OLD SECOND BANCORP INC annual report, FY2016

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Old Second Bancorp, Inc. — FY2016 Form 10-K

Reporting period: Fiscal year ended December 31, 2016; comparisons are primarily with FY2015. The filing also reports unaudited fourth-quarter results. Old Second is an Illinois community banking and trust company operating through Old Second National Bank, primarily in the western and southern Chicago metropolitan area.

Financial performance and condition

  • Earnings: Net income and net income available to common shareholders were $15.7 million, or $0.53 per diluted share, versus $15.4 million and $0.46 per diluted share in 2015. Fourth-quarter net income was $5.0 million, or $0.17 per diluted share.
  • Revenue and margins: Net interest income was $63.4 million, up 7.4%. Net interest margin was 3.28% on a GAAP basis and 3.31% tax-equivalent, compared with 3.21% and 3.23%, respectively, in 2015. Noninterest income was $28.6 million, down 2.5%. The filing does not present a single total-revenue figure.
  • Expenses and credit costs: Noninterest expense declined 2.4% to $66.8 million. The company recorded a $750,000 loan-loss provision, compared with a $4.4 million reserve release in 2015. Net charge-offs were $815,000, versus $1.0 million.
  • Profitability: Return on average assets was 0.73% versus 0.74%; return on average equity was 9.43% versus 8.87%.
  • Balance sheet and lending: Total assets were $2.25 billion, up 8.4%. Gross loans rose 30.4% to $1.48 billion; $221.0 million of the increase came from the Talmer branch acquisition and $124.1 million was organic growth. Deposits increased 6.1% to $1.87 billion.
  • Credit quality: Nonperforming assets declined to $27.9 million from $33.8 million, chiefly as other real estate owned fell 37.7% to $11.9 million. Nonperforming loans, however, increased to $16.0 million from $14.6 million. The allowance was $16.2 million, or 1.09% of loans, versus 1.43% a year earlier.
  • Cash flow and liquidity: Operating cash flow was $27.3 million, investing cash outflow $123.1 million, and financing cash inflow $102.8 million. Cash and cash equivalents ended at $47.3 million. FHLB advances were $70.0 million; disclosed remaining FHLB funding availability was $51.7 million after outstanding advances and letters of credit.
  • Debt and capital: Total borrowings were $197.3 million versus $152.1 million. In December, the company retired $45.0 million of subordinated debt and $0.5 million of senior debt, issuing $45.0 million of senior notes; the notes pay 5.75% for five years and then float at three-month LIBOR plus 385 basis points. Stockholders’ equity was $175.2 million, up 12.4%. The Bank’s Tier 1 leverage and total capital ratios were 10.24% and 13.45%; the company reported that it and the Bank met applicable well-capitalized standards.

Material changes and notable items

  • The October 28, 2016 Talmer Chicago branch acquisition added $48.9 million of deposits and approximately $221.0 million of loans, net of purchase-accounting discount, and established a commercial-focused metropolitan Chicago presence. Net cash paid was approximately $181.4 million.
  • To fund the acquisition and loan growth, the company sold securities and recorded $2.2 million of net securities losses. Total securities declined $172.0 million, or 24.4%, and all held-to-maturity securities were transferred to available-for-sale in the second quarter. The transfer restricts the company from classifying securities as held-to-maturity for two years.
  • Mortgage banking revenue continued to grow; residential mortgage loans sold were approximately $191.4 million. Trust income and deposit service charges declined year over year.
  • OREO expense decreased to $2.7 million from $5.2 million, accompanying lower OREO balances. The company resumed common dividends in 2016, paying $888,000 in total; no common dividends were paid in 2015.

Outlook, risks and contingencies

  • No formal earnings or revenue guidance is provided. Management described local real estate conditions as generally stable and improving, but characterized borrower demand and the market for qualified loans as competitive and, in some areas, soft. It intends to pursue loan growth and portfolio diversification while monitoring credit quality, liquidity, capital and interest-rate exposure.
  • Interest-rate sensitivity modeling estimated pretax net income increases of 3.6% for an immediate 1% rate rise and 7.3% for a 2% rise; a 1% decline reduced modeled pretax income by 6.6%. A 2% decline was not modeled. Management cautions that actual results may differ and the analysis excludes mitigating management actions.
  • Key risks include the concentration of approximately 79.7% of loans in real estate-related lending; exposure to local Illinois economic and fiscal conditions; potential deterioration in collateral values and loan performance; interest-rate and deposit-funding pressures; competition; regulatory and capital requirements; cyber and third-party technology risks; and uncertainty in valuing securities and mortgage servicing rights.
  • The company reported $53.5 million of net deferred tax assets, including federal and state loss carryforwards. A material tax-rate reduction, weaker taxable earnings, or ownership changes could affect their realization or measurement. Management reported no valuation allowance at year-end.
  • Commitments to extend credit and letters of credit totaled approximately $353.5 million. Management did not anticipate significant losses from these commitments. Ordinary-course legal proceedings were pending; management believed any resulting liabilities would not materially affect the company based on information then available.
  • The filing identifies no numerical liquidity or earnings target. It reports that the company and Bank were in compliance with financial covenants and that management considered interest-rate risk moderate.

Important facts for investors to verify

  • How much of subsequent loan, deposit and earnings growth is organic versus attributable to the Talmer acquisition, and whether acquired relationships and purchase-accounting benefits are retained.
  • Whether the allowance remains adequate as nonperforming loans and classified loans increased modestly, while the allowance-to-loans ratio declined and the acquired portfolio is accounted for separately.
  • The sustainability of improved net interest income and mortgage banking revenue against higher funding costs, the new senior-note coupon, and changing interest rates.
  • Realized versus reported values of securities and OREO, including the $13.6 million net unrealized loss on available-for-sale securities and Level 3 valuation exposures.
  • Capital and liquidity headroom after acquisition-related balance-sheet growth, including the company’s reliance on FHLB advances and regulatory limits on dividends and capital distributions.
  • Potential effects of tax-law changes on deferred tax assets and the company’s ability to use federal and state loss carryforwards.