First Merchants Corporation — Q2 2011 Form 10-Q
Reporting period: Three and six months ended June 30, 2011; balance-sheet comparisons are with December 31, 2010. First Merchants is an Indiana-based community banking holding company operating primarily in Indiana and Ohio.
Financial performance and position
- Q2 earnings: Net income was $5.5 million and diluted EPS was $0.18; net income available to common shareholders was $4.5 million. A year earlier, common earnings were $8.3 million ($0.35 per diluted share), including a $10.1 million gain related to exchanging preferred stock for trust-preferred debt.
- First-half earnings: Net income was $10.9 million and diluted EPS was $0.35; common earnings were $9.0 million versus $8.4 million and $0.36 per share in 2010. The prior-year comparison also included the $10.1 million exchange gain.
- Net interest income and margin: Q2 net interest income was $35.8 million, down from $36.2 million. Fully taxable-equivalent net interest margin rose to 3.99% from 3.90%. For the first half, GAAP net interest income was $71.3 million versus $72.4 million, while FTE margin increased to 3.96% from 3.86%.
- Other income and expenses: Q2 other income was $11.1 million versus $10.9 million; first-half other income was $22.9 million versus $23.9 million. Other expenses were nearly flat in Q2 at $34.4 million and declined 1.0% year over year for the first half to $68.3 million.
- Credit costs: Q2 provision for loan losses was $5.6 million, down from $15.0 million; first-half provision was $11.2 million versus $28.9 million. Net charge-offs were $9.4 million in Q2 and $17.1 million for the first half. The allowance was $77.1 million, or 2.83% of loans, down from $83.0 million, or 2.90%, at year-end.
- Assets and lending: Total assets were $4.09 billion, down $76.6 million from year-end. Loans, including loans held for sale, declined $128.3 million (4.5%) amid runoff and lower consumer and commercial borrowing demand. Investment securities increased by approximately $111.6 million.
- Deposits, liquidity and debt: Deposits declined $126.3 million (3.9%) to $3.14 billion. Cash and cash equivalents were $50.9 million; cash plus interest-bearing deposits fell $56.8 million during the first half. Total borrowings were $447.8 million, up from $419.0 million. The Bank reported $183.7 million of remaining FHLB borrowing capacity.
- Cash flow: First-half operating cash flow was $57.5 million, investing cash flow was $34.7 million, and financing cash flow was negative $99.6 million. Cash and cash equivalents decreased $7.4 million to $50.9 million.
- Capital: Tangible common equity to tangible assets was 6.36%, up from 5.86% at year-end. The Corporation and Bank exceeded “well-capitalized” regulatory thresholds; the Bank’s total risk-based, Tier 1 risk-based and Tier 1 leverage ratios were 15.55%, 14.29% and 10.57%, respectively.
Changes, outlook and material risks
- Management attributed the margin improvement to funding costs falling faster than asset yields. First-half asset yields declined 31 basis points, while interest costs fell 41 basis points.
- Nonperforming assets plus loans at least 90 days delinquent were $109.5 million, or 2.7% of assets, down from $120.0 million, or 2.9%, at year-end. However, commercial and industrial nonaccrual loans increased to $21.1 million from $9.8 million.
- Q2 credit results included a $6.1 million recovery on a commercial and industrial relationship; seven customer charge-offs above $500,000 totaled $6.7 million. Management cited lower criticized loan balances, including an 11% decline in commercial substandard loans since year-end, in explaining the reduced provision.
- Management reported $5.6 million amortized cost and only $144,000 fair value for pooled trust-preferred securities. First-half OTTI credit losses were $0.4 million; management recognized no additional OTTI in Q2 and considered remaining declines temporary. The assessment depends on estimated cash flows and other Level 3 inputs.
- Debt covenant issue: At June 30 the Corporation failed the Bank of America credit facility’s minimum return-on-average-assets covenant of 0.75%. The lender applied a 3% default rate to the $5 million term loan but had not accelerated it. The $50 million subordinated debt has no covenant-based acceleration remedy under the agreement.
- The Bank had $79 million of FDIC-guaranteed senior notes maturing March 30, 2012. Management also cited deposit pricing and retention, credit quality, property values, interest-rate sensitivity, regulatory change (including Dodd-Frank), and the economy as risks. No specific earnings guidance was provided; management noted that first-half results are not necessarily indicative of full-year results.
- Management reported effective disclosure controls and no material changes in internal control over financial reporting. The filing reported no legal proceedings and no material changes to previously disclosed risk factors.
Most important facts for investors to verify
- How the Bank of America covenant breach and 3% default rate affect debt costs, compliance status and potential remedies.
- Whether the $79 million FDIC-guaranteed notes can be refinanced or repaid at their March 2012 maturity.
- Subsequent trends in nonaccrual commercial loans, criticized credits, charge-offs and the adequacy of the loan-loss allowance.
- Valuation and expected cash flows of the pooled trust-preferred securities, including any further impairment.
- Whether deposit outflows and loan contraction continue, and how redeployment into securities affects margin, liquidity and interest-rate risk.