First Commonwealth Financial Corporation — Q2 2016 Form 10-Q
Business context and period. The filing reports unaudited results for the three and six months ended June 30, 2016, compared with the corresponding 2015 periods. First Commonwealth is a bank holding company. Dollar amounts below are in millions unless otherwise noted.
Financial performance and position
| Metric | Q2 2016 | Q2 2015 | First half 2016 | First half 2015 |
|---|---|---|---|---|
| Net interest income, GAAP | $49.1 | $46.4 | $97.9 | $93.5 |
| Net interest income, fully taxable equivalent | $50.0 | $47.2 | $99.8 | $95.2 |
| Provision for credit losses | $10.4 | $3.0 | $16.9 | $4.2 |
| Noninterest income | $15.6 | $16.3 | $29.3 | $30.5 |
| Noninterest expense | $37.4 | $40.6 | $75.6 | $80.5 |
| Net income | $12.0 | $13.4 | $24.5 | $27.7 |
| Diluted EPS | $0.14 | $0.15 | $0.28 | $0.31 |
For the first half, net income declined about 12% year over year; Q2 net income declined about 11%. Net interest margin on a fully taxable equivalent basis was 3.27% for Q2 and 3.28% for the first half, versus 3.26% and 3.30%, respectively, in 2015. First-half return on average assets was 0.74% and return on average equity was 6.70%, compared with 0.88% and 7.80%.
- Balance sheet at June 30: Total assets were $6,749.8; portfolio loans were $4,843.8, with net loans of $4,784.0; deposits were $4,394.5; and shareholders’ equity was $741.8. From December 31, 2015, assets increased $182.9, portfolio loans increased $160.0, and deposits increased $198.6.
- Funding and debt: Short-term borrowings were $1,464.7, subordinated debentures $72.2, and other long-term debt $9.0. Deposits grew principally in interest-bearing demand and savings accounts, while time deposits declined.
- Cash flows, first half: Operating activities provided $37.5; investing activities used $147.6, including a $173.8 net increase in loans; financing activities provided $139.3. Cash and cash equivalents rose $29.2 to $98.6.
- Credit: The allowance for credit losses was $59.8, or 1.24% of loans, versus $50.8, or 1.08%, at year-end 2015. Nonperforming loans were $64.4, or 1.33% of loans, compared with $50.8, or 1.09%, at year-end. First-half net charge-offs were $7.9, down from $10.9 in 2015.
- Capital and shareholder returns: The company and its bank subsidiary met applicable capital requirements and were considered well-capitalized. The first-half dividend declared was $0.14 per share. Shareholders’ equity increased $22.2 from year-end.
Material changes versus the prior comparable period
- Credit-loss provision rose sharply: $16.9 for the first half versus $4.2 in 2015. Management cited specific reserves for commercial relationships, higher historical loss factors and changes to certain qualitative assumptions.
- Net interest income increased, primarily as average interest-earning assets grew. Average loans rose 7% in the first half. The first-half net interest margin nevertheless eased by two basis points as the cost of interest-bearing liabilities increased.
- Noninterest expense declined 6% in the first half, including lower salaries and employee benefits, occupancy costs and asset write-downs. Data-processing costs increased, partly due to chip debit card issuance.
- Noninterest income declined 4% in the first half. A negative derivative mark-to-market adjustment was a major factor; management said it reflected fair-value changes, not an actual loss on the swaps. Mortgage loan sale gains increased.
Outlook, risks, contingencies and unusual items
- The filing provides no quantified earnings or revenue guidance. Management cautioned that interim results are not necessarily indicative of full-year 2016 results.
- Management identified credit quality as a key concern. Nonperforming loans increased, including new commercial relationships in steel and aluminum servicing and coal-related businesses. Commercial, financial and agricultural loans drove much of the first-half provision. Management considered the allowance adequate, but noted estimates may change with economic conditions, interest rates, borrower performance and collateral values.
- Oil and gas industry exposure was $137.5 in commitments, with $67.2 outstanding. Some ancillary-business and energy-related relationships were nonperforming; management described potential effects from lower drilling activity.
- Interest-rate sensitivity modeling showed that an immediate 100-basis-point increase could raise estimated 12-month net interest income by 1.60%, while a 100-basis-point decrease could lower it by 4.05%. Management cautioned that the model depends on assumptions and is less reliable in declining-rate scenarios.
- On July 27, 2016, the company announced an agreement to acquire 13 Ohio branches from FirstMerit, with approximately $735 in deposits and $115 in performing loans. Closing was expected in Q4 2016, subject to regulatory approval. The company suspended its $25 million share repurchase program in July, citing the acquisition as a better use of capital.
- A putative class action concerning vehicle repossession practices remained pending. The parties reached an agreement in principle to settle during Q2; the estimated settlement cost was accrued, but the filing does not state its amount. Management estimated reasonably possible aggregate litigation losses beyond recorded liabilities of $0–$7.
- The available-for-sale portfolio included pooled trust-preferred securities with a $42.8 book value and $33.7 fair value; these below-investment-grade, illiquid securities accounted for most unrealized losses. No other-than-temporary impairment charges were recorded in the first half, but the filing notes future impairment remains possible.
- Management reported disclosure controls were effective and no material changes to internal control over financial reporting during the quarter. The filing reported no material change in risk factors from the 2015 Form 10-K.
Most important facts for investors to verify
- Whether elevated commercial credit provisions and the rise in nonperforming loans persist, and whether collateral valuations support the recorded allowance.
- The final terms, court approval and total cost of the vehicle-repossession settlement.
- Regulatory approval, timing, funding and expected financial impact of the Ohio branch acquisition.
- Whether deposit growth and loan growth can sustain net interest income as funding costs and interest rates change.
- Future valuation, cash-flow assumptions and impairment risk for pooled trust-preferred securities, as well as the company’s capital and liquidity after the acquisition.