved promissory note.
- Deposit retention, upcoming time-deposit maturities, uninsured deposit concentrations, and access to wholesale funding.
- Execution and economics of the planned mortgage-loan purchase, securities-management strategy, and remaining share repurchases.