1st Source Corporation — Q2 2018 Form 10-Q
Business context and reporting period
1st Source is an Indiana bank holding company providing banking, specialty finance, equipment rental, trust and wealth advisory, insurance, and related services. This unaudited filing covers the quarter and six months ended June 30, 2018; balance-sheet comparisons are to December 31, 2017. Amounts below are U.S. dollars unless noted.
Financial performance and position
| Metric | Q2 2018 | Q2 2017 | Six months 2018 | Six months 2017 |
|---|---|---|---|---|
| Net interest income | $53.2 million | $45.9 million | $103.7 million | $89.6 million |
| Provision for loan and lease losses | $4.8 million | $2.7 million | $8.6 million | $3.7 million |
| Noninterest income | $25.0 million | $24.1 million | $48.8 million | $47.4 million |
| Noninterest expense | $45.9 million | $41.1 million | $91.4 million | $82.2 million |
| Net income | $22.0 million | $16.7 million | $41.1 million | $32.9 million |
| Diluted EPS | $0.84 | $0.64 | $1.57 | $1.26 |
| Net interest margin, fully taxable-equivalent | 3.71% | 3.57% | 3.71% | 3.55% |
- Growth: Total assets were $6.32 billion, up 7.35% from year-end. Loans and leases totaled $4.84 billion, up 6.89%; deposits were $5.11 billion, up 7.48%. Management attributed loan growth principally to commercial and agricultural and construction-equipment lending.
- Margins and costs: For the first six months, average earning-asset yield rose to 4.40% from 4.03%, while the cost of average interest-bearing liabilities increased to 0.92% from 0.64%. The fully taxable-equivalent margin expanded 16 basis points.
- Credit: The allowance for loan and lease losses was $103.0 million, or 2.13% of loans and leases. Six-month net charge-offs were $0.5 million. Nonperforming assets rose to $44.4 million, or 0.89% of loans and leases, from $31.3 million and 0.67% at year-end; nonaccrual loans and leases increased to $34.6 million.
- Cash flow and liquidity: For the six months, operating cash flow was $69.8 million, investing cash outflow was $407.5 million, and financing cash inflow was $404.1 million. Cash and cash equivalents ended at $144.5 million, versus $78.0 million at year-end. Management reported $265 million of additional short-term bank borrowing capacity, $110.1 million of additional FHLB capacity, and $595.5 million of FRB capacity.
- Debt and capital: Short-term borrowings were $277.1 million; long-term debt and mandatorily redeemable securities were $71.2 million; subordinated notes were $58.8 million. Shareholders’ equity was $740.3 million and the equity-to-assets ratio was 11.71%. Regulatory capital ratios exceeded the filing’s stated minimums with capital buffer.
- Dividends: Cash dividends were $0.24 per share in Q2 and $0.46 per share for the first six months, versus $0.19 and $0.37, respectively, in 2017.
Material changes versus the prior comparable period
- Six-month net income rose about 25%; net interest income increased 16%, while noninterest income rose 3%. Lower income-tax expense helped results, partly offset by higher credit-loss provision and operating expenses.
- The effective tax rate for the first six months fell to 21.74% from 35.63%, primarily reflecting the federal corporate tax-rate reduction; a state tax settlement also benefited Q2 results.
- Credit indicators weakened: nonperforming assets increased 44% from year-end, and 30-days-or-more delinquencies were 0.54% of loans and leases versus 0.16% at June 2017. Management cited a large aircraft relationship placed on nonaccrual during Q2.
- Available-for-sale securities had $17.5 million of gross unrealized losses at June 30, compared with $7.5 million at year-end. The company reported a $8.4 million six-month other comprehensive loss, primarily from securities valuation changes.
Management commentary, risks, contingencies and unusual items
- Management said higher loan yields reflected rising rates and identified early-loan-payoff effects, including a $1.03 million unaccreted purchased-loan discount and prepayment penalty recognized during the first half. Deposit and borrowing costs also rose as rates increased.
- Management highlighted aircraft-portfolio concentration and foreign aircraft exposure of $223.9 million, including borrowers in Brazil and Mexico. It also cited increased special-attention credits, delinquencies and nonaccruals, as well as geopolitical, trade, and Latin American political and economic uncertainties.
- The company reported no formal earnings or revenue guidance. It said available funding sources were adequate for expected liquidity needs; this is management’s assessment, not a quantified forecast. Potential collateral requirements on public-fund deposits could create liquidity exposure of approximately $825 million if rules change.
- Management did not believe available-for-sale securities were impaired for credit reasons and said it did not intend, nor expect to be required, to sell them before recovery. A first-quarter portfolio repositioning following tax reform contributed to a $0.35 million net securities loss for the first half.
- A state tax settlement reduced unrecognized tax benefits by $1.05 million; the filing says the settlement produced a $0.80 million tax benefit in Q2. The company had not completed all accounting for the Tax Cuts and Jobs Act. It estimated $10–$20 million of right-of-use assets and lease liabilities upon adoption of the new lease standard in 2019.
- Loan commitments to extend credit totaled $1.02 billion; standby letters of credit were $30.9 million. Management said routine legal proceedings were not expected to have a material adverse effect. The filing reported no material changes to risk factors since the 2017 Form 10-K.
Important facts for investors to verify
- Whether aircraft and other portfolio deterioration continues, and how nonaccrual loans, delinquencies, repossessions and the allowance develop.
- Whether loan growth continues to support net interest income as deposit and wholesale funding costs rise.
- The drivers and sustainability of expense growth, particularly salaries, technology, professional fees and credit-collection costs.
- The eventual impact of tax-law estimates, the state settlement, and adoption of expected-credit-loss and lease accounting standards.
- Available liquidity and capital under stress, including contingent collateral needs and the company’s capacity to fund commitments.