FIRST BUSINESS FINANCIAL SERVICES, INC. quarterly report, Q2 FY2017

Full document

Business context and reporting period

First Business Financial Services, Inc. is a commercial bank holding company serving businesses and individuals primarily in Wisconsin and the greater Kansas City market, with trust and investment services. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2017; comparisons are to the corresponding 2016 periods unless otherwise noted. Effective June 1, 2017, the company consolidated its three bank charters and rebranded Alterra Bank as First Business Bank.

Financial performance and position

  • Revenue and earnings: Second-quarter net interest income was $15.5 million, down 1.7%; non-interest income was $4.7 million, down 18.6%; and total top-line revenue was $20.2 million, down 6.2%. Net income fell to $1.9 million from $3.7 million, and diluted EPS to $0.22 from $0.43. For the first half, revenue was $39.2 million, down 6.1%; net income was $5.3 million versus $8.3 million; diluted EPS was $0.61 versus $0.95.
  • Margins and returns: Net interest margin was 3.64% for Q2, up 5 basis points year over year, and 3.58% for the first half, down 1 basis point. Annualized ROAA and ROAE were 0.42% and 4.50% in Q2 (0.82% and 9.45% in Q2 2016); first-half figures were 0.59% and 6.38% (0.91% and 10.57%). The efficiency ratio increased to 65.39% in Q2 and 68.03% for the first half.
  • Credit costs: Provision for loan and lease losses was $3.7 million in Q2 and $4.2 million for the first half, versus $2.8 million and $3.3 million, respectively, a year earlier. First-half net charge-offs were $3.5 million, or 0.47% annualized of average loans, versus $1.4 million, or 0.20%.
  • Balance sheet: Assets were $1.769 billion at June 30, down $11.8 million from year-end. Gross loans and leases were $1.459 billion, up $7.6 million; deposits were $1.475 billion, down $64.3 million. Stockholders’ equity was $165.2 million.
  • Debt and liquidity: FHLB advances and other borrowings were $106.4 million and junior subordinated notes were $10.0 million at quarter-end. The borrowing note reports total borrowed funds of $116.4 million, including $23.7 million in subordinated notes. Cash and equivalents were $63.7 million, down from $77.5 million at year-end. Management reported immediate on-balance-sheet liquidity of $412.8 million, down from $543.1 million. First-half operating cash flow was $9.1 million; investing cash flow was negative $3.2 million and financing cash flow negative $19.7 million.
  • Capital and shareholder returns: The company and Bank remained well capitalized. Consolidated total capital, Tier 1, common equity Tier 1 and leverage ratios were 11.91%, 9.33%, 8.77% and 9.28%, respectively. First-half dividends declared were $0.26 per share.

Material changes versus prior periods

  • Earnings and revenue declined, primarily reflecting sharply lower SBA loan-sale gains following the decision to rebuild the SBA platform, softer commercial loan demand, and a shift toward lower-yielding conventional commercial loans.
  • Trust and investment services income rose 22.6% in Q2 and 25.2% for the first half. Q2 SBA loan-sale gains fell 74.9%; first-half gains fell 74.5%.
  • Non-performing assets increased to $39.7 million from $26.7 million at year-end; non-accrual loans and leases rose to $37.2 million from $25.2 million. The allowance was $21.7 million, or 1.49% of gross loans, compared with 1.44% at year-end; allowance coverage of non-accrual loans fell to 58.33% from 83.00%.
  • Deposits contracted as the company reduced wholesale deposits; FHLB advances and other borrowings increased. Loan growth was modest, with multifamily loans increasing and commercial and industrial loans declining.
  • Operating expenses rose 5.7% in Q2 and 6.2% for the first half, including higher SBA recourse provision and costs related to rebranding, charter consolidation, technology investment and FDIC insurance.

Outlook, commentary, risks and contingencies

  • Management expects net interest margin of 3.50% or better and modest loan growth, while noting that loan fees, non-accrual recoveries and deposit flows can make margin volatile.
  • Management expects SBA production to resume modestly in late 2017 and 2018. It targets an efficiency ratio of 58%–62% over the long term and expects the charter consolidation and planned core-system conversion to support efficiency and earnings growth in 2018 and beyond. These are expectations, not assurances.
  • The company recorded a $3.7 million specific reserve related to a $6.7 million Wisconsin commercial and industrial impaired loan and charged off $3.4 million tied to its remaining energy-sector exposure. Management cautioned that further charge-offs and provisions may occur.
  • The SBA recourse reserve was $1.7 million at quarter-end after a $780,000 first-half provision and $795,000 in net charge-offs. SBA repurchase, guaranty reduction or loss-recovery exposure may arise if the SBA finds origination, funding or servicing deficiencies.
  • Other stated risks include competition, economic deterioration, borrower defaults, interest-rate and market changes, growth execution, regulatory and tax changes, fraud and cybersecurity, and compliance with SBA requirements. Management did not expect ordinary-course legal proceedings to have a material adverse effect. No material risk-factor changes were reported.
  • Management said the company was in compliance with debt covenants, had adequate liquidity and capital, and had no significant subsequent events requiring adjustment or disclosure. The Bank declared a $3.5 million dividend on July 26, 2017.

Important facts for investors to verify

  1. Whether problem credits, non-accrual balances, charge-offs and specific reserves stabilize or worsen, especially the impaired C&I and energy exposures.
  2. Whether SBA lending production and loan-sale gains recover as planned, and whether SBA recourse costs remain volatile.
  3. Whether loan growth, funding mix and interest-rate changes support management’s 3.50% net interest margin expectation without putting pressure on funding costs.
  4. Whether charter consolidation and core-system conversion deliver the anticipated operating efficiencies, and whether expenses move toward the 58%–62% efficiency-ratio goal.
  5. How the $64.3 million deposit decline, increased borrowings and reduced reported on-balance-sheet liquidity evolve; confirm the company’s liquidity and funding capacity against its stated needs.