1st Source Corporation — Q3 2020 Form 10-Q
Business context and period: Indiana-based bank holding company providing banking, specialty finance, equipment leasing, trust and wealth advisory, insurance, and mortgage services. This unaudited report covers the quarter and nine months ended September 30, 2020; balance-sheet comparisons are with December 31, 2019. Amounts below are U.S. dollars.
Financial performance and position
| Metric | Q3 2020 | Q3 2019 | Nine months 2020 | Nine months 2019 |
|---|---|---|---|---|
| Net interest income | $54.9 million | $57.2 million | $163.7 million | $168.6 million |
| Provision for loan and lease losses | $9.3 million | $3.7 million | $31.0 million | $12.9 million |
| Noninterest income | $28.0 million | $25.8 million | $77.9 million | $75.6 million |
| Noninterest expense | $47.0 million | $47.1 million | $138.4 million | $139.7 million |
| Net income available to common shareholders | $20.1 million | $24.4 million | $55.0 million | $70.0 million |
| Diluted EPS | $0.78 | $0.95 | $2.14 | $2.72 |
| Fully tax-equivalent net interest margin | 3.20% | 3.68% | 3.33% | 3.74% |
- Balance sheet at September 30: Total assets were $7.29 billion, up 10.1% from year-end 2019. Loans and leases were $5.63 billion, up 10.7%; deposits were $5.90 billion, up 10.1%. The loan increase was led by Paycheck Protection Program (PPP) lending.
- Credit reserves and asset quality: The loan and lease loss reserve was $136.8 million, or 2.43% of loans (2.69% excluding PPP loans), compared with $111.3 million at year-end. Nine-month net charge-offs were $5.5 million, or 0.13% of average loans. Nonperforming assets rose to $75.8 million (1.33% of loans and leases) from $19.2 million at year-end; nonaccrual loans and leases were $70.6 million.
- Cash flow, liquidity and funding: For the first nine months, operating activities provided $97.0 million; investing activities used $587.2 million; financing activities provided $561.0 million. Cash and cash equivalents ended at $154.2 million, versus $83.4 million at year-end. Management said funding sources were adequate. Available additional borrowing included $500.5 million from the FHLB, $456.5 million from the Federal Reserve and $225 million from bank relationships, subject to stated conditions.
- Debt and capital: Short-term borrowings were $165.6 million; long-term debt and mandatorily redeemable securities were $81.7 million; subordinated notes were $58.8 million. Common shareholders’ equity was $877.8 million and the shareholders’ equity-to-assets ratio was 12.04%. Corporation total capital and common equity Tier 1 ratios were 15.74% and 12.92%, respectively.
- Dividend: The company paid $0.28 per share in Q3; year-to-date dividends were $0.85 per share. Open-market share repurchases remained suspended due to COVID-19.
Material changes and management commentary
- Q3 common earnings fell about 18% year over year; nine-month earnings fell about 21%. Lower interest income and higher credit-loss provisions outweighed higher noninterest income. Nine-month return on average assets declined to 1.05% from 1.45%; return on average common equity declined to 8.52% from 11.83%.
- Lower market rates reduced asset yields, while lower deposit and borrowing costs provided a partial offset. Nine-month fully tax-equivalent net interest margin declined 41 basis points. Mortgage banking income increased substantially, supported by higher loan-sale volume and margins; equipment rental income declined with lower leasing volume.
- PPP lending totaled $597.5 million across 3,540 loans; the September 30 balance was $580.6 million net of unearned discount. The loans are SBA-guaranteed. Forgiveness applications were being processed, with most submitted requests still awaiting SBA review. The company had not used the PPP Liquidity Facility.
- COVID-related modifications still in deferment totaled $126 million at September 30, with another $69 million of modifications expected or being extended. Bus and hotel borrowers were particularly exposed: disclosed modification balances represented 50.85% of bus loans and 47.25% of hotel loans, including certain expected extensions. Management anticipated further bus-sector defaults and possible repossessions, and said bus collateral may take a long time to liquidate.
- Management reported rising special-attention and nonperforming balances, especially in bus lending, auto rental and construction equipment, and anticipated further downgrades into Q4 2020 and 2021. It increased COVID-related qualitative reserve factors for bus and non-owner-occupied commercial real estate, including hotels, offices and strip malls.
- Year-to-date mortgage servicing rights impairment was $0.8 million, attributed to lower rates and faster expected prepayments. Management said goodwill was not impaired in its first-, second- and third-quarter assessments, but future impairment charges remain possible if pandemic effects persist.
- The company delayed CECL adoption under CARES Act relief until the earlier of the end of the COVID-19 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 a further $0–$2 million allowance increase at adoption. Adoption was not expected to significantly affect regulatory capital ratios.
- Management identified pandemic impacts, borrower repayment capacity, collateral values, interest rates, economic and geopolitical conditions, and aircraft lending exposure—including foreign exposure in Brazil and Mexico—as risks. It provided no specific earnings or revenue guidance. Management said legal proceedings were not expected to materially adversely affect financial position or results.
Key facts for investors to verify
- Whether elevated nonperforming assets and reserve levels adequately reflect credit risk, particularly in bus, auto rental, hotel and construction equipment exposures.
- How many deferred loans resume payments, require further extensions, default, or result in charge-offs or repossessions; monitor the bus and hotel portfolios closely.
- The timing and outcomes of SBA review and reimbursement of PPP forgiveness applications, and the effect of PPP balances and fees on future interest income.
- The final CECL adoption date and actual allowance and unfunded-commitment adjustments, compared with the estimates disclosed.
- Whether lower interest rates continue to pressure net interest margin, and whether deposit growth and funding capacity remain durable as pandemic-related balances change.
- Any further mortgage servicing rights or other asset impairment, and any change in dividend or share-repurchase policy.