First Merchants Corporation — Q3 2020 Form 10-Q
Reporting period: Three and nine months ended September 30, 2020. First Merchants is an Indiana-based community banking company operating through First Merchants Bank across Indiana, Illinois, Ohio and Michigan. Unless noted, amounts below are in millions of dollars. Comparisons with 2019 are affected by the September 2019 MBT acquisition.
Financial performance and condition
| Metric | Q3 2020 | Q3 2019 | Nine months 2020 | Nine months 2019 |
|---|---|---|---|---|
| Net interest income | $92.9 | $88.9 | $279.8 | $259.1 |
| Provision for loan losses | $12.5 | $0.6 | $54.2 | $2.3 |
| Other income | $26.2 | $22.1 | $82.4 | $62.4 |
| Other expenses | $64.7 | $67.4 | $190.9 | $181.6 |
| Net income available to common shareholders | $36.2 | $36.8 | $103.5 | $116.6 |
| Diluted EPS | $0.67 | $0.71 | $1.91 | $2.32 |
- Revenue and margin: Net interest income plus other income was $119.1 million in Q3 and $362.3 million for the nine months. FTE net interest margin fell to 3.15% from 3.62% in Q3 and to 3.26% from 3.72% year to date. Lower market rates reduced asset yields, while management’s deposit and funding cost reductions partly offset the pressure. PPP loans reduced Q3 margin by an estimated 7 basis points.
- Balance sheet at September 30: Assets were $13.74 billion, up 10.3% from year-end 2019; loans were $9.24 billion, up $784.5 million, and deposits were $10.91 billion, up $1.07 billion. PPP loans totaled $901.4 million, net of deferred fees and costs.
- Credit quality: The allowance for loan losses was $126.7 million, or 1.37% of loans (1.52% excluding PPP loans), compared with $80.3 million and 0.95% at year-end. Nonperforming loans reached $59.4 million versus $16.8 million at year-end; nonperforming assets plus loans at least 90 days past due totaled $67.7 million. The filing cites commercial real estate relationships, including senior living and self-storage, as key contributors to increased nonaccruals.
- Cash flow and liquidity: Nine-month operating cash flow was $145.2 million; investing used $1.18 billion and financing provided $1.02 billion. Cash and cash equivalents ended at $164.6 million, down $12.6 million from year-end. Available-for-sale securities were $1.82 billion, and reported unused FHLB borrowing capacity was $690.3 million.
- Debt and capital: Borrowings totaled $785.6 million, compared with $732.7 million at year-end; this included $399.5 million of FHLB advances. The company and bank remained above regulatory well-capitalized thresholds. The company’s total risk-based capital ratio was 14.38%, CET1 was 12.02%, and tangible common equity to tangible assets was 9.57% (a non-GAAP measure). The company completed its $75 million share-repurchase authorization in Q1.
Material changes and notable items
- Q3 net income declined 1.5% and diluted EPS fell from $0.71 to $0.67; nine-month net income declined 11.3%. The substantially higher credit-loss provision was the principal pressure on earnings.
- Net interest income rose, but lower interest rates reduced FTE margin. Other income benefited from mortgage loan-sale activity, wealth fees and securities gains. Q3 card fees were pressured by the July 2020 implementation of the Durbin Amendment interchange cap; deposit service charges also fell as stimulus-related customer balances reduced overdraft and insufficient-funds fees.
- Q3 expenses were lower year over year partly because Q3 2019 included MBT acquisition-related costs. Nine-month expenses increased, reflecting the larger post-acquisition franchise, higher FDIC assessments and COVID-related costs, partly offset by prior-year acquisition expenses.
- Loan deferrals remaining at September 30 were $175.9 million across 179 loans; $92 million, or 52% of that balance, related to hotels. Management reported that a second COVID-related modification was processed on approximately $116 million of loans during Q3.
- The Bank had funded more than 5,200 PPP loans. Management expected most to be forgiven in whole or in part, subject to SBA program terms. At September 30, the Bank had no PPPL Facility borrowing outstanding.
Outlook, risks and contingencies
- The filing provides no specific earnings or revenue guidance. Management warned that pandemic duration, further economic restrictions, borrower performance, collateral values and market rates could materially affect credit costs, income and liquidity.
- CECL implementation was deferred under pandemic-related relief and was planned for Q4 2020. Management estimated that an adoption measured retrospectively from January 1, 2020 would increase the allowance by 55%–65% from December 31, 2019 levels, and estimated an approximately $18 million reserve for unfunded commitments. Management also expected to use available regulatory-capital transition relief.
- Management’s 12-month interest-rate simulation at September 30 estimated net interest income of $348.7 million in the base case, $367.5 million under an immediate 200-basis-point rise, and $352.2 million under a 100-basis-point decline. These are model scenarios, not forecasts.
- PPP risks include potential borrower or agent litigation and possible SBA denial or reduction of guarantees if loan origination, funding or servicing deficiencies are identified. COVID-related deferrals may also delay recognition of borrower stress.
- Other stated risks include interest-rate, credit, liquidity and economic risks; integration and regulatory risks; and compliance with a DOJ fair-lending settlement agreement and agreed order. Management said routine legal proceedings were not expected to have a material adverse effect.
- As a subsequent event, the Bank agreed on November 6, 2020 to acquire Hoosier Trust Company for $3.225 million cash, subject to regulatory approval, with closing expected in Q1 2021.
Important facts for investors to verify
- Progress and actual credit performance of the $175.9 million of remaining loan deferrals, particularly hotel exposures, and developments in the commercial real estate relationships moved to nonaccrual.
- Final Q4 2020 CECL adoption impact versus management’s estimates for the allowance and unfunded-commitment reserve, and the resulting effects on earnings and capital.
- PPP forgiveness progress and whether any SBA guarantee disputes, servicing issues or related litigation arise.
- Whether margin and earnings stabilize as deposit costs adjust, and the ongoing effects of low rates and the Durbin interchange cap.
- Capital and liquidity trends, including the use of FHLB capacity and the effect of the Hoosier Trust transaction; confirm that regulatory capital remains comfortably above applicable requirements.