QCR HOLDINGS INC quarterly report, Q3 FY2018

QCR Holdings, Inc. — Q3 2018 Form 10-Q

Reporting period: Quarter and nine months ended September 30, 2018. QCR is a financial holding company operating five commercial banks, a leasing business, and wealth-management services across Iowa, Illinois, Missouri, and nearby markets. Results include Springfield First Community Bank (SFC Bank) from its July 1, 2018 acquisition; the prior-year comparison does not include SFC Bank and is also affected by the 2017 Guaranty Bank acquisition.

Financial performance and position

Metric	Q3 2018	Comparable period
Net income	$8.8 million	$7.9 million in Q3 2017; $10.4 million in Q2 2018
Diluted EPS	$0.55	$0.58 in Q3 2017; $0.73 in Q2 2018
Net interest income	$38.3 million	$28.6 million in Q3 2017
Provision for loan and lease losses	$6.2 million	$2.1 million in Q3 2017; $2.3 million in Q2 2018
Noninterest income	$8.8 million	$6.7 million in Q3 2017
Noninterest expense	$30.5 million	$23.4 million in Q3 2017
Net interest margin	3.46% GAAP; 3.60% tax-equivalent	3.43% GAAP and 3.71% tax-equivalent in Q3 2017

For the first nine months, net income was $29.8 million and diluted EPS was $2.02, compared with $25.8 million and $1.91 in 2017. Net interest income was $102.8 million, up 22%; provision expense was $11.0 million, up 78%; noninterest income was $26.3 million, up 26%; and noninterest expense was $82.7 million, up 25%. The effective tax rate declined to 15.5% from 21.2%, primarily reflecting the Tax Act’s reduction of the federal corporate tax rate.

Management reported Q3 core net income of $10.4 million and core diluted EPS of $0.65, both non-GAAP measures that exclude specified items. Q3 GAAP net income increased year over year but fell from Q2, mainly as provision expense and noninterest expense rose. The company’s reported efficiency ratio was 64.72% for Q3.

Balance sheet, funding, and credit

• Total assets were $4.79 billion at September 30, up from $3.98 billion at December 31, 2017. Net loans and leases were $3.61 billion, up from $2.93 billion; gross loans and leases were 76% of assets.
• Total deposits were $3.79 billion, versus $3.27 billion at year-end. Noninterest-bearing deposits were $802 million, or 21% of deposits; brokered deposits were $276 million, or 8%.
• Total borrowings were $483.6 million, compared with $309.5 million at year-end. FHLB advances were $359.1 million. Wholesale funding, including borrowings and brokered deposits, was 16% of assets, above the company’s stated long-term goal of less than 15%.
• Cash and due from banks was $73.4 million. Cash, federal funds sold, and interest-bearing deposits at financial institutions totaled about $203.1 million at quarter-end. Subsidiary-bank credit lines totaling $371.9 million were available; $1.0 million remained available on the parent company’s $10 million revolving line.
• Stockholders’ equity was $457.4 million. The company’s total risk-based capital ratio was 10.87%, and management said the company and each subsidiary bank met applicable capital requirements; subsidiary banks qualified as “well capitalized.” Tangible common equity to tangible assets was 7.82%, a non-GAAP measure.
• Nonperforming assets were $41.6 million, or 0.87% of assets, up from $26.8 million and 0.65% at Q2-end. Nonperforming loans and leases were $29.2 million, up from $13.9 million; nonaccrual loans and leases were $23.6 million. The allowance was $43.1 million, 1.18% of loans and leases, compared with 1.21% at Q2-end.
• Operating cash flow was $36.9 million for the first nine months, compared with $27.2 million in 2017. Investing activities used $209.6 million and financing activities provided $170.4 million; cash and due from banks declined $2.3 million over the period.

