FIRST BUSINESS FINANCIAL SERVICES, INC. annual report, FY2014

First Business Financial Services, Inc. — 2014 Form 10-K

Reporting period: Fiscal year ended December 31, 2014. The filing was signed March 6, 2015. The company is a commercial bank holding company serving small and midsize businesses, primarily in Wisconsin and, following its acquisition of Alterra Bank, the Kansas City area.

Business context and reporting period

The company operates through First Business Bank, First Business Bank-Milwaukee and Alterra Bank, with additional lending, equipment-finance, factoring, SBA, trust and treasury-management businesses. On November 1, 2014, it acquired Aslin Group and Alterra in a cash-and-stock transaction valued at $30.1 million. Alterra contributed about $2.5 million of 2014 revenue; its year-end assets were $258.8 million. The acquisition affected results for two months and is expected to have a greater effect in 2015.

Financial performance and condition

Metric	2014	2013
Total revenue (net interest income plus non-interest income)	$56.2 million	$50.5 million
Net interest income	$46.1 million	$42.1 million
Net interest margin	3.56%	3.54%
Net income	$14.1 million	$13.7 million
Diluted earnings per share	$3.51	$3.49
Return on average assets / equity	1.04% / 11.78%	1.10% / 13.12%
Operating cash flow	$11.9 million	$15.9 million

Net interest income rose 9.6%, supported mainly by loan and lease growth and lower funding costs; average earning-asset yield declined to 4.45% from 4.52%. Non-interest income increased 19.7% to $10.1 million, including higher trust fees and $392,000 of SBA loan-sale gains.
Provision for loan and lease losses was $1.2 million, versus a $959,000 provision release in 2013. Net charge-offs were 0.08% of average loans, compared with 0.06%.
Non-interest expense increased 11.2% to $33.8 million, reflecting higher compensation and professional fees, including $990,000 of identified Alterra transaction costs. The 2013 period included a $1.3 million charitable-foundation endowment.
At year-end, total assets were $1.629 billion, gross loans and leases $1.282 billion, deposits $1.438 billion, and stockholders’ equity $137.7 million. Assets increased 28.4% and net loans 31.0%, substantially reflecting the acquisition.
Commercial real estate loans were $811.8 million, or 63.3% of gross loans and leases. Commercial and industrial loans were $416.7 million, or 32.5%.
Nonperforming assets were $11.5 million, or 0.70% of assets, down from $16.2 million, or 1.28%, in 2013. Nonaccrual loans were 0.76% of gross loans; the allowance was $14.3 million, or 1.12% of gross loans and 146.3% of nonaccrual loans. Management attributed part of the lower allowance-to-loans ratio to acquired loans recorded at fair value without a carried-over allowance.
Cash and cash equivalents were $103.2 million; reported immediate on-balance-sheet liquidity was $290.8 million. In-market deposits were $1.011 billion at year-end. Wholesale deposits were $427.3 million, or 29.7% of deposits, within the company’s stated 75% limit and below its 50% operating goal.
Borrowings, including junior subordinated notes, totaled $44.3 million, versus $22.3 million in 2013. Year-end stockholders’ equity was 8.5% of assets. Consolidated regulatory capital ratios were 12.13% total capital to risk-weighted assets, 9.52% Tier 1 risk-based capital and 8.71% Tier 1 leverage; the Banks were reported as well-capitalized under the then-applicable framework.
Investing cash outflow was $332.7 million, largely from loan growth, securities activity and the Alterra acquisition; financing cash inflow was $342.8 million, primarily from deposit growth. Annual dividends declared rose to $0.84 per share from $0.56.

Material changes versus the prior comparable period

The Alterra acquisition expanded the company into Kansas City, adding approximately $250 million of assets, $200 million of gross loans and $210 million of deposits at transaction announcement/closing disclosures. The purchase accounting recognized $10.7 million of goodwill.
Revenue increased 11.2% and net income reached a record, but EPS was nearly flat as the company issued 360,081 shares for the acquisition. Returns on average assets and equity declined as the average asset and equity bases grew.
Asset quality measures improved, including lower nonperforming loans and assets; however, foreclosed properties increased to $1.7 million from $333,000, primarily due to Alterra-acquired properties.
Year-end deposits increased $308.4 million, while wholesale deposits rose in dollars but fell as a share of deposits. Net interest margin improved modestly despite lower loan yields.

Outlook, management commentary, risks and unusual items

Management’s 2015 priorities are maintaining asset quality, growing loans organically, building transaction and in-market deposits, increasing fee income from treasury management, trust and SBA lending, and investing in technology and people. No quantified earnings, revenue or margin guidance is provided.
Management expects continued loan growth, while emphasizing that it will not relax underwriting standards to pursue volume. It notes ongoing competitive pricing pressure and a prolonged low-rate environment.
Key risks include concentration in commercial real estate and commercial lending; borrower, collateral and regional economic deterioration; funding reliance on wholesale deposits; interest-rate and securities valuation risk; regulatory and Basel III requirements; and operational, cyber, third-party and acquisition-integration risks.
Interest-rate simulations estimated next-12-month net interest income changes of -1.27% for a 50-basis-point decline, +0.72% for a 100-basis-point increase, +4.19% for +200 basis points, +2.38% for +300, and +4.40% for +400. These are modeled sensitivities, not forecasts.
The company invested $7.5 million in a community development entity linked to federal new markets tax credits; it used $375,000 of credits in 2014. The remaining credits are subject to the investment and program qualification requirements, including potential recapture.
The company transferred $44.6 million of securities from available-for-sale to held-to-maturity in 2014; the $874,000 unrealized loss at transfer remains in equity and is amortized over the securities’ lives. No securities were reported as other-than-temporarily impaired at year-end.
James Ropella resumed the CFO role after David Papritz resigned in January 2015; the company was searching for a longer-term replacement. Management and the auditors reported effective internal control over financial reporting, but Alterra was excluded from the control assessment because of its recent acquisition. The financial-statement audit opinion was unqualified.
Management reported no litigation expected to have a material adverse effect. The company had $406.2 million in loan commitments and $17.6 million in standby letters of credit; it reported no accrued credit losses on these off-balance-sheet exposures.

Important facts for investors to verify

How Alterra’s results, integration costs, deposit base and asset quality develop in 2015; the acquisition’s full-year contribution was not reflected in 2014.
Whether loan growth can continue without weakening underwriting, especially given the 63.3% commercial real estate concentration and 9.5% construction and land-development share.
Whether the allowance remains adequate as acquired loans season; its year-end ratio was affected by acquisition accounting, and management cautioned that further provisions or charge-offs may be needed.
How funding costs and net interest margin respond to rate changes, competition, wholesale-deposit maturities and the company’s reliance on wholesale funding.
The effect of the CFO transition, completion of Alterra control integration, and the company’s ability to meet Basel III capital and liquidity requirements while sustaining dividends and growth.