Mercantile Bank Corporation — Q2 2020 Form 10-Q
Reporting period: Three and six months ended June 30, 2020. The filing was signed August 7, 2020. Comparisons below are year over year for earnings and to December 31, 2019 for balance-sheet changes, unless otherwise noted.
Business context and financial results
Mercantile is a Michigan-based bank holding company. Results were shaped by COVID-19, Federal Reserve rate cuts, substantial Paycheck Protection Program (PPP) lending, and a surge in residential mortgage refinancing.
| Metric | Q2 2020 | Q2 2019 | Six months 2020 | Six months 2019 |
|---|---|---|---|---|
| Interest income | $37.2 million | $39.8 million | $75.1 million | $78.5 million |
| Net interest income | $30.6 million | $31.1 million | $60.9 million | $61.8 million |
| Net interest margin | 3.17% | 3.79% | 3.38% | 3.83% |
| Provision for loan losses | $7.6 million | $0.9 million | $8.4 million | $1.8 million |
| Noninterest income | $11.0 million | $6.3 million | $17.5 million | $13.0 million |
| Noninterest expense | $23.2 million | $22.1 million | $46.2 million | $43.9 million |
| Net income | $8.7 million | $11.7 million | $19.4 million | $23.5 million |
| Diluted earnings per share | $0.54 | $0.71 | $1.19 | $1.43 |
Financial condition, cash flow and liquidity
- At June 30, 2020, assets were $4.31 billion, up $681 million from year-end 2019. Loans were $3.33 billion, up $476 million (16.7%); deposits were $3.26 billion, up $572 million (21.3%).
- Cash and cash equivalents totaled $471.2 million, compared with $233.7 million at year-end. Six-month operating cash flow was negative $12.4 million, investing cash flow negative $412.0 million, and financing cash flow positive $661.9 million. Financing inflows included $636.0 million of growth in non-time deposits; investing outflows principally reflected loan growth.
- Borrowings included $394.0 million of Federal Home Loan Bank advances, $167.5 million of repurchase agreements, and $47.2 million of subordinated debentures. The bank reported approximately $375 million of remaining availability under its FHLB borrowing line.
- Shareholders’ equity was $425.2 million. The bank was reported well capitalized; its total risk-based capital ratio was 13.5%, and its Tier 1 leverage ratio was 10.0%.
- Nonperforming loans were $3.2 million, or 0.10% of loans. The allowance was $32.2 million, approximately 1.16% of loans excluding PPP loans; management said this represented more than 1,000% of nonperforming loans.
Material changes and unusual items
- Q2 net income declined about 26% year over year, and first-half net income declined about 18%. Management attributed the decline to higher credit-loss provisions and expenses and lower net interest income, partly offset by higher mortgage banking income. Excluding specified 2019 insurance and branch-sale gains, management said diluted EPS declined 14.3% for Q2 and 4.0% for the first half.
- Net interest margin contracted as falling yields on variable-rate commercial loans and interest-earning deposits outweighed lower funding costs. Average earning assets grew, but the Q2 yield on earning assets fell to 3.85% from 4.85% a year earlier.
- PPP lending was a major balance-sheet and income item: $549 million was included in loans at June 30, and net PPP origination fees of $14.7 million were recognized for Q2 and are being accreted into loan interest income. By July 31, the company reported nearly 2,200 PPP loans totaling $550 million.
- Noninterest income growth was mainly mortgage-related. First-half residential mortgage originations were $408 million, about 225% above the prior-year period; nearly 75% were refinances. Q2 and first-half mortgage banking income were $7.6 million and $10.3 million, respectively.
- The allowance build reflected a newly established COVID-19 environmental factor and a higher economic-conditions factor. Management said each added almost $4 million to the required reserve level during Q2.
- In June, the company replaced $70 million of shorter-term FHLB advances with new advances maturing in 2024–2027. A $0.9 million prepayment fee was embedded in the new rates. The company also suspended share repurchases in late March; it repurchased 222,385 shares for $6.3 million in the first half, with none in Q2.
Outlook, risks and contingencies
- Management described the pandemic’s economic effects and timing of recovery as highly uncertain, warning of possible deterioration in asset quality, increased delinquencies and charge-offs, further provisions, and reduced earnings. The bank identified itself as asset-sensitive; falling rates can pressure net interest income. Its June simulation estimated a 0.6% NII decline under a 100-basis-point rate decrease over the next 12 months, versus increases under rising-rate scenarios.
- Management expected PPP effects on loan and deposit mix and net interest income to continue for at least most of the remainder of 2020. It expected elevated interest-earning deposits to persist, anticipated securities purchases generally consisting of agency and municipal bonds, and planned to maintain securities at about 10% of assets.
- Management reported a strong commercial lending pipeline, including $176 million of new commitments expected mostly to be accepted and funded over 12–18 months, and expressed optimism about continued solid mortgage originations. These are expectations, not guarantees.
- Three branch closures were planned for Q4 2020. The company recorded an approximately $0.3 million pretax Q2 charge, expected about $1.5 million in facility valuation costs in Q4, and anticipated annual pretax savings of approximately $0.7 million.
- COVID-related payment relief outstanding at June 30 included commercial interest-only amendments covering $421 million in loan balances, commercial principal-and-interest deferments covering $298 million, and retail deferments covering $23.8 million. Additional commercial relief was granted through July 31. The filing notes substantial off-balance-sheet commitments, including $1.19 billion of unfunded loan commitments and $21.4 million of standby letters of credit.
- The company postponed CECL adoption as permitted under the CARES Act and continued using its incurred-loss methodology. It stated that legal proceedings were not material and that there were no material changes to previously disclosed risk factors.
Most important facts for investors to verify
- Whether pandemic-related borrower relief translates into increased delinquencies, criticized loans, nonperforming assets, charge-offs, or additional reserve expense as relief periods end.
- PPP fee accretion, forgiveness and repayment timing, and the effect of PPP balances on reported loan growth, yields, and future net interest income.
- Whether mortgage banking income remains strong if refinance volumes normalize, and whether operating costs and planned branch-closure charges match management’s expectations.
- Deposit stability and liquidity, including the sustainability of unusually high cash balances and the potentially variable sweep-account funding.
- Capital and credit-loss sensitivity under changing economic and interest-rate conditions, including the effects of continued CECL deferral and future adoption.