Capitol Federal Financial, Inc. quarterly report, Q3 FY2013

Capitol Federal Financial, Inc. — Form 10-Q

Business context and period: Community-oriented savings institution focused on retail deposits and residential mortgage lending, with additional mortgage purchases, consumer and commercial real estate loans, and securities investments. This unaudited report covers the fiscal third quarter and nine months ended June 30, 2013; balance-sheet comparisons are to September 30, 2012.

Financial results and position

Metric	Quarter ended June 30, 2013	Nine months ended June 30, 2013
Net interest income	$44.4 million; prior year $46.2 million	$134.4 million; prior year $139.0 million
Net interest margin	1.96%; prior year 2.00%	1.98%; prior year 2.01%
Net income	$18.0 million; prior year $18.7 million	$53.3 million; prior year $56.8 million
Diluted EPS	$0.13; prior year $0.12	$0.37; prior year $0.35
Provision for credit losses	Negative $0.8 million, a credit to earnings; prior year nil	Negative $0.6 million; prior year expense of $2.0 million

Quarterly interest income declined 8.6% year over year to $73.7 million, while interest expense fell 15.1% to $29.3 million. Lower loan and securities yields continued to pressure margin; reduced funding costs partly offset the decline.
Nine-month non-interest income fell 4.7% to $17.5 million; non-interest expense rose 6.9% to $71.6 million. Increased compensation, technology, occupancy, regulatory services and advertising costs were partly offset by lower other expenses.
At June 30, assets were $9.24 billion, down $138.5 million from September 30. Net loans were $5.79 billion, up $184.5 million; securities totaled $2.99 billion, down approximately $307.9 million.
Deposits were $4.63 billion, up $77.8 million. FHLB borrowings were $2.61 billion and repurchase agreements were $290 million. Stockholders’ equity was $1.62 billion, down $182.0 million; equity was 17.6% of assets versus 19.3% at September 30.
Operating cash flow was $74.6 million for the nine months. Investing activities provided $84.0 million; financing activities used $169.0 million. Cash and cash equivalents declined $10.4 million to $131.3 million.

Changes, outlook and risks

Management attributed lower earnings year over year mainly to reduced net interest income and higher operating expenses. EPS rose despite lower net income, alongside a reduction in weighted-average shares following repurchases.
Credit indicators improved: non-performing loans declined to $26.4 million from $31.8 million; loans 30–89 days delinquent fell to $20.6 million from $23.3 million. Non-performing assets were $31.9 million, or 0.35% of assets, versus $39.9 million, or 0.43%. The allowance for credit losses was $9.2 million, 0.16% of loans; nine-month net charge-offs were $1.3 million.
The loan portfolio remains concentrated in one- to four-family residential mortgages, particularly Kansas and Missouri. Management identified economic conditions, unemployment, real estate values, loan performance and regulatory reviews as risks. The allowance estimate involves significant judgment.
Rising market yields reduced unrealized gains on available-for-sale securities; nine-month other comprehensive income included a $16.9 million after-tax loss, and AOCI fell to $7.3 million from $24.2 million. Management reported no other-than-temporary impairment at June 30.
Interest-rate sensitivity worsened: modeled net interest income over four quarters declines 2.25% under a +100 bp shock, 5.04% under +200 bp and 8.35% under +300 bp. Modeled market value of portfolio equity falls 11.99%, 25.27% and 38.18%, respectively. These are scenarios, not management earnings forecasts.
The Bank exceeded well-capitalized thresholds: Tier 1 leverage 14.7%, Tier 1 risk-based capital 36.0%, and total risk-based capital 36.3%. Management expected the Bank to remain well-capitalized under Basel III, while still evaluating its impact.
Management expected one new Kansas City-area branch in calendar 2013. It forecast higher fiscal 2013 expenses in compensation, technology/occupancy and advertising, partly offset by lower other expenses; it anticipated salaries and benefits to decline about $7.5 million in fiscal 2014, primarily due to lower ESOP expense. No earnings or revenue guidance was provided.
The company paid $136.1 million in dividends and repurchased $89.4 million of shares during the nine months. A new $175 million repurchase authorization was underway. Dividends depend on financial results, holding-company cash, and regulatory limits on Bank distributions.
Liquidity included $1.28 billion of FHLB excess borrowing capacity and $1.67 billion of eligible, unused securities collateral. Approximately $1.15 billion of certificates of deposit were due within one year. After quarter-end, a $100 million FHLB line of credit was replaced with an 84-month repurchase agreement at 2.53%; $45 million of repurchase agreements matured without replacement.
Commitments included $351.1 million to originate or purchase loans, $263.1 million of unused home-equity and commercial loan facilities, and $34.7 million of unadvanced construction loans. Management said routine pending litigation was not expected to have a material effect; no material changes to previously disclosed risk factors were reported.

Important facts for investors to verify

Whether loan and securities yields continue to decline faster than funding costs, and the resulting effect on net interest margin.
Whether improving delinquency and non-performing asset trends persist, and whether the $9.2 million allowance remains adequate as the portfolio grows.
Actual sensitivity to higher rates, including potential securities valuation effects and slower mortgage prepayments.
Funding costs and deposit retention as certificates mature, plus the post-quarter borrowing changes and remaining liquidity capacity.
The sustainability of dividends and repurchases given falling equity, regulatory distribution limits and the Bank’s capital needs.
Execution of the stated expense outlook, fiscal 2014 ESOP-related savings, and the planned branch opening.