Arrow Financial Corporation — Q2 2016 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2016. Arrow is a New York bank holding company operating two banks and related insurance, investment-advisory, and other businesses. Financial amounts below are in U.S. dollars; figures are unaudited unless noted.
Financial performance and position
- Q2 earnings: Net income was $6.65 million, up 5.4% from $6.31 million a year earlier. Diluted EPS was $0.51 versus $0.49. For the first half, net income was $13.20 million, up 8.5%, and diluted EPS was $1.01 versus $0.94.
- Net interest and margins: Q2 GAAP net interest income increased to $17.95 million from $16.16 million. Tax-equivalent net interest income, a non-GAAP measure, rose 10.4% to $19.06 million; net interest margin increased to 3.23% from 3.15%. First-half GAAP net interest income was $35.32 million versus $32.07 million; tax-equivalent margin was 3.21% versus 3.20%.
- Other income and expenses: Q2 noninterest income declined 3.4% to $7.19 million, while noninterest expense rose 3.5% to $14.88 million. The reported efficiency ratio improved to 56.72% from 57.94% (non-GAAP). First-half noninterest income was $14.07 million, down 1.6%; expenses were $29.26 million, up 3.2%; efficiency ratio improved to 56.55% from 58.15% (non-GAAP).
- Returns: Q2 annualized ROA was 1.07% and ROE was 11.98%, compared with 1.09% and 12.23%, respectively, a year earlier. First-half ROA was 1.07%; ROE was 12.02% versus 11.98%.
- Balance sheet and lending: Total assets were $2.54 billion at June 30, up 8.9% year over year. Loans were $1.67 billion, up 13.0% year over year and 6.3% since year-end 2015. Deposits totaled $2.07 billion, up 5.1% year over year. Stockholders’ equity was $225.4 million; tangible book value per share was $15.43 (non-GAAP), up from $14.10 a year earlier.
- Credit quality: The allowance for loan losses was $16.8 million, or 1.00% of loans. Q2 provision was $669,000 versus $70,000 in Q2 2015; first-half provision was $1.07 million versus $345,000. Nonperforming loans were $7.27 million, or 0.43% of loans; nonperforming assets were $8.20 million, or 0.32% of assets. Q2 net charge-offs were $158,000, or 0.04% of average loans on an annualized basis.
- Cash flow, funding, and liquidity: In the first half, operating cash flow was $15.0 million, investing cash outflow $77.6 million, and financing cash inflow $74.6 million; cash and cash equivalents ended at $63.1 million, up $12.0 million. Funding included $41.5 million of federal funds and repurchase agreements, $102 million of overnight FHLB advances, $55 million of FHLB term advances, and $20 million of junior subordinated obligations. Management reported a 10.7% basic liquidity ratio including FHLB collateralized borrowing capacity, versus its 4% internal minimum; unused FHLB capacity was approximately $228.2 million and Federal Reserve discount-window capacity approximately $348.8 million.
- Capital: Arrow reported a 12.74% CET1 ratio, 13.95% Tier 1 risk-based ratio, 14.96% total risk-based ratio, and 9.37% leverage ratio. The company and both banks exceeded applicable minimums and qualified as well-capitalized.
Material changes and notable items
- Loan growth, especially in commercial real estate and indirect auto lending, was a principal driver of higher average earning assets and net interest income. Consumer and business deposits also grew; the company supplemented deposit funding with increased overnight FHLB borrowing.
- Management said Q2 margin benefited in part from interest income recognized on a large nonaccrual commercial loan that was fully paid off during the quarter. It also cited a modest benefit from higher short-term rates following the Federal Reserve’s December 2015 increase.
- The higher loan-loss provision reflected growth in loans, increased adversely rated commercial real estate loans, charge-offs, and a higher economic-conditions factor, including uncertainty associated with Brexit. Classified substandard commercial and commercial real estate loans rose to $35.1 million from $24.6 million at year-end, primarily following downgrades of three commercial borrowers.
- Q2 securities gains were $144,000 pretax. The company reported no other-than-temporary impairment losses in the first half. Unrealized securities losses were attributed primarily to interest rates and market factors, not issuer credit deterioration, according to management.
- Insurance commissions were lower partly because the sports-insurance business of Loomis & LaPann was sold in October 2015. The company expected post-closing cash payments from 2016 to 2018.
- Cash dividends paid in the first half totaled $6.48 million, or $0.50 per share. The board declared a further $0.25-per-share dividend payable September 15, 2016. The 2016 repurchase program authorized up to $5 million; $494,000 was repurchased under the program in the first half.
Outlook, risks, and contingencies
- The filing gives no specific earnings or revenue guidance. Management described regional business conditions as reasonably sound but noted that future loan demand and credit quality could weaken if the economy deteriorates.
- Management highlighted persistent low long-term interest rates and the possibility of a flatter yield curve. It cautioned that deposit and other funding costs could reprice faster than earning assets in a rising-rate environment. A model scenario showed net interest income decreasing 3.28% under a hypothetical +200-basis-point shift and 0.94% under an adjusted -100-basis-point shift over 12 months; management stressed these are simulations, not forecasts.
- Risks include credit deterioration, interest-rate and market risk, competition, cybersecurity and service interruptions, regulatory changes, and seasonal or competitive fluctuations in municipal deposits. The company reported no liquidity problems during the period.
- Off-balance-sheet exposure included $292.8 million of commitments to extend credit and $3.1 million of standby letters of credit. Management said commitments commonly expire undrawn and did not expect material losses from them.
- The company disclosed potential indirect contingent exposure related to Visa litigation claims against former member banks; it believed Visa’s litigation escrow was sufficient and assigned no economic value to its Visa Class B shares. Management reported no material pending legal proceedings apart from ordinary-course matters.
- Arrow was evaluating the future effect of the new expected-credit-loss accounting standard, effective for it in 2020. Management did not expect material effects from several other recently issued accounting standards described in the filing.
Important facts for investors to verify
- Whether loan growth and net interest income continue without further material deterioration in commercial real estate or other credit quality.
- How the elevated Q2 provision, classified commercial exposures, and loan-loss allowance develop in subsequent quarters.
- Whether margin benefits from loan growth and the paid-off nonaccrual loan persist, particularly if funding costs rise faster than asset yields.
- The stability and cost of municipal deposits and the company’s increased reliance on overnight FHLB funding.
- Actual liquidity and regulatory capital trends, and any subsequent developments in Visa-related litigation or other contingencies.