Arrow Financial Corporation — Q2 2011 Form 10-Q
Reporting period: Three and six months ended June 30, 2011. Arrow is a New York bank holding company with banking, insurance and investment-advisory businesses. Financial statements are unaudited; the independent accountant performed an interim review, not an audit. Unless stated otherwise, dollar amounts below are in millions.
Financial performance and position
| Metric | Q2 2011 | Q2 2010 | Six months 2011 | Six months 2010 |
|---|---|---|---|---|
| Net income | $5.849 | $5.714 | $11.130 | $11.129 |
| Diluted EPS | $0.51 | $0.50 | $0.98 | $0.98 |
| Net interest income, GAAP | $14.581 | $15.655 | $29.135 | $31.366 |
| Net interest margin, tax-equivalent | 3.35% | 3.70% | 3.37% | 3.75% |
| Noninterest income | $6.228 | $5.028 | $11.848 | $9.046 |
| Noninterest expense | $12.171 | $12.002 | $24.490 | $23.542 |
- Profitability: Q2 net income rose 2.4%; first-half net income was essentially unchanged. Q2 return on average assets was 1.20% and return on average equity was 14.51%, versus 1.22% and 15.38% a year earlier. First-half figures were 1.15% and 14.15%, respectively.
- Revenue and margins: Q2 tax-equivalent net interest income fell 5.9% as the 62-basis-point decline in earning-asset yield exceeded the 33-basis-point decline in funding cost. First-half tax-equivalent net interest income fell 6.3%. Higher insurance commissions and fiduciary income offset much of the pressure. The six-month efficiency ratio was 57.98%, up from 56.74%.
- Balance sheet at June 30: Assets were $1,901.8; deposits $1,541.9; gross loans $1,120.1; and stockholders’ equity $163.6. Compared with June 2010, assets increased 3.0% and deposits 7.1%, while loans declined 2.2%.
- Credit: Allowance for loan losses was $14.8, or 1.32% of loans. Nonperforming loans were $5.9 (0.52% of loans), up from $4.9 at year-end 2010; nonperforming assets were $5.9 (0.31% of assets). First-half net charge-offs were $0.259, down from $0.353 a year earlier. Management attributed the increase in nonperforming assets mainly to two residential loans and noted it did not expect losses on them.
- Cash flow and liquidity: First-half operating cash flow was $24.2, investing cash flow $31.5, and financing cash flow negative $29.5. Cash and cash equivalents increased $26.2 to $57.3. The company reported no material liquidity constraints. Available facilities included $30.0 of correspondent-bank lines, $72.5 of FHLB overnight capacity and $244.6 of Federal Reserve discount-window capacity, with no discount-window advances outstanding.
- Borrowings and capital: Period-end borrowings included $60.4 of repurchase agreements, $2.2 of other short-term borrowings, $90.0 of FHLB advances and $20.0 of trust preferred obligations. FHLB advances declined $40.0 from year-end. Arrow’s Tier 1 leverage, Tier 1 risk-based and total risk-based capital ratios were 8.67%, 14.76% and 16.02%; the company and both banks were classified as well-capitalized.
Material changes and notable items
- Insurance commissions rose to $1.815 in Q2 from $0.728, primarily reflecting insurance-agency acquisitions, including Upstate Agency in February 2011. On August 1, 2011, after quarter-end, Arrow completed another agency acquisition; its financial impact is not included in Q2 results.
- Loans declined $25.4 from year-end: commercial and commercial real estate balances grew, while residential real estate and auto balances decreased. Arrow sold $28.1 of residential mortgage originations in the first half.
- First-half equity increased $11.3, reflecting earnings, securities-related other comprehensive income and shares issued in an acquisition, partly offset by dividends and share repurchases. The quarterly dividend was $0.25 per share; the board authorized a new $5.0 share-repurchase program.
- Q2 FDIC assessment expense declined 45.5% year over year following the shift to an asset-based assessment method.
Outlook, risks and contingencies
- No earnings or revenue guidance is provided. Management expects continued pressure on net interest margins as asset yields may decline faster than deposit costs; it did not anticipate substantial near-term rate increases. The interest-rate model estimated net interest income would rise 0.47% under a 200-basis-point increase and fall 0.62% under a 100-basis-point decrease, subject to modeling assumptions and not a forecast.
- Management identified interest-rate risk as its most significant market risk. Other risks include a weakening regional economy, deterioration in loan quality, real-estate market weakness, competitive pressures, and regulatory changes under Dodd-Frank and proposed capital and liquidity standards. Management cautioned that actual results may differ materially from forward-looking statements.
- Arrow reported a $0.294 liability for its estimated share of remaining covered Visa litigation obligations; the amount is subject to change. It also had approximately $8.3 of standby letters of credit, most expiring within one year, some without collateral. Management reported no material pending legal proceedings.
- Management stated that securities with unrealized losses were considered temporarily impaired and that it did not intend, and was not more likely than not required, to sell them before recovery. A $0.017 other-than-temporary impairment was recorded on a held-to-maturity security in Q2.
Key investor verification points
- Track whether net interest margin and net interest income continue to contract, and how deposit costs respond to market rates.
- Review trends in nonperforming loans, residential delinquencies, the allowance and charge-offs, including the two residential loans cited by management.
- Assess the earnings contribution, integration costs and goodwill/intangible effects of insurance-agency acquisitions, including the August 2011 acquisition.
- Confirm liquidity availability, municipal-deposit seasonality and the pace of FHLB borrowing repayment.
- Monitor the Visa litigation estimate, standby-letter-of-credit exposure, and the effects of evolving regulatory capital, liquidity and fee rules.