OLD SECOND BANCORP INC quarterly report, Q3 FY2017

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Old Second Bancorp, Inc. — Q3 2017 Form 10-Q

Business context and period: Old Second Bancorp is an Illinois-based bank holding company providing commercial and retail banking, trust, and wealth-management services. This unaudited report covers the quarter and nine months ended September 30, 2017; balance-sheet comparisons are with December 31, 2016. Amounts below are in millions unless noted.

Financial performance and condition

  • Q3 earnings: Net income was $8.1 million, or $0.27 per diluted share, versus $3.5 million, or $0.12, in Q3 2016. Pretax income was $9.9 million versus $5.4 million.
  • Nine-month earnings: Net income was $17.7 million, or $0.59 per diluted share, versus $10.7 million, or $0.36, in the comparable 2016 period.
  • Net interest income and margin: Q3 GAAP net interest income rose to $19.3 million from $15.3 million. Tax-equivalent net interest margin was 3.77%, up 55 basis points year over year. For nine months, GAAP net interest income was $55.5 million versus $45.9 million; tax-equivalent margin was 3.68% versus 3.23%.
  • Noninterest income and expense: Q3 noninterest income was $7.8 million, up from $6.6 million; noninterest expense was $16.9 million, up from $16.6 million. The reported efficiency ratio was 57.66%, versus 66.21% a year earlier. Nine-month noninterest income was $22.2 million and expense was $53.0 million, compared with $20.1 million and $49.5 million, respectively.
  • Cash flow: Nine-month operating cash flow was $28.5 million, investing cash outflow was $105.7 million, and financing cash inflow was $77.3 million. Cash and cash equivalents ended at $47.5 million, little changed from $47.3 million at year-end 2016. The much higher September 2016 cash balance reflected funds held ahead of the Talmer branch purchase.
  • Balance sheet and funding: Total assets were $2.36 billion, up $109.2 million from year-end. Loans were $1.59 billion, up 7.8%; deposits were $1.89 billion, up 1.2%. Stockholders’ equity was $200.8 million, up from $175.2 million. Total borrowings were $253.5 million, versus $197.3 million, including $125.0 million of FHLB advances, up from $70.0 million.
  • Capital and liquidity: The Bank’s Tier 1 leverage ratio was 10.63% and total risk-based capital ratio was 13.52%; both exceeded management’s stated objectives of 8% and 12%, respectively. The Bank reported $74.5 million of excess collateral available to secure FHLB borrowings.
  • Credit quality: Nonperforming loans were $16.3 million, or 1.0% of total loans, versus $16.0 million and 1.1% at year-end 2016. The allowance for loan losses was $16.5 million. Q3 net recoveries were $0.3 million; classified loans were $23.7 million, down 10.4% from year-end. OREO declined to $9.0 million from $11.9 million at year-end, but Q3 included $0.9 million of valuation write-downs.

Material changes and drivers

  • Management attributed earnings growth largely to loan growth, improved asset yields, securities repositioning toward higher-yielding tax-exempt securities, and the October 2016 acquisition of Talmer’s Chicago branch. The acquisition added approximately $221 million of loans and $48.9 million of deposits.
  • Q3 securities results improved to a $0.1 million net gain from a $2.0 million net loss in Q3 2016; much of the prior-year loss was incurred to fund the Talmer acquisition. Trust income increased, while mortgage banking revenue declined as higher rates reduced originations and refinancing.
  • Higher employee costs contributed to expense growth. Q3 OREO expense also increased year over year, primarily due to valuation costs. The nine-month comparison additionally reflects increased loan and securities balances.
  • A $1.6 million nonrecurring tax benefit from the Illinois tax-rate increase raised the deferred tax asset and materially benefited reported earnings. Q3 income tax expense was $1.8 million and the effective tax rate was 18.5%, versus 34.7% a year earlier.

Outlook, risks, and unusual items

  • The filing provides no specific earnings or growth guidance. Management described local-market growth opportunities, strong loan production, and generally stable credit performance, while noting competitive pressure on loan pricing and stringent underwriting standards.
  • Management expects adoption of the revenue-recognition standard in 2018 to affect the method of recording some trust and asset-management fees, but does not expect a significant financial-statement impact. The company adopted a securities premium-amortization change in Q3 2017; management expects it to reduce quarterly net interest income by about 10 basis points until the remaining $25.0 million premium is amortized.
  • Interest-rate risk is material: the company’s simulation estimated annual pretax income would decline 6.5% with an immediate 1% rate decrease and increase 3.2% with a 1% increase. Management characterized current exposure as moderate; actual results may differ from the model.
  • Real-estate-related lending represented 78.6% of the loan portfolio. Management cautioned that actual loan and OREO losses could exceed estimates, including because of economic changes or collateral values. About 57.5% of OREO had been held for five years or more.
  • The company reported no material change in risk factors, no material adverse effect expected from ordinary-course legal proceedings, and effective disclosure controls as of September 30, 2017. The board declared a $0.01-per-share dividend after quarter-end.

Important facts for investors to verify

  • How much of earnings growth is sustainable after excluding the $1.6 million tax benefit and separating Talmer-related growth from organic growth.
  • Whether loan growth can continue without weakening underwriting, and how commercial real estate concentration, classified loans, and nonperforming loans evolve.
  • Whether further OREO valuation adjustments or collateral losses arise, particularly for long-held properties.
  • How higher funding costs, FHLB borrowing levels, and the expected securities-premium amortization affect net interest margin and earnings.
  • Whether modeled interest-rate sensitivity, capital ratios, and available borrowing collateral remain appropriate as rates and balance-sheet composition change.