Independent Bank Corporation — Q2 2011 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2011. The Michigan-based bank holding company reports two principal segments: Independent Bank and Mepco Finance Corporation. Dollar figures below are in millions unless stated otherwise.
Financial performance and condition
- Q2 earnings: Net income was $0.04 million, but preferred dividends and discount accretion resulted in a $1.01 million loss applicable to common stock, or $0.12 loss per share. Q2 2010 net income was $7.88 million, including an $18.09 million gain on debt extinguishment; common income was $6.77 million.
- First-half earnings: Net loss was $7.36 million, versus a $5.95 million loss in first-half 2010. Loss applicable to common stock was $9.42 million, versus $8.14 million.
- Interest and other income: Q2 net interest income was $23.38 million, down 18.2%; first-half net interest income was $47.83 million, down 18.4%. Net interest margin was 4.36% in Q2 (4.38% in Q2 2010) and 4.35% for the first half (4.41% in first-half 2010). Non-interest income was $12.46 million in Q2 and $25.17 million for the first half; prior-year comparisons were elevated by the debt-extinguishment gain.
- Credit costs and expenses: Provision for loan losses was $4.38 million in Q2 and $15.45 million for the first half, down from $12.68 million and $29.69 million, respectively, a year earlier. Non-interest expense fell 15.7% to $31.68 million in Q2 and 15.5% to $65.18 million for the first half.
- Cash flow: First-half operating cash flow was $37.72 million and investing cash flow was $110.78 million; financing used $213.08 million. Cash and cash equivalents declined $64.59 million to $320.78 million.
- Balance sheet at June 30: Assets were $2.318 billion, down $217.64 million from year-end 2010. Portfolio loans were $1.676 billion, down 7.6%; deposits were $2.065 billion, down $187.15 million. Cash and cash equivalents were $320.78 million, including $262.11 million of interest-bearing deposits. Other borrowings were $40.91 million, down from $71.03 million; subordinated debentures were $50.18 million.
- Capital and liquidity: Shareholders’ equity was $114.44 million, compared with $119.09 million at year-end. Tangible common equity was $28.4 million and tangible common equity to tangible assets was 1.23%. The Bank’s total capital/risk-weighted assets ratio was 11.45% and Tier 1 capital/average assets was 6.96%. It met federal “well-capitalized” standards, but fell short of its Board’s 8.00% Tier 1 leverage target; it met the Board’s 11.00% total-capital target.
- Asset quality: Non-performing loans were $53.72 million, down from $67.58 million at year-end; non-performing assets were $91.32 million, or 3.94% of assets. The allowance for loan losses was $61.12 million, equal to 3.65% of portfolio loans and 113.77% of non-performing loans. First-half annualized net charge-offs were 2.58% of average loans, versus 3.33% a year earlier. Performing troubled debt restructurings totaled $108.12 million.
Material changes and management commentary
- Management attributed lower net interest income mainly to shrinking earning assets, reduced higher-yielding loans and Mepco receivables, and maintaining substantial low-yield cash for liquidity. In Q2, approximately $158.2 million of cash was used to repay brokered CDs; related accelerated issuance-cost amortization was $0.6 million.
- Management said lower loan-loss provisions and operating expenses improved underlying Q2 results compared with 2010, excluding the prior-year debt-extinguishment gain. Non-performing loans and charge-offs declined, though credit costs remained elevated.
- Mepco’s payment-plan receivables fell to $155.4 million from $201.3 million at year-end. The segment recorded a first-half loss of $0.58 million, compared with income of $1.15 million in 2010, primarily reflecting reduced business and lower net interest income.
- Mepco recorded $3.66 million of first-half counterparty-contingency expense. A bankrupt counterparty owed Mepco $51.1 million for cancelled plans; net receivables from that counterparty were $27.7 million, and the related reserve was $23.4 million. Management considered the reserve adequate but cautioned actual losses could exceed amounts reserved.
- Available-for-sale securities had $4.55 million of gross unrealized losses at June 30. Two below-investment-grade private-label mortgage securities were identified as other-than-temporarily impaired; first-half net impairment charges recognized in earnings were approximately $0.14 million.
Outlook, risks and contingencies
- Management expected a net loss for 2011, citing continuing credit costs and lower net interest income, and projected a return to profitability in 2012 as credit costs abate. It believed the Bank could remain federally well-capitalized without new capital, principally through further balance-sheet contraction. These are forward-looking estimates and may not be achieved.
- The capital plan targets Board minimum ratios through at least 2012. Management was reassessing the timing and size of a possible common-stock offering. A Dutchess equity line provides up to $15 million over the agreement term; the company had received $1.8 million in net proceeds through June 30, 2011. Capital raising could dilute shareholders and potentially limit use of approximately $70.6 million of federal loss carryforwards under ownership-change rules.
- Cash dividends on common and preferred stock and distributions on trust preferred securities remained suspended; subordinated-debt interest was deferred. Preferred dividends in arrears were reported as $4.1 million in Part II and accrued preferred dividends as $4.6 million in the notes. The filing does not reconcile these amounts clearly. The U.S. Treasury could elect two directors if the specified dividend arrearage conditions continued; it had requested a Board observer beginning in Q3 2011.
- Key risks include Michigan economic and real-estate conditions, further loan losses, Mepco counterparty defaults and collection shortfalls, access to wholesale funding and deposits, and regulatory capital constraints. If the Bank ceased to qualify as well-capitalized, brokered-CD access could be restricted and Fannie Mae or Freddie Mac could require transfer or sale of mortgage servicing rights. Management also cited possible effects of Dodd-Frank and potential Nasdaq delisting.
- Uninsured deposits were $114.9 million; another $141.8 million of non-interest-bearing transaction deposits had temporary unlimited insurance through December 31, 2012. Of $90.4 million in brokered CDs, $30.5 million matured within twelve months. The company reported up to $0.3 million of reasonably possible litigation losses above accrued amounts; it considered currently accrued litigation losses immaterial.
Important facts for investors to verify
- Progress toward the Board’s 8.00% Tier 1 leverage target, federal capital requirements, and the capital-restoration plan.
- Quarterly loan performance, allowance adequacy, charge-offs, TDR trends, and Michigan commercial and residential real-estate exposure.
- Recoveries from the bankrupt Mepco counterparty, the adequacy of the $23.4 million reserve, and collectability of Mepco’s $40.8 million net counterparty receivables.
- Deposit retention, brokered-CD maturities, wholesale funding availability, and maintenance of liquidity as the balance sheet contracts.
- Whether the 2011 loss and 2012 profitability outlook remain achievable, and the implications of any equity issuance for dilution and tax-loss carryforwards.
- The preferred-dividend arrearage discrepancy: $4.1 million in Part II versus $4.6 million accrued in the financial-statement notes.