SOUTHSIDE BANCSHARES INC annual report, FY2014

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Southside Bancshares, Inc. — 2014 Form 10-K

Business context and reporting period. The filing covers the fiscal year ended December 31, 2014. Southside is a Texas community bank holding company operating primarily in East Texas, Fort Worth and Austin. It completed its acquisition of OmniAmerican Bancorp on December 17, 2014; 2014 results include OmniAmerican’s operations only from that date, so year-end balance-sheet growth substantially reflects the acquisition.

Financial performance and position

  • Earnings: Net income was $20.8 million, down 49.4% from $41.2 million in 2013. Diluted EPS was $1.09 versus $2.19. The fourth quarter recorded a net loss of $3.9 million, compared with net income of $12.2 million in fourth-quarter 2013.
  • Revenue and margins: Net interest income rose 5.1% to $106.8 million. Net interest margin improved to 3.77% from 3.69%; net interest spread was 3.63% versus 3.54%. Total noninterest income fell 30.5% to $24.5 million, including lower securities gains and a $2.8 million impairment of the SFG investment.
  • Expenses and credit costs: Noninterest expense increased 19.6% to $97.7 million, including merger-related costs. Provision for loan losses rose to $14.9 million from $8.9 million; net charge-offs increased to $20.5 million from $10.6 million, largely associated with SFG subprime auto loans and their sale.
  • Assets and lending: Total assets grew 39.5% to $4.81 billion. Loans were $2.18 billion, up 61.4%, primarily from the acquisition. Securities were approximately $2.09 billion. Net loans were $2.17 billion after a $13.3 million allowance, down from $18.9 million at year-end 2013.
  • Asset quality: Nonperforming assets declined to $12.3 million, or 0.26% of assets, from $13.6 million, or 0.39%. Nonaccrual loans fell to $4.1 million; restructured loans rose to $5.9 million. Acquired OmniAmerican loans were recorded at fair value without a transferred loan-loss allowance.
  • Funding and liquidity: Deposits increased 33.5% to $3.37 billion. Total FHLB advances were $897.4 million, and short-term obligations were $301.6 million. Cash and cash equivalents were $84.7 million. The Bank reported approximately $756.8 million of additional potential FHLB funding against unpledged securities.
  • Debt and capital: Long-term obligations totaled $660.4 million, including $600.1 million of long-term FHLB advances and $60.3 million of junior subordinated debt. Shareholders’ equity rose to $425.2 million, or 8.8% of assets, partly due to shares issued for the acquisition. Year-end regulatory capital ratios remained well above applicable 2014 minimums; the Bank’s total risk-based capital ratio was 16.13% and Tier 1 leverage ratio was 10.95%.
  • Cash flow: Operating cash flow was $56.0 million; investing activities used $67.3 million and financing activities provided $41.5 million. Cash and cash equivalents increased $30.2 million to $84.7 million.

Material changes and unusual items

  • OmniAmerican was acquired for total consideration of $298.3 million, comprising cash and stock. The Company recorded $69.3 million of initial goodwill and an $8.6 million core deposit intangible. Merger-related expenses were approximately $15.9 million, including accelerated share-based compensation.
  • The acquisition drove much of the increase in assets, loans, deposits, equity and borrowings. Reported annual results are therefore not directly comparable with 2013. Unaudited pro forma results, assuming the acquisition occurred January 1, 2013, were 2014 net income of $33.3 million and revenue of $209.0 million; the filing notes integration costs were not included.
  • Southside completed the sale of SFG’s purchased subprime auto loans and repossessed assets in fourth-quarter 2014. The sale involved a write-down, contributed to higher charge-offs and provision expense, and resulted in the $2.8 million impairment of the SFG investment.
  • Management prepaid $39.2 million of higher-cost FHLB advances and recorded $539,000 of prepayment fees. Cash dividends were $0.96 per share, and a 5% stock dividend was also paid.

Outlook, commentary and risks

Management expected national and served-market economies to grow at a slow-to-moderate pace in 2015, while noting economic headwinds, including declining oil prices. The filing provides no specific earnings or revenue guidance. Management described a continued focus on balance-sheet management, loan growth, funding costs and interest-rate risk.

  • Texas energy exposure is a concern: energy loans were approximately 1.8% of the portfolio, while crude oil fell to about $53 per barrel at year-end 2014 from about $98 a year earlier. A prolonged downturn could weaken borrowers and local economies.
  • Real estate secured approximately 65% of loans; management also identified lending exposure to the medical community. Local economic weakness, collateral declines or changes in healthcare reimbursement could increase credit losses.
  • Interest-rate and securities risks include MBS prepayment uncertainty, potential changes in securities values and sensitivity to funding costs. The year-end model projected negative net-interest-income variances under both rising- and falling-rate shocks.
  • Other principal risks include acquisition integration and realization of synergies, deposit and wholesale-funding availability, competition, regulatory and compliance costs, cybersecurity, and uncertainty in loan-loss estimates. The Company was subject to updated Basel III capital rules beginning January 1, 2015.
  • Management and the auditor reported effective internal control over financial reporting for the covered Company; OmniAmerican’s controls were excluded from the assessment. Ernst & Young issued unqualified opinions on the financial statements and the Company’s internal controls. Ordinary-course litigation was not considered material by management.

Important facts for investors to verify

  • How much of reported 2015 growth and earnings reflects OmniAmerican, and what integration costs or synergies remain unrecognized?
  • Whether loan losses and the allowance remain adequate after 2014’s elevated charge-offs, particularly given acquired loans had no transferred allowance.
  • The quality and performance of acquired loans, including purchased credit-impaired loans, and the evolution of restructured and criticized credits.
  • Whether low oil prices affect borrowers, deposits or credit quality beyond the disclosed 1.8% direct energy-loan exposure.
  • How FHLB funding, deposit concentration and the maturity profile affect liquidity and net interest income as rates change.
  • Whether reported earnings are sustainable without securities gains and after merger-related and SFG-related items; confirm the fourth-quarter loss drivers and pro forma comparability.