Material changes and transactions

• The July 1 SFC Bank merger added $575.7 million of assets and $439.6 million of deposits at acquisition. Consideration was $89.0 million, including $80.6 million in QCR stock, and goodwill of $45.5 million was recorded. SFC contributed $7.4 million of revenue and $2.2 million of net income in Q3, including after-tax post-acquisition costs.
• Q3 loan and lease growth was 7.9% annualized, excluding acquired SFC loans; year-to-date growth was 10.5%. Management attributed higher net interest income primarily to loan growth and acquisitions.
• Net interest margin improved 8 basis points from Q2 on a tax-equivalent basis, but was below Q3 2017. Excluding acquisition-accounting accretion, tax-equivalent margin declined 2 basis points sequentially. Management cited rising deposit costs, competition and a flat yield curve.
• Q3 provision expense included $4.7 million related to two unrelated borrowers, as well as the effects of loan growth and acquired-loan accounting. Management noted that acquired loans have no allowance at acquisition and may require provision as they renew.
• On October 1, 2018, after quarter-end, QCR completed its acquisition of the Bates Companies, adding approximately $700 million of wealth-management assets under management. Consideration included cash and potential stock payments tied to future performance.
• Other comprehensive loss for the first nine months was $5.1 million, largely reflecting unrealized losses on available-for-sale securities. Management considered debt-security valuation declines temporary and reported no other-than-temporary impairment.

Outlook, commentary, and risks

The filing provides long-term operating goals rather than specific near-term earnings guidance. Goals include a 73%–78% loans-to-assets ratio, tax-equivalent NIM above 3.65%, ROAA above 1.10%, NPAs below 0.75% of assets, net charge-offs below 0.25% annually, and wholesale funding below 15% of assets. At Q3-end, NIM was 3.60% tax-equivalent, ROAA was 0.75%, NPAs were 0.87% of assets, and wholesale funding was 16% of assets. Management said it would pursue quality loan growth, core-deposit growth, lower reliance on wholesale funding, and expansion of wealth management and fee income.

• Credit quality warrants attention: management attributed the Q3 increase in NPAs primarily to three loans downgraded to nonaccrual, including two large Rockford-market credits. Criticized and classified commercial loans also increased during Q3. Management cautioned that economic deterioration or borrower cash-flow weakness could require additional provisions.
• Funding costs and interest-rate sensitivity are risks. Interest expense rose substantially year over year as deposit rates increased and the company used more borrowings to fund asset growth. Management reported modeled interest-rate exposures within policy limits and had hedged $39 million of variable-rate trust preferred securities with swaps.
• Acquisition execution, integration costs, fair-value estimates, and the realization of expected acquisition benefits remain uncertainties. Management said acquisition-related costs were expected to affect expenses during 2018.
• The filing disclosed a legal matter involving two RB&T employees charged with wrongdoing related to an SBA loan application. Neither RB&T nor QCR was charged; the company expected related legal expense to continue until proceedings were completed, anticipated in mid-2019.
• Other stated risks include economic conditions, interest rates, tariffs and trade policy, cybersecurity, litigation, severe weather, accounting changes, and acquisition outcomes. No material changes to previously disclosed risk factors were reported. Management stated disclosure controls were effective and there were no significant changes in internal control over financial reporting.

Investor verification priorities

1. Review the Q3 increase in nonperforming assets and the borrower-specific provision, including subsequent performance, collateral, and charge-off developments.
2. Assess whether deposit growth and funding mix can reduce wholesale funding below the 15% goal, and monitor deposit pricing, brokered deposits, and FHLB advances.
3. Separate organic growth and earnings from acquired contributions, acquisition accounting accretion, integration costs, and share dilution; review SFC integration and Bates acquisition terms and performance conditions.
4. Track margin, return on assets, efficiency, and the trajectory of credit costs against management’s long-term goals; distinguish GAAP results from management’s non-GAAP core measures.
5. Monitor the employee-related SBA legal matter and related costs, as well as interest-rate exposure and unrealized securities losses.