Business context and reporting period
1st Source Corporation is an Indiana-based bank holding company offering banking, specialty finance, equipment leasing, mortgage, wealth management and insurance services. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2020; balance-sheet comparisons are with December 31, 2019. Amounts below are in millions unless stated otherwise.
Financial performance and condition
| Metric | Q2 2020 | Q2 2019 | Six months 2020 | Six months 2019 |
|---|---|---|---|---|
| Net interest income | $54.0 | $56.4 | $108.8 | $111.4 |
| Provision for loan and lease losses | $10.4 | $4.2 | $21.7 | $9.2 |
| Noninterest income | $25.2 | $25.7 | $49.9 | $49.8 |
| Noninterest expense | $44.8 | $47.4 | $91.4 | $92.6 |
| Net income available to common shareholders | $18.5 | $23.4 | $34.9 | $45.6 |
| Diluted earnings per share | $0.72 | $0.91 | $1.36 | $1.76 |
Net interest margin was 3.23% for Q2 and 3.39% for the first half (fully tax-equivalent: 3.24% and 3.40%), versus 3.73% and 3.75% in the respective 2019 periods. Lower asset yields, including lower market rates and 1% PPP loan yields, more than offset reduced funding costs. Combined net interest and noninterest income was $79.2 million in Q2 and $158.7 million for the first half, down approximately 3.5% and 1.5% year over year, respectively. Six-month return on average assets was 1.02% (1.44% in 2019); return on average common equity was 8.23% (11.75%).
At June 30, 2020, total assets were $7.37 billion, up 11.2% from year-end; loans and leases were $5.69 billion, up 11.9%, principally reflecting PPP lending. Deposits rose 11.9% to $5.99 billion, supported by PPP proceeds and government stimulus payments. The allowance for loan and lease losses was $131.3 million, or 2.31% of loans and leases (2.54% excluding PPP loans). Shareholders’ equity was $865.0 million; the shareholders’ equity-to-assets ratio was 11.74%, versus 12.51% at year-end.
Cash and cash equivalents were $180.2 million, versus $83.4 million at year-end. For the first half, operating cash flow was $44.4 million, investing cash flow was negative $623.7 million, and financing cash flow was positive $676.2 million. Total liabilities included $177.0 million of short-term borrowings, $81.8 million of long-term debt and mandatorily redeemable securities, and $58.8 million of subordinated notes. Deposits totaled $5.99 billion. The company reported regulatory capital ratios above applicable well-capitalized thresholds: consolidated total capital 15.58%, Tier 1 14.32%, and common equity Tier 1 12.76%.
Material changes versus the prior comparable period
- First-half net income available to common shareholders fell 23.4%; the higher credit-loss provision and lower net interest income were the principal pressures. Lower noninterest expense partly offset these declines.
- Nonperforming assets increased to $69.5 million from $19.2 million at year-end 2019; nonaccrual loans and leases rose to $62.8 million from $9.8 million. Nonperforming assets were 1.20% of loans and leases, versus 0.37% at year-end.
- Special-attention loan balances increased $67.6 million from year-end. First-half net charge-offs were $1.7 million, below $4.7 million in the prior-year period; management nevertheless increased reserves in response to emerging risk.
- Mortgage banking income increased, reflecting higher secondary-market originations and loan-sale gains. Equipment rental income declined 20.1% year over year for the first half as leasing volume fell. Mortgage servicing rights incurred a $0.55 million impairment charge.
- The company repurchased no shares in the first half and temporarily suspended open-market repurchases due to COVID-19. It paid a $0.28 per-share dividend in Q2.
Outlook, management commentary, risks and contingencies
- Management gave no quantified earnings or financial guidance. It anticipated additional loan downgrades in the second half of 2020 and into 2021, and potential further defaults, particularly in bus lending and other businesses affected by reduced travel and economic disruption. Management noted that bus collateral could be difficult to liquidate; used auto values had remained strong to date.
- COVID-19-related deferrals totaled $840 million across loan categories, or 15% of total loans; excluding PPP loans, the reported ratio was 16%. PPP lending included 3,350 loans totaling $592.2 million disbursed; the June 30 balance was $573.2 million net of unearned discount and was SBA-guaranteed. The company had not used the PPP Liquidity Facility as of quarter-end.
- The company delayed adoption of CECL under CARES Act relief until the earlier of the end of the national emergency or December 31, 2020. It expected a $2.58 million opening retained-earnings adjustment to increase the allowance and a $0.78 million increase in the unfunded commitment liability; it estimated an additional $0–$8 million allowance increase at June 30, to be recognized through earnings after adoption. Management did not expect a significant effect on regulatory capital ratios.
- Liquidity sources include securities, deposits, FHLB and Federal Reserve borrowing capacity, and loan sales. At June 30, the company reported potential additional borrowing capacity of $550.5 million from the FHLB and $449.8 million from the Federal Reserve, subject to stated conditions, and $225.0 million from correspondent banks. Management considered funding sources adequate. It also noted that a future requirement to collateralize public deposits could create approximately $807 million of liquidity exposure.
- Key risks include the pandemic’s effects on borrowers, collateral values, deposits, staffing and service providers; lower interest rates; concentrations in transportation, hotels, aircraft and foreign lending; and economic and geopolitical uncertainty. Foreign loan and lease exposure was $160.4 million, primarily aircraft lending in Mexico and Brazil. Loan commitments to extend credit were $1.07 billion; standby letters of credit were $25.9 million.
- Management reported no material expected adverse effect from pending ordinary-course legal proceedings and no material change in market risk since year-end. Disclosure controls were assessed as effective; no material second-quarter change in internal control over financial reporting was reported.
Important facts for investors to verify
- Whether nonaccrual loans, special-attention exposures and deferrals—particularly in auto rental, buses, construction equipment, hotels and aircraft—continue to rise, and how recoveries and collateral values develop.
- Whether the allowance remains adequate as the company adopts CECL, including the final adjustment and subsequent effects on provision expense and capital.
- How PPP forgiveness, fee recognition and repayments affect loan balances, deposits, liquidity and reported interest margins.
- Whether lower net interest margin, equipment leasing activity and pandemic-related pressure on fee income persist, and how these trends affect earnings and the dividend.
- Whether capital and borrowing capacity remain sufficient under adverse conditions, including any changes to public-deposit collateral requirements and the suspended share-repurchase program.