Business context and reporting period
South State Corporation, a bank holding company headquartered in Columbia, South Carolina, filed this unaudited Form 10-Q for the quarter and nine months ended September 30, 2017. It provides banking, lending, wealth-management and related services through South State Bank and affiliates. Unless noted otherwise, financial amounts below are in U.S. dollars; statement amounts are in millions.
Results reflect the January 3, 2017 acquisition of Southeastern Bank Financial Corporation (SBFC). The proposed Park Sterling Corporation acquisition had shareholder approval on October 25, 2017, but remained subject to regulatory approvals and other closing conditions; closing was expected in Q4 2017.
Financial performance and condition
- Q3 earnings: Net income was $35.0 million, up 24.7% from $28.1 million a year earlier. Diluted EPS was $1.19 versus $1.16; basic EPS was $1.20 versus $1.17.
- Nine-month earnings: Net income was $85.1 million, up from $77.1 million. Diluted EPS declined to $2.90 from $3.18, as weighted-average diluted shares rose to 29.3 million from 24.2 million, principally reflecting shares issued in the SBFC acquisition.
- Revenue and margins: Q3 net interest income increased 23.5% to $100.3 million; noninterest income rose 2.0% to $36.0 million. The non-tax-equivalent net interest margin declined to 4.06% from 4.13% year over year (tax-equivalent margin: 4.11% versus 4.18%). Management attributed margin pressure primarily to lower acquired-loan yields and higher funding costs. Q3 noninterest expense increased 11.5% to $81.6 million.
- Profitability: Q3 return on average assets was 1.25% versus 1.28%, and return on average equity was 8.57% versus 10.00%. The quarterly efficiency ratio improved to 59.5% from 62.3% in Q3 2016 and 62.8% in Q2 2017.
- Balance sheet at September 30: Total assets were $11.17 billion, up 27% from $8.80 billion a year earlier. Net loans were $8.22 billion, up 27%; deposits were $9.06 billion, up 25%. Available-for-sale securities were $1.32 billion. Total shareholders’ equity was $1.63 billion, including $597.2 million of goodwill.
- Credit quality: Non-acquired nonperforming assets were $19.2 million, down from $21.6 million a year earlier. Non-accrual non-acquired loans were $11.5 million; the allowance for non-acquired loan losses was $41.5 million, or 0.67% of those loans and 3.22 times non-acquired nonperforming loans. Q3 annualized net charge-offs on non-acquired loans were 0.04%, compared with 0.03% a year earlier. Acquired non-credit-impaired nonperforming loans were $6.4 million.
- Cash flow and liquidity: For the first nine months, operating cash flow was $147.9 million, investing cash flow was negative $188.5 million, and financing cash flow was $70.1 million. Cash and cash equivalents ended at $403.9 million. Management described liquidity as adequate and readily available; disclosed sources included $516 million of federal funds credit lines, $336.2 million of Discount Window availability and a $1.3 billion FHLB facility.
- Debt and capital: At quarter-end, federal funds purchased and repurchase agreements totaled $291.1 million and other borrowings were $83.3 million. The company’s CET1, total risk-based capital and Tier 1 leverage ratios were 12.11%, 13.51% and 10.34%, respectively; management said capital exceeded regulatory minimums and met the “well capitalized” thresholds.
Material changes versus comparable periods
- SBFC materially expanded assets, loans, deposits, employees and shares outstanding. The company issued 4,978,338 shares for the acquisition, at a purchase price of approximately $435.1 million.
- Q3 interest income rose with acquired assets and organic loan growth, while interest expense also increased as funding balances and rates rose. Average interest-bearing liability cost increased 9 basis points year over year.
- Q3 noninterest expense growth reflected acquired operations, including higher compensation, occupancy, information services and intangible amortization. Nine-month merger and branch-consolidation expense was $26.9 million, versus $3.2 million in the prior-year period; the filing identifies change-in-control, severance and vendor-contract resolution costs among the 2017 items.
- Mortgage banking income fell to $3.4 million from $6.3 million in Q3, which management attributed to lower mortgage pipeline and production. Trust and investment-services income and deposit fees increased.
- Loans, deposits and investment securities all grew substantially, while the company’s total nonperforming assets, including acquired assets, declined to $33.5 million from $42.5 million a year earlier.
Outlook, commentary, risks and contingencies
- No formal earnings or revenue guidance is provided. Management expected its effective tax rate to increase in Q4 2017, partly due to expected nondeductible Park Sterling transaction expenses.
- Management estimated that exceeding $10 billion in assets would bring an approximately $0.5 million annual increase in FDIC insurance costs beginning in 2018. The Durbin interchange-fee cap was expected to take effect for the company in July 2018; management estimated an annual reduction of approximately $17 million pretax, or $11 million after tax ($0.30 per share), including the expected Park Sterling impact.
- Management planned to close 12 Park Sterling branches and two legacy South State branches by the end of 2018, subject to completion of the merger. Integration, deposit retention, cost savings and regulatory approval remain relevant uncertainties.
- Credit, interest-rate, liquidity, market, cybersecurity, compliance and regulatory risks are discussed. Management noted four credit concentrations exceeding its stated regulatory threshold, including loans to lessors of nonresidential buildings, residential-building lessors, religious organizations and construction borrowers.
- Commitments to extend credit and standby letters of credit totaled $2.2 billion; management did not anticipate material losses from them. The company disclosed ordinary-course litigation and said any ultimate liability was not expected to materially affect its financial statements.
- Two equity securities were written down by $753,000 in Q3 after management decided to sell them. Unrealized losses on available-for-sale securities totaled $5.9 million; management stated that the debt securities remained current and it did not expect to be required to sell them before recovery.
- The company’s FDIC loss-share agreements had been terminated in 2016; it now bears the full impact of future losses and recoveries on assets formerly covered. Management also cautioned that interim results are not necessarily indicative of full-year results.
Most important facts for investors to verify
- Completion, regulatory approval, integration costs and expected benefits of the Park Sterling acquisition, including the stated branch closures.
- Whether organic loan growth and deposit retention can offset the expected Durbin-related interchange revenue reduction and higher FDIC costs.
- Net interest margin trends, including acquired-loan runoff and yields, deposit pricing and the effect of further interest-rate changes.
- Credit performance and allowance adequacy as the loan book expands, with particular attention to commercial real estate, construction and acquired loans.
- Underlying earnings after merger costs and other unusual items, and the effect of share issuance on per-share results.
- Goodwill and acquisition-related valuation assumptions, the securities portfolio’s unrealized losses, and the potential sensitivity of mortgage servicing rights to rates and prepayments.