ISABELLA BANK CORP quarterly report, Q2 FY2018

Isabella Bank Corporation 10-Q Summary

Business context and reporting period

Isabella Bank Corporation is a Michigan-based bank holding company whose primary subsidiary, Isabella Bank, provides commercial, agricultural, residential real estate, consumer, investment and trust services primarily in central Michigan. This unaudited Form 10-Q covers the three and six months ended June 30, 2018, filed August 6, 2018. Dollar amounts are in thousands except per-share data.

Financial condition and key metrics

Metric	Three months ended June 30	Six months ended June 30
Net interest income	$11,972	$23,692
Provision for loan losses	$328	$712
Noninterest income	$2,736	$5,223
Noninterest expenses	$10,784	$20,880
Net income	$3,333	$6,795
Basic EPS	$0.42	$0.86
Diluted EPS	$0.41	$0.84
Cash dividends per share	$0.26	$0.52

Total assets were $1.837 billion at June 30, 2018, up 1.3% from December 31, 2017.
Gross loans were $1.152 billion, up $60.2 million, or 5.5%, from year-end; commercial loans increased 9.0% and consumer loans increased 9.2%.
Total deposits were $1.275 billion, up $9.5 million, or 0.8%, while borrowed funds increased $17.6 million to $362.5 million. Gross loans to deposits rose to 90.35% from 86.27% at year-end.
Available-for-sale securities declined $24.6 million to $524.1 million. Cash and cash equivalents declined $8.6 million to $22.2 million.
The allowance for loan and lease losses was $8.2 million, or 0.71% of gross loans, compared with $7.7 million and 0.71% at December 31, 2017.
Net interest margin yield on a fully taxable equivalent basis was 2.95% for both the quarter and six-month period, compared with 3.03% and 3.01%, respectively, in the comparable 2017 periods.
Return on average assets was 0.74% for the quarter and 0.75% year to date; return on average shareholders’ equity was 6.89% and 7.00%, respectively.
Shareholders’ equity was $191.9 million, or 10.45% of assets. The Bank reported a 12.11% common equity tier 1 ratio, 8.71% Tier 1 leverage ratio and 12.76% total risk-based capital ratio, and remained well capitalized.

Cash flow and liquidity

For the six months ended June 30, 2018, operating activities provided $10.9 million, investing activities used $44.4 million and financing activities provided $24.9 million.
Cash and cash equivalents decreased $8.6 million during the period, ending at $22.2 million, compared with $21.8 million at June 30, 2017.
Primary liquidity, consisting of cash and unencumbered AFS securities, totaled $256.4 million, or 13.96% of assets, down from $293.2 million, or 16.17%, at year-end.
The company reported $112.1 million of additional borrowing capacity based on pledged collateral.
Off-balance-sheet credit commitments totaled $211.8 million, including $164.4 million of unfunded lines of credit, $45.7 million of loan commitments and $1.6 million of letters of credit.

Material changes versus prior comparable periods

Six-month net income decreased 2.7% from $7.0 million to $6.8 million, and diluted EPS declined from $0.87 to $0.84. Second-quarter net income decreased 13.3% from $3.8 million to $3.3 million.
Six-month net interest income increased $1.2 million, or 5.3%, primarily because of loan growth. Interest income increased $2.5 million, but interest expense increased $1.3 million as deposit and borrowing costs rose.
The six-month provision for loan losses increased $676 thousand, from $36 thousand to $712 thousand, reflecting loan growth and higher credit costs.
Six-month noninterest income decreased 3.4%, primarily because mortgage loan sale gains declined $186 thousand and 2017 included $142 thousand of AFS securities gains. Trust and brokerage advisory fees increased $159 thousand.
Six-month noninterest expenses increased 7.3% to $20.9 million. Management cited higher employee benefits, technology and network-security spending, consulting fees related to tax strategies, and the absence of a $525 thousand insurance settlement recognized in 2017.
The effective federal corporate tax rate declined from 34% in 2017 to 21% in 2018 following the Tax Cuts and Jobs Act. Federal income tax expense declined to $528 thousand from $1.4 million despite lower pretax income.
Accumulated other comprehensive loss increased to $10.2 million from $2.6 million of loss at year-end, primarily because of $7.9 million of after-tax unrealized losses on AFS securities. Management attributed the losses to higher intermediate- and long-term interest rates rather than credit deterioration.
Nonperforming loans increased to $6.6 million, or 0.58% of gross loans, from $3.4 million, or 0.31%, at year-end. Nonperforming assets increased to $6.8 million, or 0.37% of assets.

Guidance, outlook, commentary and risks

Management expects continued loan growth in 2018, particularly in commercial and consumer lending, with modest growth expected in agricultural and residential real estate loans.
Management anticipates marginal improvement in net interest yield from Federal Reserve rate increases, a greater loan mix and growth in income-earning assets, but continues to expect pressure from low yields and higher funding costs.
Management expects investment and trust fee income to exceed 2017 levels and expects mortgage loan sale gains to increase during the remainder of 2018, although they may not exceed 2017 levels.
Management expects employee benefits, computer and network-security costs, and consulting fees to remain above 2017 levels.
Second-quarter charge-offs were elevated at $566 thousand, with management stating that most related to one borrower and were not indicative of a broader trend. Credit quality indicators nevertheless deteriorated and are being monitored.
Troubled debt restructurings totaled $27.8 million at June 30, 2018, compared with $26.2 million at year-end. The company reported no loans modified within the prior 12 months that subsequently defaulted.
The company is preparing for CECL adoption, effective for it in 2020. It has collected borrower and loan-level data, selected a software solution and expects to run parallel models during 2019. The eventual impact may be significant but was not quantified.
Key risks include interest-rate and liquidity risk, deposit flows, competition, economic conditions in the Michigan market, collateral values, credit quality, cyber-security, regulatory and tax changes, accounting changes and demand for financial services.
Interest-rate sensitivity was within Board-approved limits. A parallel 100-basis-point decline was estimated to reduce net interest income by 2.35% over 12 months and 2.66% over 24 months; a 100-basis-point increase was estimated to increase it by 1.39% and 1.45%, respectively.
No material legal proceedings or material changes to previously disclosed risk factors were reported. Disclosure controls and procedures were deemed effective.

Important facts for investors to verify

Whether rapid loan growth and the higher 90.35% loan-to-deposit ratio increase funding, liquidity or credit risk.
Whether the increase in nonperforming loans, past-due loans and commercial/agricultural credit exposure persists beyond the one-borrower charge-off cited by management.
The adequacy of the $8.2 million allowance as CECL implementation progresses and economic forecasts are incorporated.
The effect of rising deposit and borrowing costs on the 2.95% net interest margin.
The duration, credit quality and unrealized-loss exposure of the $524.1 million AFS securities portfolio.
The eventual balance-sheet and earnings impact of CECL, including results from the planned 2019 parallel models.
The sustainability of earnings after considering higher operating costs, lower mortgage and securities gains, and the benefit from the 21% tax rate.
Capital and liquidity trends after dividends, share repurchases and additional borrowing used to fund loan growth.