Capitol Federal Financial, Inc. — FY2019 Form 10-K
Reporting period: Fiscal year ended September 30, 2019. The filing is an annual report, not a standalone calendar fourth-quarter report; it also provides unaudited quarterly results. Capitol Federal is a Kansas-focused community bank whose principal business is residential mortgage lending, with commercial banking expanded through its August 2018 acquisition of Capital City Bancshares (CCB). CCB operations were integrated in April 2019.
Financial performance and position
| Metric | FY2019 / September 30, 2019 | Comparison |
|---|---|---|
| Net interest and dividend income | $206.4 million | Up $7.6 million from FY2018 |
| Net interest margin | 2.26% | 1.95% in FY2018; excluding the leverage strategy, 2.30% versus 2.24% |
| Net income / diluted EPS | $94.2 million / $0.68 | $98.9 million / $0.73 in FY2018 |
| Non-interest income | $22.0 million | Down 0.3% |
| Non-interest expense | $106.9 million | Up $10.0 million, or 10.4% |
| Efficiency ratio | 46.83% | 43.89% in FY2018 |
| Operating cash flow | $80.9 million | $124.2 million in FY2018 |
| Total assets | $9.34 billion | Down 1.2% from $9.45 billion |
| Loans receivable, net | $7.42 billion | Down from $7.51 billion |
| Deposits | $5.58 billion | Down $21.5 million |
| Borrowings | $2.24 billion | Down from $2.29 billion |
| Stockholders’ equity | $1.34 billion | Down $55.3 million |
Net income declined 4.7%, mainly because of higher personnel and technology-related expenses and higher income taxes; higher-yielding CCB commercial loans helped lift net interest income. Net interest margin improved as commercial loans added through CCB and higher asset yields partly offset increased deposit costs. FY2019 cash flows were $80.9 million provided by operations, $233.3 million provided by investing activities, and $199.6 million used in financing activities. Cash, cash equivalents and restricted cash increased $114.6 million to $253.7 million.
Commercial loans grew 35% to $767.9 million, while one- to four-family loans declined $285.6 million. Commercial loans were 10.4% of total loans, versus 7.7% a year earlier. Securities totaled $1.20 billion at fair value; the portfolio was reclassified entirely to available-for-sale (AFS) after adoption of hedge-accounting guidance. The allowance for credit losses was $9.2 million, or 0.12% of loans, and the company recorded a $750,000 provision.
Credit indicators remained low overall: non-performing loans were 0.10% of loans versus 0.15% in FY2018; non-performing assets were 0.10% of assets versus 0.14%. The allowance covered 122% of non-performing loans. The Bank and Company exceeded regulatory capital requirements; the Bank’s Tier 1 leverage ratio was 12.1%, and its total risk-based capital ratio was 24.3%.
Liquidity funding included $5.58 billion of deposits, $2.14 billion of FHLB advances, $100 million drawn on the FHLB line of credit, and $100 million of repurchase agreements. About $1.51 billion of certificates of deposit were scheduled to mature within 12 months. The Bank reported $708.8 million of securities eligible but unused as borrowing collateral. Total borrowings were approximately 24% of assets, below the stated 55% internal limit.
Material changes versus FY2018
- Commercial lending expanded following CCB: commercial loans rose $198.3 million, while the residential one- to four-family portfolio contracted.
- Non-interest expense increased $10.0 million, including a $6.6 million increase in salaries and benefits and a $3.6 million increase in information technology costs. The efficiency ratio worsened.
- Average deposit cost rose, and interest expense on deposits increased $13.6 million. Interest expense on FHLB borrowings fell $12.7 million, partly reflecting reduced use of the leverage strategy.
- Public unit certificates of deposit declined $112.8 million as management sought to reduce more expensive wholesale funding; retail/business certificates increased $163.4 million.
- Cash dividends paid rose to $134.9 million, or $0.98 per share, compared with $118.3 million, or $0.88 per share, in FY2018. Equity declined as dividends exceeded net income.
- Adoption of hedge-accounting guidance moved $444.7 million of securities from held-to-maturity to AFS. AFS securities are measured at fair value, with unrealized changes reflected in equity.
Outlook, commentary, and risks
- Management expects FY2020 net interest margin to decline if rates remain at or below FY2019 levels, citing lower asset yields, adjustable-rate loan repricing, and faster prepayments that could accelerate premium amortization.
- Management expects the loan portfolio may not grow overall in the next year, but intends to use residential portfolio cash flows to support commercial loan growth.
- Management anticipates FY2020 salaries and benefits to be approximately $4.0 million higher, mainly from commercial banking and technology staffing. It expects an effective tax rate of approximately 21%–22%.
- The Board and management stated an intention to distribute 100% of FY2019 earnings and continue that payout approach in FY2020, subject to earnings, capital, regulatory limits, and holding-company liquidity. FY2019 regular quarterly dividends were $0.085 per share; a $0.34-per-share FY2019 true-up dividend was announced after year-end.
- A $50 million commercial real estate participation loan for a recently opened hotel and convention center was classified as special mention. The loan was current at year-end, but management cited below-policy debt-service coverage, slower-than-expected surrounding development, and construction delays; personal guarantees were available.
- Commercial loan growth increases exposure to property, construction, business cash-flow, geographic, and borrower-concentration risks. The filing reports $921.1 million of commercial real estate and construction exposure including undisbursed balances and commitments.
- The company identified $780.7 million of adjustable-rate residential loans tied to LIBOR with maturities after 2021. It had stopped originating or purchasing new LIBOR-indexed residential ARMs and was transitioning to the one-year CMT index. Management warned of conversion costs, possible disputes, and potential effects on interest income.
- Other material risks include interest-rate and yield-curve changes, deposit competition and funding costs, regional economic or real-estate deterioration, cyber and third-party technology incidents, regulatory changes, and the possibility that the allowance may prove inadequate. CECL adoption was expected October 1, 2020; the impact had not yet been reasonably estimated.
- Management identified a possible $400,000 write-down of a CCB-acquired OREO property in FY2020 following a subsequent offer. Pending litigation was not expected by management to materially affect financial condition, results, or liquidity.
Most important facts for investors to verify
- Whether commercial loan growth, especially the special-mention hotel exposure and construction commitments, produces additional credit deterioration, provisions, or charge-offs.
- Whether FY2020 margin pressure, deposit repricing, and expected expense increases develop as management anticipated.
- The quality and timing of funding for maturing certificates of deposit and borrowings, and the Bank’s continuing access to FHLB capacity and regulatory approval for distributions.
- The progress and financial impact of the LIBOR transition, including the identified loan exposure and swap fallback provisions.
- The eventual CECL allowance impact and any change in credit-loss estimates or capital after adoption.
- The sustainability of the stated 100% earnings payout policy given dividends, capital requirements, and the Bank’s ability to distribute funds to the holding company.
- Reported audit context: the auditor gave an unqualified opinion on the financial statements and concluded internal control over financial reporting was effective; the allowance for credit losses was identified as a critical audit matter.