1st Source Corporation — FY 2018 Form 10-K
Business context and reporting period. This annual report covers the year ended December 31, 2018, with comparative results for 2017 and 2016. 1st Source is an Indiana-based bank holding company offering commercial and consumer banking, trust and wealth services, insurance, and specialty equipment finance. At year-end 2018, it reported $6.29 billion in assets, $4.84 billion in loans and leases, and $5.12 billion in deposits.
Financial performance and position
- Earnings: Net income was $82.4 million, up 21.1% from $68.1 million in 2017; diluted EPS was $3.16 versus $2.60. Return on average assets was 1.34% and return on average common equity was 11.09%.
- Interest income and margins: Net interest income rose 15.2% to $213.9 million. Fully taxable-equivalent net interest margin increased to 3.73% from 3.57%. Higher loan yields and loan growth supported results, while funding costs also rose.
- Other income and costs: Noninterest income declined 1.7% to $97.1 million, including a $4.7 million swing from securities gains in 2017 to losses in 2018. Noninterest expense increased 7.2% to $186.5 million, led by salaries, technology-related costs, and leased-equipment depreciation.
- Credit costs: Provision for loan and lease losses increased to $19.5 million from $9.0 million. Net charge-offs rose to $13.9 million from $2.6 million, principally reflecting significant losses in aircraft and auto/light-truck financing. The allowance was $100.5 million, or 2.08% of loans and leases, versus $94.9 million, or 2.10%, a year earlier.
- Asset quality: Nonperforming assets increased to $35.3 million from $31.3 million; nonperforming loans and leases were 0.58% of loans and leases versus 0.44%. Management identified three auto/light-truck relationships totaling $4.2 million as potential problem loans.
- Funding, liquidity, and debt: Year-end deposits were $5.12 billion, up from $4.75 billion; short-term borrowings were $199.3 million, down from $214.6 million. Long-term debt and mandatorily redeemable securities were $71.1 million, and subordinated notes were $58.8 million. Management said the company met its internal liquidity guidelines and reported additional borrowing capacity from correspondent banks, the FHLB, and the Federal Reserve.
- Capital and equity: Shareholders’ equity was $762.1 million, compared with $718.5 million. The Bank was classified as well capitalized; its total risk-based capital ratio was 13.29% and common equity Tier 1 ratio was 12.00%. These exceeded stated regulatory thresholds.
- Cash flows: Operating activities provided $144.4 million; investing activities used $442.6 million, principally reflecting loan growth and securities purchases; financing activities provided $319.3 million, including deposit growth. Cash and cash equivalents increased by $21.0 million to $99.1 million.
Material changes versus prior periods
- Loan and lease balances grew 6.8% to $4.84 billion, with growth in commercial/agricultural, construction equipment, auto/light truck, and commercial real estate. Aircraft and medium/heavy-duty truck balances declined.
- Net interest margin improved as asset yields rose more than funding costs; average earning assets increased 9.7%.
- Credit losses increased sharply, with aircraft net charge-offs of $9.7 million and auto/light-truck net charge-offs of $3.2 million. The aircraft loss involved a syndicated account described as unusually large and complex; the auto/light-truck loss involved specialized collateral.
- Trust assets under management fell 14.9% to $3.94 billion, attributed to fourth-quarter market declines and the loss of a large employee benefit plan account.
- Common dividends increased to $0.96 per share from $0.76. The company repurchased approximately 201,000 shares during 2018.
Outlook, management commentary, risks, and unusual items
- Management described the U.S. economy as strong and forecast it to remain robust through at least the first half of 2019, while noting downside risks and uncertainty, including the government shutdown underway at year-end. It provided no specific earnings or revenue guidance.
- Management viewed commercial lending and solar financing opportunities positively, but highlighted agricultural borrower stress, aircraft-market and foreign-credit exposure, collateral-value volatility, and risks in transportation and construction-related businesses.
- The 2018 effective tax rate was 21.53%, down from 32.86%, principally reflecting the federal corporate tax rate reduction from 35% to 21%. 2018 tax expense included a $0.80 million state tax settlement benefit and a $0.88 million benefit from finalizing tax-reform estimates. The 2017 fourth-quarter comparison included a $2.61 million one-time tax benefit from deferred-tax revaluation.
- 2018 securities sales produced a $0.35 million net loss, mainly from portfolio repositioning following tax reform; 2017 included $4.34 million of net gains, including gains on marketable equity securities.
- The company warned that CECL, effective for it in 2020, could materially affect financial condition and results, but its adoption impact was not yet reasonably estimable. Other significant risks include interest-rate changes, credit deterioration, deposit or funding pressure, cyber incidents and third-party technology risk, regulation, and realization of tax benefits from tax-advantaged investments.
- Management said ordinary-course litigation was not expected to have a material effect. The independent auditor issued unqualified opinions on the financial statements and internal control over financial reporting; management also assessed controls as effective.
Most important facts for investors to verify
- Whether elevated aircraft and auto/light-truck credit losses are contained, and whether nonperforming assets and charge-offs continue to rise.
- Whether the $100.5 million loan-loss allowance adequately reflects portfolio growth, collateral risk, foreign exposure, and forthcoming CECL requirements.
- Whether loan growth and margin expansion persist as deposit costs rise and purchased-fund reliance increases.
- How trust assets under management, fee income, and earnings respond to market conditions and the loss of the employee benefit account.
- The expected impact of CECL adoption, tax-advantaged project performance and potential tax-credit recapture, and any changes in liquidity or regulatory capital.
- Whether the company’s stated liquidity capacity, including contingent borrowing sources, remains available under stress.