Old Second Bancorp, Inc. — Q1 2017 Form 10-Q
Business context and reporting period
Old Second Bancorp is an Illinois-based bank holding company providing commercial and retail banking, trust, and wealth management services. This unaudited report covers the three months ended March 31, 2017; balance-sheet comparisons are with December 31, 2016. Amounts below are in millions unless stated otherwise. The October 2016 acquisition of Talmer Bank and Trust’s Chicago branch is an important factor in year-over-year comparisons.
Key financial metrics
| Metric | Q1 2017 | Comparable period / change |
|---|---|---|
| Interest and dividend income | $20.8 | $17.6 in Q1 2016 |
| Net interest and dividend income | $17.7 | $15.2 in Q1 2016 |
| Net interest margin, tax-equivalent | 3.58% | 3.25% in Q1 2016; 3.54% in Q4 2016 |
| Noninterest income | $7.0 | $6.3 in Q1 2016 |
| Noninterest expense | $18.1 | $16.3 in Q1 2016 |
| Income before taxes | $6.7 | $5.2 in Q1 2016 |
| Net income / diluted EPS | $4.6 / $0.15 | $3.3 / $0.11 in Q1 2016 |
| Net cash from operating activities | $6.7 | $3.1 in Q1 2016 |
- Total assets were $2.35 billion, up $102.1 million from year-end. Loans were $1.49 billion, up $9.2 million, and available-for-sale securities were $611.1 million, up $79.2 million.
- Deposits were $1.94 billion, up $70.4 million. Cash and cash equivalents were $60.7 million, versus $47.3 million at year-end.
- Total borrowings were $221.3 million, up from $197.3 million at year-end, including $85.0 million of FHLB advances and $44.0 million of senior notes. Stockholders’ equity was $182.3 million.
- Net cash used in investing activities was $87.2 million, largely reflecting securities purchases; financing activities provided $93.9 million, mainly from deposit growth and additional FHLB advances.
- The Bank’s Tier 1 leverage ratio was 10.14% and total risk-based capital ratio was 13.33%; management reported both above its stated objectives. The company’s tangible common equity to tangible assets ratio was 7.40%.
Material changes versus the prior comparable period
- Net income rose approximately 38% year over year. Management attributed earnings growth primarily to the acquired Talmer loan portfolio, higher net interest income, and a smaller mortgage-servicing-rights valuation loss.
- Average earning assets increased $171.2 million year over year, primarily reflecting loan growth associated with the Talmer acquisition. The average yield on earning assets and tax-equivalent net interest margin also increased; management cited repositioning securities toward higher-yielding tax-exempt holdings.
- Interest expense increased to $3.1 million from $2.4 million, reflecting the senior notes, higher rates on short-term borrowings, and deposit costs. Cost of funds on interest-bearing liabilities rose to 0.80% from 0.63%.
- Noninterest expense increased 11% year over year. Management identified one-time Q1 2017 compensation and benefit items totaling about $1.0 million: an executive retirement agreement, a deferred loan-cost adjustment, and higher-than-expected health-insurance accruals. Nine additional full-time-equivalent employees, associated with the acquisition, also contributed.
- Nonperforming loans declined to $12.5 million from $16.0 million at year-end; nonperforming loans were 0.8% of loans versus 1.1% at year-end. Classified loans declined to $21.7 million from $26.5 million.
Outlook, risks, contingencies, and unusual items
- Management described local opportunities for moderate growth, but noted uncertainty and reluctance among consumers and businesses to invest. It cited loan competition and pressure on renewal pricing, while maintaining underwriting standards. No numerical earnings or revenue guidance was provided.
- Credit remains a key risk: real-estate-related lending represented 78.9% of loans. Net charge-offs were $417,000 in Q1 2017, compared with net recoveries of $23,000 in Q1 2016. The allowance for loan losses was $15.7 million, or 1.06% of loans; management considered it adequate and recorded no provision or release. Management cautioned actual losses could exceed estimates.
- Other real estate owned increased to $13.5 million from $11.9 million at year-end. About 44.8% had been held for five years or more, and the filing notes valuation and disposal losses may arise. The Bank recorded $3.4 million of OREO additions in the quarter.
- The securities portfolio had $10.6 million of gross unrealized losses at quarter-end, primarily attributed to interest-rate changes; management reported no credit-quality deterioration and no other-than-temporary impairment. Rate sensitivity analysis estimated annual pre-tax income would decline 7.1% under an immediate 1% rate decrease and increase 3.6% under a 1% increase; management cautioned these are simulations, not forecasts.
- Off-balance-sheet exposures include $13.0 million of letters of credit and customer loan commitments; total commitment amounts and associated risks are described in the filing. Ordinary-course legal matters were not expected by management to have a material adverse effect.
- After quarter-end, the board declared a $0.01-per-share dividend payable May 8, 2017. A new CFO was announced to begin May 2, 2017. The filing states disclosure controls were effective and there were no material changes to internal controls during the quarter.
Important facts for investors to verify
- How much of earnings growth reflects Talmer acquisition benefits versus ongoing organic loan growth and margin trends?
- Whether the disclosed one-time compensation and benefit costs are nonrecurring, and how expenses and the efficiency ratio develop after the acquisition integration.
- Credit quality trends, including net charge-offs, classified and nonperforming loans, allowance coverage, and the sizable real-estate exposure.
- Deposit retention and funding costs, particularly the use and cost of FHLB advances and the company’s senior and junior subordinated debt.
- Valuation and duration risks in the securities portfolio, mortgage servicing rights, and long-held OREO, as well as sensitivity to changing interest rates.