Waterstone Financial, Inc. — Q3 2017 Form 10-Q
Reporting period: Three and nine months ended September 30, 2017. Balance-sheet comparisons are against December 31, 2016. Dollar amounts are in millions unless otherwise noted.
Business context
Waterstone operates two segments: community banking, primarily in southeastern Wisconsin, and mortgage banking through Waterstone Mortgage, which originates residential loans mainly for sale in the secondary market. Community banking generates most net interest income; mortgage banking contributes most noninterest income and a majority of noninterest expense.
Financial performance
| Metric | Q3 2017 | Q3 2016 | Nine months 2017 | Nine months 2016 |
|---|---|---|---|---|
| Net interest income | $13.0 | $11.3 | $37.4 | $31.5 |
| Provision for loan losses | $0.02 | $0.14 | $(1.17) credit | $0.34 |
| Noninterest income | $33.1 | $37.4 | $96.2 | $95.2 |
| Noninterest expense | $34.3 | $35.5 | $99.6 | $95.0 |
| Income before taxes | $11.8 | $13.1 | $35.2 | $31.3 |
| Net income | $7.4 | $7.5 | $22.8 | $19.1 |
| Diluted EPS | $0.26 | $0.27 | $0.82 | $0.70 |
| Net interest margin | 2.95% | 2.70% | 2.97% | 2.56% |
Q3 net income declined about 2% year over year, while nine-month net income rose about 19%. Nine-month return on average assets was 1.70% (1.45% in 2016) and return on average equity was 7.42% (6.38%). The nine-month effective tax rate was 35.2%, down from 39.0%, including an approximately $0.83 million benefit from the 2017 stock-compensation accounting change.
Financial condition, liquidity and capital
- Total assets were $1.854 billion, up $63.5 million from year-end 2016. Loans held for investment rose $83.3 million to $1.261 billion; loans held for sale fell $50.1 million to $175.1 million, and available-for-sale securities declined $26.0 million to $200.8 million.
- Cash and cash equivalents increased $45.4 million to $92.6 million. Nine-month operating cash flow was $73.5 million, versus negative $36.3 million in 2016; investing cash use was $64.9 million and financing cash provided was $36.7 million. Operating cash flow includes substantial mortgage-loan originations and sale proceeds.
- Deposits were $956.8 million, up $7.4 million. Borrowings were $435.5 million, up $48.3 million; the increase included new FHLB advances. Total shareholders’ equity was $411.9 million. The Bank exceeded regulatory capital requirements and was classified as well capitalized; its total risk-based capital ratio was 28.99%.
- Time deposits of $514.3 million mature within one year. The company reported $55.0 million of short-term FHLB advances, $410.0 million of long-term FHLB advances, and $15.0 million of repurchase agreements at quarter-end. Management said additional FHLB borrowing is a liquidity source, but availability and terms are not assured.
- Cash dividends paid were $23.6 million in the first nine months, including regular and special dividends. The company had authorization to repurchase a further 916,800 shares at September 30, 2017.
Material changes and management commentary
- Q3 net interest income increased 15.1%, chiefly from portfolio-loan growth and lower borrowing costs as higher-rate FHLB funding matured and was replaced. Nine-month net interest income rose 18.9%; lower average borrowing costs were a major contributor.
- Q3 mortgage banking income fell 10.4% to $31.9 million. Management attributed the decline to a $48.0 million (6.8%) reduction in originations, lower margins of about 1.5%, and a decline in the value of the rate-lock pipeline. Refinance originations fell sharply; purchase originations increased 3.1%.
- For nine months, mortgage banking income increased 1.8% to $92.8 million as origination volume rose 7.1% to $1.88 billion, partly offset by lower margins. Segment net income nevertheless declined to $8.3 million from $9.8 million as expenses increased.
- The nine-month $1.17 million negative loan-loss provision reflected management’s assessment of improving credit quality. Nonaccrual loans fell to $7.0 million from $9.9 million; nonperforming assets declined to $11.6 million from $16.0 million. The allowance was $14.1 million, or 1.12% of loans, versus $16.0 million, or 1.36%, at year-end.
- Mortgage servicing rights related to $295.1 million of loans were sold for $2.6 million, producing a $0.31 million gain. A $0.11 million securities-sale loss was recorded in the nine-month period.
- Management provided no specific earnings or operating guidance and cautioned that interim results are not necessarily indicative of full-year results. Identified risks include economic and competitive conditions, interest-rate changes, mortgage-market activity, credit losses, regulation, and operational or third-party risks. The filing reported no change in risk factors from the 2016 Form 10-K.
Legal matters and contingencies
In Herrington v. Waterstone Mortgage Corporation, an arbitrator found the subsidiary liable in a wage-and-hour matter and awarded $7.3 million in damages plus $3.3 million in attorney fees and costs. The company estimated the potential award could reach $11.0 million, is contesting the result, assessed the low end of possible loss as zero, and recorded no accrual because it did not consider an unfavorable outcome probable. A separate wage-and-hour action, Werner, was in its early stages; the company could not assess likelihood or estimate a loss range.
Most important facts for investors to verify
- Subsequent developments, legal exposure and any eventual judgment in the Herrington arbitration, plus progress in the Werner case.
- Whether mortgage origination volume and margins stabilize, particularly given the decline in refinance activity and Q3 mortgage banking revenue.
- Loan growth, delinquency trends, collateral values and whether the negative provision and improved asset-quality measures persist.
- Funding costs and liquidity as $514.3 million of time deposits mature within one year and borrowings remain a significant funding source.
- How the company’s dividends and share repurchases affect capital, alongside any changes in regulatory requirements.
- The sensitivity of earnings and mortgage-related assets to interest-rate moves; management’s model estimated a 2.51% increase in 12-month net interest income for a 100-basis-point rise and a 2.89% decrease for a 100-basis-point decline.