Old Second Bancorp, Inc. — Q1 2018 Form 10-Q
Reporting period: Three months ended March 31, 2018; balance-sheet comparisons are to December 31, 2017, and operating results primarily to Q1 2017. The unaudited results are not necessarily indicative of full-year performance. Old Second is an Illinois-based community bank holding company.
Key financial results
| Metric | Q1 2018 | Comparable period / change |
|---|---|---|
| Net interest and dividend income | $19.6 million | $17.5 million in Q1 2017 |
| Net interest margin | 3.66% GAAP; 3.76% tax-equivalent | 3.44% GAAP; 3.54% tax-equivalent in Q1 2017 |
| Noninterest income | $8.5 million | Up 21.0% from $7.0 million |
| Noninterest expense | $17.4 million | Down 3.9% from $18.1 million |
| Pre-tax income | $11.5 million | $6.5 million in Q1 2017 |
| Income tax expense / effective rate | $2.0 million / 17.4% | $2.1 million / 32.1% in Q1 2017 |
| Net income / diluted EPS | $9.5 million / $0.31 | $4.4 million / $0.15 in Q1 2017 |
| Operating cash flow | $9.0 million provided | $6.7 million provided in Q1 2017 |
Management attributed higher earnings mainly to increased net interest income, a $0.7 million release of the loan-loss allowance, higher noninterest income, and lower noninterest expense. The $1.0 million increase in noninterest income included a $1.026 million bank-owned life insurance (BOLI) death benefit. The allowance release followed a recovery on a previously charged-off loan and no net loan growth since year-end. The adjusted efficiency ratio, a non-GAAP measure, was 60.50%, versus 66.97% in Q1 2017.
Financial condition, liquidity and capital
- Assets and loans: Total assets were $2.37 billion, down $16.9 million from year-end. Loans were $1.60 billion, down $15.8 million (1.0%) since year-end, as payoffs exceeded growth; loans were up 7.6% year over year. Commercial real estate, residential real estate and construction lending represented 77.6% of loans.
- Deposits and borrowings: Deposits rose $39.1 million to $1.96 billion. Total borrowings were $188.1 million, down from $246.6 million at year-end, principally reflecting a $70.0 million reduction in Federal Home Loan Bank advances. Repurchase agreements rose to $41.4 million; FHLB advances were $45.0 million.
- Cash and investing: Cash and cash equivalents were $47.9 million, down from $55.8 million at year-end. Investing activities provided $3.3 million, including $17.2 million of net loan paydowns, partly offset by net securities purchases.
- Credit quality: The allowance was $18.2 million, or 1.14% of average loans; net recoveries were $1.4 million. Nonperforming loans were reported as $12.8 million, and classified loans declined to $17.5 million from $23.3 million at year-end. OREO fell to $7.1 million from $8.4 million.
- Equity and regulatory capital: Stockholders’ equity was $204.0 million, up $3.7 million from year-end; accumulated other comprehensive loss increased by $5.1 million during the quarter, largely reflecting securities valuation changes. The Bank’s Tier 1 leverage ratio was 11.19% and total capital ratio 14.51%, above management’s stated 8% and 12% objectives.
Material changes, outlook and risks
- Net interest income growth reflected loan growth and higher rates, plus a 43-basis-point year-over-year increase in the average securities yield following a shift toward higher-yielding tax-exempt securities. The tax-equivalent margin increased 22 basis points year over year. Funding costs also rose, from 0.80% to 0.90%.
- The lower tax rate reflects the Tax Cuts and Jobs Act’s reduction of the federal corporate rate to 21%; a $483,000 tax benefit associated with vesting restricted stock also reduced Q1 tax expense. The 2017 fourth-quarter tax charge included the deferred-tax-asset impact of the law.
- On April 20, 2018, after quarter-end, the Company acquired Greater Chicago Financial Corp. and ABC Bank for $41.1 million and retired $6.6 million of the seller’s debentures. The transaction was funded with cash on hand. ABC Bank had four Chicago-area branches, $333.7 million of assets, $233.1 million of net loans and $250.5 million of deposits at March 31. Purchase accounting valuations were to be completed in Q2; Q1 acquisition costs were $246,000.
- Management said it believes the franchise is positioned for further growth, but provided no quantified earnings or revenue guidance. It cited competitive pressure on loan pricing and tighter underwriting standards. Integration, conversion costs, customer attrition and realization of expected merger benefits are identified risks.
- Other material risks include loan defaults and real-estate-market conditions, interest-rate and liquidity changes, competition, regulatory and capital requirements, technology/cybersecurity and vendor risks, and litigation. Management described interest-rate risk as moderate; its simulation estimated annual pre-tax income increases of 1.8% for an immediate 0.5% rate rise and decreases of 2.8% for a 0.5% decline. These are modeled sensitivities, not forecasts.
- Management reported effective disclosure controls and no material change in internal control over financial reporting during the quarter. It said there were no material changes to the risk factors in the 2017 Form 10-K.
Important facts for investors to verify
- Nonperforming-loan ratio inconsistency: The filing gives different ratios: the overview states 0.8% for Q1 2018 and Q1 2017, while the detailed asset-quality discussion states 1.2% at March 31, 2018 and 1.7% at March 31, 2017. The reported $12.8 million of nonperforming loans against $1.60 billion of loans implies approximately 0.8%; confirm the intended ratios and definitions.
- Assess whether the Q1 earnings increase is sustainable given the one-time BOLI death benefit, allowance release, tax benefit from restricted-stock vesting, and elevated recoveries.
- Monitor loan performance and real-estate concentration, allowance adequacy, and the extent to which the decline in classified assets and OREO continues.
- Review post-close acquisition accounting, integration costs, customer retention, and realized versus expected benefits from the Greater Chicago Financial transaction.
- Track deposit pricing and funding costs as rates rise, and the effect of securities fair-value losses on accumulated other comprehensive income and capital.