Sound Financial Bancorp, Inc. — Q1 2018 Form 10-Q
Business context and period. The company is a bank holding company whose banking subsidiary, Sound Community Bank, gathers deposits and makes residential, commercial real estate, construction, consumer and commercial business loans. This unaudited report covers the three months ended March 31, 2018; comparisons are with Q1 2017 for results and December 31, 2017 for balance-sheet changes. Amounts below are in millions unless stated otherwise.
Financial performance and position
- Income and earnings: Net income was $1.60 million, up 13.3% from $1.41 million. Basic and diluted EPS were $0.65 and $0.63, respectively; the comparable 2017 figures were $0.57 and $0.54. The MD&A separately states 2018 diluted EPS of $0.62, inconsistent with the financial statements’ $0.63.
- Interest income and margin: Interest income rose 13.7% to $7.49 million. Interest expense rose 28.7% to $1.02 million, while net interest income increased 11.6% to $6.47 million. Net interest margin was 4.32%, versus 4.28%.
- Other income and expenses: Noninterest income grew 9.5% to $1.09 million, primarily from loan-sale gains, which rose to $332,000 from $171,000. Noninterest expense increased 17.7% to $5.44 million, including higher salaries, operations and occupancy. The efficiency ratio increased to 71.89% from 67.99%.
- Taxes: Income tax provision fell to $423,000 from $760,000, reflecting the federal corporate tax rate reduction from 35% to 21% under the Tax Act.
- Assets and loans: Total assets increased 2.2% from year-end to $659.5 million. Net loans reached $554.7 million, up $11.3 million; gross loans rose 2.1% to $560.0 million. Commercial and multifamily loans were $221.3 million, or 39.4% of gross loans.
- Credit quality: Nonperforming assets declined to $2.56 million, or 0.39% of assets, from $2.89 million, or 0.45%. Nonperforming loans were $1.93 million. The allowance for loan losses was $5.33 million, 0.95% of gross loans and 276.78% of nonperforming loans. The quarter included a $100,000 provision and $13,000 of net charge-offs.
- Deposits, debt and liquidity: Deposits increased 2.9% to $529.2 million, including a $12.2 million increase in noninterest-bearing demand accounts. Borrowings declined $3.0 million to $56.0 million; the reported weighted-average borrowing cost was 1.73%. Cash and cash equivalents were $64.7 million. The bank reported $155.1 million of remaining FHLB borrowing availability and $49.7 million of Federal Reserve discount-window capacity.
- Cash flow: Operating activities provided $4.36 million; investing activities used $11.91 million, principally reflecting $11.49 million of net loan growth; financing activities provided $11.56 million, mainly from deposit growth, partly offset by borrowing repayments. Cash increased $4.01 million during the quarter.
- Capital and equity: Stockholders’ equity was $66.5 million, up 2.1% from year-end. The bank was reported as well-capitalized: CET1 risk-based capital was 12.15%, total risk-based capital 13.20%, and Tier 1 leverage 10.04%.
Material changes and management commentary
- Higher average loan balances and yields supported interest income and net interest income. Average loans increased 10.9% year over year to $549.7 million; the loan yield rose to 5.27% from 5.20%.
- Funding costs increased: the weighted-average cost of interest-bearing liabilities rose to 0.83% from 0.71%. Management attributed higher borrowing costs partly to rising overnight rates.
- Management attributed expense growth partly to staffing and operating costs associated with the University Place and Belltown branches and the Sequim loan production office. It also cited a $124,000 provision for off-balance-sheet commitments related to a loss on a loan sold with recourse.
- Management said lower nonperforming loans reflected improving local economic conditions and continued work with borrowers. It noted that more commercial business loans moved into the specific-reserve pool for closer monitoring.
- The company declared a $0.14-per-share quarterly dividend on April 26, payable May 25, 2018. No earnings or financial guidance is provided.
Risks, contingencies and unusual items
- Key disclosed risks include changes in economic conditions and interest rates; loan credit quality and allowance estimates; real estate values; access to cost-effective funding and deposit retention; loan-sale market conditions; regulatory actions; operating costs; cyber and technology risks; competition; and execution of business strategies.
- Off-balance-sheet loan commitments totaled $75.8 million, including $35.8 million of undisbursed construction and land loans, $34.0 million of unused lines and $1.4 million of irrevocable letters of credit. Certificates of deposit of $96.9 million were scheduled to mature within one year.
- The company expects adoption of the expected-credit-loss standard (CECL) to result in earlier loss recognition and anticipates an increase in the allowance, but had not quantified the impact. The standard was effective for the company in 2020 under the stated timetable.
- Management reported that legal proceedings in the ordinary course were not expected to have a material adverse effect. Disclosure controls were assessed as effective, with no material changes in internal control over financial reporting reported during the quarter.
- Management disclosed no material change in market risk since the 2017 Form 10-K. The filing notes ordinary-course financial commitments and contingencies; it does not identify a material off-balance-sheet transaction beyond those described.
Important facts for investors to verify
- Resolve the diluted EPS discrepancy: the income statement and EPS note report $0.63 for Q1 2018, while MD&A reports $0.62.
- Assess whether the increase in noninterest expenses and the 71.89% efficiency ratio reflect ongoing costs associated with branch and staffing expansion.
- Monitor commercial real estate and commercial business loan exposure, criticized loans, allowance adequacy and the potential CECL impact.
- Review deposit growth and funding costs against loan growth, upcoming certificate maturities and reliance on available borrowing facilities.
- Evaluate the sustainability of loan-sale gains and the impact of higher interest rates on margins, funding costs and mortgage servicing rights.