Business context and reporting period
Independent Bank Corporation, a Michigan-based bank holding company, filed this unaudited Form 10-Q for the quarter ended June 30, 2014. Its two reportable segments are Independent Bank and Mepco, which finances vehicle service contract payment plans. Comparisons below are against the corresponding 2013 period unless otherwise noted.
Financial performance and condition
- Second-quarter results: Net interest income was $18.5 million, down 5.0%; non-interest income was $10.1 million, down $2.9 million; and non-interest expense was $22.6 million, down $5.2 million. Pre-tax income increased to $7.9 million from $6.9 million, while net income was $6.1 million versus $63.4 million. Diluted EPS was $0.26 versus $2.64.
- Six-month results: Net interest income was $37.0 million versus $39.1 million; non-interest income was $19.0 million versus $24.1 million; and non-interest expense was $45.0 million versus $53.2 million. Net income was $9.2 million versus $69.2 million; diluted EPS was $0.39 versus $2.90.
- Margin: Tax-equivalent net interest margin declined to 3.74% in Q2 from 4.16%, and to 3.76% for the first half from 4.20%.
- Balance sheet at June 30: Assets were $2.25 billion, up $39.9 million from year-end 2013. Loans were $1.38 billion, essentially flat; available-for-sale securities were $518.1 million, up from $462.5 million. Deposits were $1.91 billion, up $23.3 million. Cash and cash equivalents were $105.5 million, down from $119.1 million at year-end.
- Credit quality: The allowance for loan losses was $28.2 million, or 2.05% of portfolio loans, versus $32.3 million, or 2.35%, at year-end. Non-performing loans were $17.3 million, 1.26% of portfolio loans, versus $17.9 million, or 1.30%. Non-performing assets were $35.5 million, or 1.58% of assets. Performing troubled debt restructurings totaled $108.7 million.
- Cash flow: For the first half, operating activities provided $8.2 million, investing activities used $52.1 million, and financing activities provided $30.4 million. Cash and cash equivalents declined $13.5 million.
- Debt, liquidity and capital: Other borrowings were $26.6 million and subordinated debentures were $40.7 million. The Bank was categorized as well capitalized; its total risk-based capital ratio was 16.33%, Tier 1 risk-based ratio 15.07%, and Tier 1 leverage ratio 9.91%. Tangible common equity was $240.1 million, or 10.68% of tangible assets. Management said Bank liquidity was adequate; parent-company cash and time deposits were approximately $24.8 million.
Material changes and unusual items
- The unusually high 2013 earnings reflected a $57.6 million tax benefit from reversing substantially all of the deferred-tax-asset valuation allowance. Thus, year-over-year net income and EPS comparisons are not representative of underlying operating performance.
- Lower 2014 net interest income reflected a 42-basis-point quarterly margin decline, attributed to prolonged low rates and a shift from higher-yielding loans toward lower-yielding securities. Higher average interest-earning assets partly offset the margin pressure.
- Mortgage originations and sales fell substantially as higher mortgage rates reduced refinancing volumes. Q2 mortgage gains declined to $1.5 million from $3.2 million; mortgage servicing income fell to $0.2 million from $1.7 million.
- Lower expenses included sharply reduced Mepco counterparty-contingency charges: $0.07 million in Q2 versus $3.1 million, largely because 2013 included litigation-related settlements and write-downs. The new seven-year data-processing contract was expected to reduce annual core-processing and interchange costs by approximately $1 million.
- Management reported improving Michigan economic conditions and generally improving asset quality, while noting that improvement was uneven. Non-performing loans and annualized first-half net charge-offs declined year over year.
Outlook, risks and contingencies
No specific earnings or revenue guidance was provided. Management said short-term rates were expected to remain very low at least through 2015 and that rising rates would generally benefit net interest margin over the longer term. The company stated that it believed it exceeded upcoming regulatory capital requirements taking effect January 1, 2015.
- Key exposures include Michigan economic and real-estate conditions, credit losses and allowance assumptions, competition, loan and deposit growth, interest-rate changes, liquidity, and regulatory developments.
- Mepco had $7.1 million of net vehicle-service-contract counterparty receivables outstanding and was pursuing recovery, including through litigation. Management cautioned that actual losses could exceed reserves; losses could increase if a major counterparty fails.
- Approximately $332 million of deposits were uninsured; $286 million of time deposits matured within 12 months. Wholesale funding availability and cost were not assured.
- The Bank had negative undivided profits of $40.3 million and could not currently pay dividends to the parent without regulatory approval. A $15 million approved return of capital was completed in April. The parent paid a first quarterly common dividend of $0.06 per share in May and declared another $0.06 dividend in July.
- Ordinary-course litigation accruals were described as immaterial; management estimated reasonably possible additional losses of up to approximately $0.5 million. The company also identified uncertainty in deferred tax asset realization, mortgage-servicing-right valuations, and mortgage-loan representation-and-warranty claims.
- After quarter-end, the company sold its largest other-real-estate property, carried at $5.6 million at June 30, and recorded a $0.4 million gain in July.
Investor verification points
- Separate the 2013 deferred-tax valuation-allowance benefit from recurring earnings when assessing year-over-year profitability.
- Track net interest margin, loan yields, securities mix, and mortgage production as low rates and reduced refinancing continue to affect revenue.
- Review allowance adequacy and trends in non-performing loans, troubled restructurings, charge-offs, and collateral values.
- Assess Mepco counterparty recoveries, litigation outcomes, and whether its reserves reflect cancellation, collateral, and collection risks.
- Monitor uninsured deposits, time-deposit renewals, wholesale funding access, and the Bank’s capital and dividend restrictions.