Sound Financial Bancorp, Inc. annual report, FY2019

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Sound Financial Bancorp, Inc. — FY2019 Form 10-K

Reporting period: Year ended December 31, 2019; filed March 12, 2020. This is an annual report, not a stand-alone fourth-quarter report. The company operates Sound Community Bank and serves western Washington, with lending concentrated in the Puget Sound region.

Financial performance and condition

  • Profitability: Net income was $6.68 million, down 5.1% from $7.04 million in 2018. Diluted EPS declined to $2.57 from $2.74. Return on assets was 0.95% (1.03% in 2018), and return on equity was 8.90% (10.24%).
  • Revenue and margins: Interest income rose 4.3% to $34.58 million, but interest expense increased 42.1% to $7.62 million. Net interest income fell 3.0% to $26.96 million; net interest margin narrowed to 4.06% from 4.28%. Noninterest income was $4.03 million, down 6.1%; noninterest expense was nearly unchanged at $22.79 million. The efficiency ratio worsened to 73.52% from 71.12%.
  • Credit costs: The company recorded a $125,000 allowance recapture, versus a $525,000 provision in 2018. Net charge-offs were $9,000. The allowance was $5.64 million, or 0.91% of gross loans, versus $5.77 million and 0.93% a year earlier.
  • Balance sheet: Assets were $719.9 million, up 0.4%; loans held for portfolio, net, were $614.2 million, essentially flat. Deposits rose 11.4% to $616.7 million, while FHLB borrowings fell 91.1% to $7.5 million. Stockholders’ equity increased 8.5% to $77.7 million.
  • Funding and liquidity: Cash and cash equivalents totaled $55.8 million, down $6.0 million. Cash and available-for-sale securities together were $65.1 million. The filing reports $217.8 million of remaining FHLB borrowing capacity, $41.7 million of Federal Reserve discount-window capacity, and $20 million of unused lines with other institutions, subject to collateral and facility terms.
  • Cash flow: Operating activities provided $11.1 million; investing activities used $5.8 million; financing activities used $11.3 million. Cash declined from $61.8 million to $55.8 million.
  • Capital: The Bank was classified as well-capitalized. At year-end, its leverage ratio was 10.22%, CET1 and Tier 1 risk-based ratios were 12.07%, and total risk-based capital was 13.04%. The capital conservation buffer was 5.04%.

Material changes versus 2018

  • Deposit growth, including a $59.6 million increase in certificates of deposit, helped reduce FHLB advances by $76.5 million. Deposit cost rose to 1.16% from 0.71%; the average cost of interest-bearing liabilities increased to 1.47% from 1.04%.
  • Loan mix continued shifting toward commercial and multifamily real estate and construction and land lending. Commercial and multifamily loans reached $261.3 million, up 3.4%; construction and land loans reached $75.8 million, up 16.1%. One-to-four-family loans fell 12.0% to $149.4 million, partly reflecting residential loan sales.
  • Nonperforming loans rose to $4.66 million from $2.67 million, and nonperforming assets increased to $5.23 million, or 0.73% of assets, from $3.24 million, or 0.45%. Performing restructured loans increased to $7.29 million from $1.97 million.
  • Mortgage loan sales increased to $78.9 million from $50.0 million; net gains on loan sales rose to $1.45 million from $1.04 million. Noninterest income was nonetheless lower, partly because 2018 included $490,000 from the sale of Visa B shares and the 2019 mortgage-servicing-rights fair-value adjustment was more negative.

Outlook, commentary, risks and unusual items

  • Management described local economic conditions as favorable, citing low unemployment and rising home prices, and stated its intent to pursue organic growth, relationship deposits, commercial lending and consumer products. The filing provides no specific earnings or financial guidance.
  • Key exposures include Washington-area economic and real-estate conditions; commercial real estate, construction and land credit risk; borrower and builder concentration; deposit competition and funding costs; and interest-rate movements. The five largest lending relationships totaled $55.6 million, or 8.9% of the loan portfolio.
  • Interest-rate sensitivity modeling showed estimated economic value of equity falling 22.45% under an immediate 200-basis-point rate decline, to an EVE ratio of 7.6%. Those results are outside the filing’s stated internal limits for that scenario (a maximum 20% decline and an 8% minimum EVE ratio); management nevertheless characterized overall interest-rate risk as acceptable. The model is hypothetical and depends on assumptions.
  • The filing highlights LIBOR transition risk, cybersecurity and third-party service-provider risks, and possible impacts from regulatory changes. It also notes the Federal Reserve’s March 2020 emergency rate cuts in response to coronavirus-related risks; these developments occurred after fiscal year-end.
  • Unfunded loan commitments totaled $86.0 million, including $40.2 million of construction commitments. Certificates of deposit totaling $86.6 million mature within one year. Deposits exceeding the FDIC insurance limit were a funding consideration; time deposits over $250,000 totaled approximately $78.3 million.
  • The company adopted lease accounting in 2019, recognizing $7.6 million of right-of-use assets and $8.0 million of lease liabilities. In January 2020, it declared a regular $0.15-per-share dividend and a special $0.20-per-share dividend. No securities impairment charge was recorded in 2019; $8,000 of unrealized losses remained on agency mortgage-backed securities.
  • Auditors issued an unqualified opinion on the financial statements and concluded internal control over financial reporting was effective. Management reported effective disclosure controls and no material control changes during the fourth quarter.

Important facts for investors to verify

  • Whether the rise in nonperforming loans, restructured loans and other loans of concern persists, and whether the allowance remains adequate as credit conditions change.
  • How commercial real-estate and construction exposures, including the largest borrower relationships and unfunded commitments, perform under weaker property or economic conditions.
  • Whether higher-cost certificate deposits renew or reprice, particularly the $86.6 million maturing within a year, and how deposit costs affect net interest margin.
  • The assumptions and internal-limit implications of the negative-200-basis-point EVE scenario, as well as the effect of subsequent interest-rate and economic developments.
  • Mortgage-servicing-rights valuation assumptions, loan-sale income and any potential repurchase or indemnification obligations on loans sold with representations and warranties.
  • The impact of coronavirus-related developments and any post-year-end events, regulatory changes or changes to planned dividends not reflected in the 2019 year-end results.