COMMERCE BANCSHARES INC quarterly report, Q3 FY2018

Commerce Bancshares, Inc. — Q3 2018 Form 10-Q

Reporting period: Three and nine months ended September 30, 2018. Commerce Bancshares is a bank holding company whose operations are primarily conducted through Commerce Bank. Financial statements are unaudited.

Financial performance

MetricQ3 2018Q3 2017Nine months 2018Nine months 2017
Net interest income$207.8 million$182.6 million$611.6 million$543.7 million
Non-interest income$123.7 million$116.9 million$368.3 million$341.9 million
Provision for loan losses$10.0 million$10.7 million$30.4 million$32.6 million
Non-interest expense$185.1 million$179.2 million$549.2 million$535.5 million
Net income attributable to Commerce Bancshares$112.6 million$74.6 million$323.9 million$225.0 million
Diluted earnings per common share$1.03$0.67$2.96$2.03

Q3 net income attributable to the company rose 51.0%; nine-month net income increased 43.9%. Q3 return on average assets was 1.81%, return on average common equity was 16.43%, and the efficiency ratio was 55.73%. The nine-month figures were 1.76%, 16.27%, and 55.95%, respectively. Tax-equivalent net interest margin was 3.52% in Q3 versus 3.17%; for the first nine months it was 3.51% versus 3.16%.

Growth in net interest income reflected higher loan balances and yields, while deposit and borrowing costs also increased. Q3 non-interest income growth was led by bank card and trust fees. Non-interest expense rose, particularly salaries and data processing. The 2018 federal tax rate reduction and $2.4 million of tax benefits from state-law and tax-reform adjustments reduced tax expense; the Q3 effective tax rate was 19.1% versus 30.2% a year earlier.

Balance sheet, cash flow, credit and capital

  • Balance sheet: Total assets were $25.1 billion at September 30, 2018, up from $24.8 billion at year-end 2017. Loans were $14.0 billion, essentially flat with year-end. Deposits were $20.1 billion, down $291.8 million; non-interest-bearing deposits declined $430.4 million, partly offset by growth in interest-bearing transaction, savings and money market accounts.
  • Funding and liquidity: Borrowings were $1.9 billion, up $354.8 million from year-end, principally from customer repurchase agreements and federal funds purchased. Core deposits were $18.5 billion, or 91.7% of deposits. Reported liquid assets totaled $9.7 billion, including $8.7 billion of available-for-sale debt securities. The company reported $3.6 billion of estimated additional FHLB/Federal Reserve advance capacity after outstanding letters of credit.
  • Cash flow: For the first nine months, operating activities provided $446.7 million, investing activities used $126.8 million, and financing activities used $39.1 million. Cash, cash equivalents and restricted cash increased $280.8 million to $805.2 million.
  • Credit quality: The allowance for loan losses was $159.7 million, or 1.14% of loans, versus $159.5 million and 1.14% at year-end. Nine-month net charge-offs were $30.2 million versus $30.7 million; Q3 annualized net charge-offs were 0.28% of average loans. Non-accrual loans were $8.4 million, down from $12.0 million at year-end; non-performing assets were $9.6 million, or 0.04% of assets. Potential problem loans totaled $197.7 million, down 7.4% from year-end.
  • Capital: At September 30, Tier 1 common risk-based capital was 14.07%, Tier 1 risk-based capital 14.83%, total risk-based capital 15.68%, and Tier 1 leverage 11.38%. The company said it exceeded applicable well-capitalized thresholds. It paid $0.235 per common share quarterly and repurchased shares; 2.8 million shares remained available under the board authorization.

Material changes, outlook and risks

  • Year-over-year earnings benefited from higher net interest income, fee growth, securities gains and lower taxes. Private equity fair-value gains were $4.3 million in Q3 and $12.4 million for the first nine months; results also included an $8.9 million adjustment related to dividend income on an equity security liquidated in Q2. These items make reported earnings less purely reflective of recurring operations.
  • Rising rates increased unrealized losses on available-for-sale debt securities: gross unrealized losses were $173.2 million at September 30, compared with $44.1 million at year-end. Management attributed the increase primarily to rising interest rates. Accumulated other comprehensive loss was $141.6 million, compared with accumulated other comprehensive income of $14.1 million at year-end. Management stated it did not intend, and did not expect to be required, to sell identified impaired non-agency mortgage-backed securities before recovery of amortized cost.
  • No earnings or revenue guidance is provided. Management’s rate simulations show outcomes depend materially on deposit behavior: a 100-basis-point rise is modeled to increase 12-month net interest income by $5.7 million in one scenario, but reduce it by $11.8 million in a higher-deposit-attrition scenario. A 100-basis-point decline is modeled to reduce net interest income by $13.0 million. These are simulations, not forecasts.
  • Key risks identified include economic conditions, interest-rate and deposit sensitivity, loan demand and credit losses, regulation, competition, cybersecurity, and accounting and tax estimates. The company entered a $500 million forward-starting interest-rate floor to hedge certain floating-rate commercial loans; the hedge begins in 2020.
  • Off-balance-sheet commitments included $10.5 billion of loan commitments, including about $5.2 billion of unused approved credit-card lines, $347.8 million of standby letters of credit, and $73.5 million of expected tax-credit purchase commitments to be funded during the rest of 2018. The company had ordinary-course legal proceedings; some matters were too early for losses to be assessed as probable and estimable.
  • CECL, effective for the company in 2020, is expected to increase the allowance upon adoption; implementation work was ongoing. The company estimated that adoption of the new lease standard would result in $20 million–$30 million of right-of-use assets and lease liabilities, without a material effect on its financial statements or related ratios.

Investor verification priorities

  • Assess how much earnings growth came from core net interest and fee income versus private equity marks, the liquidated-security adjustment, and tax benefits.
  • Monitor deposit trends, deposit pricing, borrowing growth and the company’s sensitivity to higher rates and deposit attrition.
  • Review the scale and duration of securities valuation losses, AOCI, and any changes to management’s ability or intent to hold securities.
  • Track consumer credit-card charge-offs, restructured and potential problem loans, and the adequacy of the allowance as CECL implementation advances.
  • Evaluate the availability and conditions of liquidity sources, pledged collateral, and the usage of substantial loan commitments and other off-balance-sheet obligations.