Hawthorn Bancshares, Inc. — Q3 2014 Form 10-Q
Business context and reporting period. This unaudited filing covers the quarter and nine months ended September 30, 2014. Hawthorn Bank provides commercial and consumer banking, lending, trust, and mortgage services in Missouri. Unless otherwise stated, financial amounts below are in millions of dollars.
Financial performance and position
- Q3 earnings: Net income was $1.57 million, essentially unchanged from $1.57 million a year earlier; diluted EPS was $0.30 in both periods. Net interest income was $9.96 million, up 0.9%, while noninterest income was $2.31 million, down 5.5%, and noninterest expense was $9.90 million, down 0.7%. No loan-loss provision was recorded in either quarter.
- Nine-month earnings: Net income was $5.65 million versus $3.25 million; diluted EPS was $1.08 versus $0.50. Net interest income was nearly unchanged at $29.46 million. Noninterest income declined 23.0% to $6.58 million, while noninterest expense fell 12.1% to $27.42 million. The prior-year period included a $2.0 million loan-loss provision and $3.0 million in other-real-estate expense; 2014 had neither comparable provision nor comparable ORE charges at that level. In 2013, preferred dividends and discount accretion also reduced earnings available to common shareholders by $0.62 million; none was recorded in 2014.
- Margins and returns: Net interest margin was 3.71% in Q3, versus 3.74% a year earlier; for the first nine months it was 3.71%, versus 3.68%. Return on average assets was 0.54% for Q3 and 0.65% year to date. The nine-month efficiency ratio improved to 76.08% from 82.18% (the filing also presents an adjusted ratio excluding ORE expense and securities-sale gains; that measure increased to 74.25% from 70.44%).
- Balance sheet at September 30: Assets were $1.157 billion, up from $1.140 billion at December 31, 2013. Loans were $861.0 million, up 2.6%; net loans were $849.0 million. Deposits were $964.7 million, up 0.9%. Stockholders’ equity was $80.5 million, up from $74.4 million.
- Credit quality: Allowance for loan losses was $12.0 million, or 1.40% of loans, versus $13.7 million, or 1.63%, at year-end. Nine-month net charge-offs were $1.69 million, down from $2.59 million. Nonperforming loans were $35.7 million, or 4.15% of loans, compared with $35.3 million, or 4.21%, at year-end. Nonperforming assets were $48.2 million, down from $50.2 million. Impaired loans totaled $35.6 million; $24.4 million of loans were on nonaccrual status. Potential problem substandard loans not included in nonperforming assets totaled approximately $12.9 million.
- Cash flow and liquidity: Nine-month operating activities provided $9.9 million; investing activities used $20.4 million, mainly reflecting securities purchases and loan growth; financing activities provided $6.9 million. Cash and equivalents ended at $24.8 million, down $3.7 million from year-end. The filing reports $210.9 million of federal funds/overnight deposits and available-for-sale securities, although $158.3 million of securities were pledged. Core deposits were $634.1 million, 65.7% of deposits.
- Debt and capital: Borrowings totaled $104.0 million: $19.5 million in repurchase agreements, $35.0 million in FHLB advances, and $49.5 million in subordinated notes. The Bank’s total risk-based, Tier 1 risk-based, and leverage ratios were 14.67%, 13.42%, and 10.23%, respectively; management said the Company and Bank met capital adequacy requirements. The company-level ratios were 15.68%, 12.02%, and 9.18%, respectively.
Material changes and management commentary
- Lower deposit costs supported net interest income despite lower yields on earning assets and loans. Management attributed reduced deposit costs in part to the maturity of a $23 million, 6.05% promotional certificate in 2013.
- Nine-month noninterest income fell mainly because mortgage-loan sale gains declined to $0.78 million from $1.52 million, real-estate servicing fees declined, and the prior-year period included $0.55 million in securities gains. Mortgage-loan sales were $25.6 million versus $63.4 million a year earlier; management cited subdued refinancing activity amid higher rates.
- Expense improvement largely reflected lower ORE costs, following significant 2013 write-downs and property expenses associated with two Branson hotels sold at auction, plus core-processing savings. Salaries rose, partly because of a 2014 incentive program approved in Q3 and payable in March 2015.
- Management reported soft loan demand in its markets and identified interest-rate changes, local and national economic conditions, credit deterioration, competition, regulation, and securities-market changes as risks. The filing provides no specific earnings or balance-sheet guidance; management said future short-term liquidity needs were not expected to vary significantly during 2014.
Risks, contingencies, and unusual items
- Employee fraud and control weakness: Management discovered employee fraud during Q3 involving $421,000 of cash over an extended period. The company recorded a $136,000 loss, net of $285,000 in expected insurance proceeds. Management deemed prior-period adjustments immaterial. Disclosure controls were assessed as ineffective due to a material weakness in cash safeguarding, reconciliation, and accounting controls. Remediation steps were taken, but management had not yet validated their operating effectiveness and could not assure successful remediation.
- ORE and impaired-loan estimates: Other real estate and repossessed assets were $12.4 million, net of a $3.3 million valuation allowance. Collateral values and loss estimates require significant judgment and may change.
- Commitments and litigation: Off-balance-sheet commitments to extend credit were $136.9 million, mortgage-origination commitments $2.8 million, and standby letters of credit $1.5 million. No estimated losses were accrued for these instruments. The company disclosed pending litigation incidental to its business and said it did not believe the matters were reasonably likely to materially adversely affect near-term financial condition or results.
- The company distributed a 4% stock dividend on July 1, 2014; share and EPS figures were adjusted retroactively. It reported that the dividend was its sixth consecutive annual 4% stock dividend.
Important facts for investors to verify
- Whether the enhanced cash controls were implemented effectively and the material weakness was subsequently remediated; confirm final insurance recovery against the $285,000 expected.
- Whether the lower allowance and absence of a 2014 loan-loss provision remain appropriate as loans, nonperforming assets, and potential problem credits evolve.
- Whether earnings growth for the first nine months is sustainable given declining noninterest income and the contribution of unusually lower ORE expenses and no loan-loss provision.
- How pledged securities, deposit mix, time-deposit maturities, and borrowing levels affect available liquidity and funding costs.
- Whether the 2014 incentive accrual, pension funding requirements, and pending legal matters create material future cash or expense obligations.