Business Context and Reporting Period
SmartFinancial, Inc. is a Tennessee bank holding company whose principal subsidiary is SmartBank, a Tennessee-chartered commercial bank serving eastern Tennessee, the Florida Panhandle and north Georgia. The filing is a Form 10-K for the fiscal year ended December 31, 2016, filed March 31, 2017. Cornerstone Community Bank was merged into SmartBank on February 26, 2016; therefore, 2016 results include a full year of the combined operations, while 2015 comparability is affected by the August 2015 Cornerstone merger.
SmartBank operated 12 full-service branches, two loan production offices, one mortgage loan production office and two service centers at year-end. The business is primarily funded by deposits and focused on commercial, real estate, construction, consumer and mortgage lending.
Financial Performance and Position
| Metric | 2016 | 2015 | Change or comment |
|---|---|---|---|
| Total assets | $1.062 billion | $1.024 billion | Up approximately 3.8% |
| Interest income | $42.6 million | $27.8 million | Driven primarily by merger-related and organic asset growth |
| Net interest income | $38.3 million | $25.0 million | Up approximately 53% |
| Noninterest income | $4.2 million | $2.2 million | Higher loan and securities-sale gains and other income |
| Provision for loan losses | $0.8 million | $0.9 million | Lower provision despite loan growth |
| Noninterest expense | $32.5 million | $23.2 million | Higher full-year post-merger operating costs |
| Net income | $5.8 million | $1.5 million | Substantial improvement |
| Net income available to common shareholders | $4.8 million | $1.4 million | Diluted EPS of $0.78 versus $0.32 |
| Return on average assets | 0.57% | 0.22% | Improved |
| Return on average equity | 5.59% | 2.15% | Improved |
| Tax-equivalent net interest margin | 4.06% | 4.07% | Essentially stable; deposit costs increased |
| Efficiency ratio | 75.7% | 85.0% | Improved materially |
| Net loans | $808.3 million | $723.4 million | Up approximately 11.7% |
| Total deposits | $907.1 million | $858.5 million | Up approximately $48.6 million |
| Cash and cash equivalents | $68.7 million | $80.0 million | Declined as funds supported loan growth |
| Stockholders’ equity | $105.2 million | $100.2 million | Increased |
Average earning assets increased to $944.6 million from $615.3 million. Average loans increased to $768.7 million from $486.2 million, while average interest-bearing deposits increased to $724.8 million from $505.8 million. The average cost of interest-bearing liabilities increased to 0.56% from 0.52%, limiting margin expansion.
Operating cash flow was $11.6 million, compared with $2.3 million in 2015. Investing activities used $54.3 million, primarily reflecting net loan originations and purchases of premises and equipment. Financing activities provided $31.5 million, principally from deposit growth and borrowing activity. Cash and cash equivalents decreased by $11.2 million during the year.
At December 31, 2016, securities available for sale totaled $129.4 million, down from $166.4 million, as securities were sold or allowed to mature to fund lending. Short-term borrowings totaled $18.5 million, and the company reported no long-term debt outstanding at year-end. Deposits were the primary funding source; brokered deposits represented approximately 10.5% of total deposits.
Asset Quality, Capital and Liquidity
- Nonperforming assets declined to $4.5 million, or 0.42% of total assets, from $8.1 million, or 0.79%.
- Nonperforming loans were 0.26% of gross loans, compared with 0.38% in 2015.
- The allowance for loan losses increased to $5.1 million from $4.4 million, equal to 0.63% of total loans versus 0.60%.
- Net charge-offs were $37,000, compared with $449,000 in 2015.
- Approximately 89% of loans had real estate as a primary or secondary component of collateral; commercial real estate, including construction loans, represented approximately 61% of the portfolio.
- Both SmartFinancial and SmartBank were well capitalized under applicable regulatory standards. SmartFinancial reported a total risk-based capital ratio of 11.99%, a Tier 1 risk-based capital ratio of 11.42%, a common equity Tier 1 ratio of 10.05% and a Tier 1 leverage ratio of 9.81%.
- The Bank paid $3.0 million in dividends to the parent during 2016 and could pay approximately $6.6 million of additional dividends without prior TDFI approval, subject to applicable restrictions.
Material Changes, Outlook and Unusual Items
- Management expects 2017 net interest income to average assets and net interest margin to face pressure because new assets are expected to have lower yields and deposit pricing may increase as short-term rates rise.
- Management expects noninterest income to average assets to improve through higher mortgage, SBA and other loan sales and increased deposit-service fees.
- Management expects noninterest expense to average assets to decline as assets grow faster than expenses and expects an effective tax rate of approximately 37%.
- The allowance for loan losses on organic loans is expected to remain in the 0.80% to 0.90% range.
- The mortgage banking operation incurred more than $1.8 million of additional expenses and generated $824,000 of noninterest income in 2016, creating execution and profitability risk.
- The company’s commercial real estate and construction and land development concentrations exceeded the regulatory guidance thresholds commonly referred to as the 100% and 300% ratios. Management acknowledged that future growth in these loan categories may be constrained by capital growth.
- The company recognized $1.022 million of preferred dividends in 2016 because the SBLF preferred dividend rate increased to 9% from 1%. The preferred stock was redeemed in full on March 6, 2017.
- On January 30, 2017, the company completed a public offering of 2,010,084 common shares, generating approximately $33.2 million of net proceeds. A portion of the proceeds was used to redeem the $12 million liquidation preference of the SBLF preferred stock.
- Available-for-sale securities had $1.8 million of unrealized losses at year-end, which management considered temporary and primarily related to interest-rate movements.
- Management reported effective disclosure controls and internal control over financial reporting. The independent auditor gave an unqualified opinion on the consolidated financial statements.
Key Risks and Contingencies
- Interest-rate changes may reduce net interest income, loan demand, asset values and mortgage activity. Management characterized the company as asset-sensitive and estimated that an immediate 200-basis-point increase in short-term rates could increase net income by approximately $2.2 million over 12 months, although actual results may differ.
- Credit losses could rise because of the concentration in commercial real estate, construction and land development, small-business lending and geographically concentrated markets.
- Liquidity could be affected by volatile deposits, brokered deposits, wholesale funding costs, deposit withdrawals and the need to fund unused commitments.
- Future acquisitions may require substantial cash, debt or equity and may create integration, credit, dilution and execution risks.
- The company had $145.3 million of unused commitments to extend credit and $3.2 million of standby letters of credit. Many commitments may expire undrawn, but they represent potential future liquidity and credit exposure.
- Cybersecurity incidents, third-party technology failures, regulatory examinations, changes in banking regulation, litigation, severe weather and declines in Tennessee or Florida real estate markets could materially affect results.
- Common dividends were not paid in 2015 or 2016 and remain subject to regulatory, capital, preferred-stock and loan-agreement restrictions.
Investor Verification Checklist
- Verify the sustainability of 2016 earnings growth after separating merger benefits, loan-sale gains, preferred-dividend effects and other unusual items.
- Monitor net interest margin, deposit pricing, brokered-deposit reliance and the effect of further Federal Reserve rate increases.
- Review commercial real estate and construction concentration, regulatory capital growth capacity and the allowance methodology under the future current expected credit loss standard.
- Assess credit quality trends, including nonperforming assets, criticized loans, charge-offs, troubled debt restructurings and the remaining purchased-credit-impaired loan discounts.
- Evaluate whether mortgage banking revenue can exceed its operating costs and whether loan-sale repurchase obligations could create future losses.
- Confirm the use of the January 2017 equity-offering proceeds, the March 2017 preferred-stock redemption and the resulting impact on diluted ownership and future common dividends.