First Merchants Corporation — Q3 2017 Form 10-Q
Reporting period: Three and nine months ended September 30, 2017. First Merchants is an Indiana-based community banking holding company. Amounts below are in millions except per-share data and ratios.
Business context and material changes
The company completed two acquisitions: Arlington Bank on May 19 and Independent Alliance Banks (IAB) on July 14, 2017. The acquisitions expanded its footprint into Columbus, Ohio and Fort Wayne, Indiana and materially increased the balance sheet. Assets were $9.05 billion at September 30, up 25.5% from year-end 2016; management attributed most of the increase to the acquisitions and also cited organic loan growth. The company issued approximately 8.0 million common shares in the transactions.
Financial results and position
| Metric | Q3 2017 | Q3 2016 | Nine months 2017 | Nine months 2016 |
|---|---|---|---|---|
| Total revenue (net interest income plus other income) | $93.1 | $74.5 | $250.5 | $217.2 |
| Net interest income | $74.4 | $57.7 | $198.5 | $168.1 |
| Net income available to common shareholders | $24.4 | $21.1 | $71.7 | $58.8 |
| Diluted earnings per share | $0.50 | $0.51 | $1.63 | $1.43 |
| Provision for loan losses | $2.1 | $1.9 | $7.3 | $3.2 |
| Net interest margin, FTE | 4.03% | 3.94% | 3.98% | 3.88% |
- Quarterly net income rose about 15.7%, while diluted EPS declined from $0.51 to $0.50, reflecting acquisition costs and a larger share count. Nine-month net income increased about 22%; diluted EPS increased 14%.
- Non-interest expense was $58.7 million in Q3, up 33.1% year over year. Management reported $7.9 million of Q3 acquisition-related expenses, primarily associated with IAB; nine-month acquisition-related expenses totaled $10.8 million, or $0.16 per share.
- At September 30, total loans were $6.48 billion, net loans $6.41 billion, deposits $6.91 billion, and total borrowings $788.6 million. Borrowings increased $94.4 million from year-end, principally due to higher FHLB advances.
- Cash and cash equivalents were $146.6 million, versus $127.9 million at year-end. For the nine months, operating cash flow was $79.4 million, investing cash outflow $307.8 million, and financing cash inflow $247.1 million.
- The allowance for loan losses was $73.4 million, or 1.13% of loans, and covered non-accrual loans 227.4%. Non-accrual loans were $32.3 million; non-performing assets plus loans 90 days past due and accruing totaled $45.2 million.
- Regulatory capital remained above applicable well-capitalized thresholds at the Bank: total risk-based capital 13.22%, Tier 1 risk-based capital 12.25%, CET1 12.25%, and Tier 1 leverage 11.10%. The company reported tangible common equity to tangible assets of 9.39%.
Outlook, commentary, and risks
Management said acquisition-related earning-asset growth, organic loan growth, and recent Federal Reserve rate increases supported higher net interest income and margin. The acquisitions were undertaken with the expectation of being accretive, but the filing provides no specific forward earnings guidance. Management’s rate-sensitivity model estimated 12-month net interest income of $289.1 million in its base case, 8.87% higher under an immediate 200-basis-point increase and 8.35% lower under a 100-basis-point decline; these are scenarios, not forecasts.
- Key stated risks include interest-rate and funding-cost changes, adverse economic conditions and credit deterioration, acquisition integration, competition, regulatory changes, and the availability of earnings and capital to support dividends.
- Loan commitments and standby/commercial letters of credit totaled $2.74 billion; the company noted that commitments may expire unused or be only partially drawn. Remaining FHLB borrowing capacity was $648.5 million.
- Management considered securities with unrealized losses temporarily impaired, primarily due to interest-rate changes, and said it did not intend or expect to be required to sell them before recovery. Gross unrealized losses were $5.7 million at quarter-end.
- The company stated that ordinary-course litigation and regulatory examinations were not expected to have a material adverse effect. It reported effective disclosure controls and no material change in internal control over financial reporting.
- Management was evaluating the expected-credit-loss (CECL) standard, with adoption planned for 2020; the eventual financial impact could not yet be determined and could include a charge to earnings.
Most important facts for investors to verify
- Whether the IAB and Arlington Bank integrations achieve expected cost savings and earnings accretion, and how acquisition expenses and share issuance affect per-share returns.
- Organic loan growth, deposit retention and pricing, funding costs, and the sustainability of net interest margin as rates change.
- Credit quality trends, including non-accrual loans, criticized loans, charge-offs and recoveries, and the adequacy of the allowance as the loan portfolio expands.
- Capital and liquidity after the acquisitions, including regulatory ratios, FHLB capacity, and the scale and potential usage of off-balance-sheet commitments.
- The eventual CECL impact and any material updates to acquisition purchase-price allocations, which were preliminary and subject to measurement-period adjustments.