Business context and reporting period
First Business Financial Services, Inc. (Nasdaq: FBIZ) is a Wisconsin-based commercial bank holding company serving businesses and individuals, primarily in Wisconsin and the greater Kansas City area, with private wealth and consulting businesses. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2020; comparisons are with the corresponding 2019 periods unless noted.
Financial performance and condition
- Profit: Second-quarter net income was $3.3 million, or $0.38 per diluted share, versus $6.6 million, or $0.75, a year earlier. First-half net income was $6.6 million, or $0.77 per diluted share, versus $12.5 million, or $1.43.
- Revenue and margin: Second-quarter net interest income rose 12.1% to $18.9 million; non-interest income rose 8.9% to $6.3 million. Top-line revenue was $25.2 million, up 11.3%. First-half top-line revenue was $48.7 million, up 8.0%. Net interest margin was 3.34% for Q2 and 3.39% for the first half, down from 3.52% and 3.66%, respectively. Lower loan yields weighed on margin, partly offset by lower deposit funding costs and fee income.
- Credit costs: Provision for loan and lease losses was $5.5 million in Q2 and $8.7 million in the first half, compared with provision benefits of $0.8 million and $0.7 million in 2019. The allowance was $27.5 million, or 1.33% of gross loans (1.58% excluding PPP loans), versus $19.5 million and 1.14% at year-end 2019.
- Expenses and profitability: Non-interest expense was $18.3 million in Q2, up 5.0%; first-half expense was $34.5 million, down 2.0%. Reported efficiency ratios were 61.22% for Q2 and 64.36% for the first half, improved from 67.41% and 67.72%. The company reported adjusted pre-tax, pre-provision earnings of $9.8 million for Q2 and $17.3 million for the first half, non-GAAP measures. Return on average assets fell to 0.55% for Q2 and 0.58% for the first half, principally reflecting higher credit provisions.
- Balance sheet and liquidity: Total assets were $2.469 billion at June 30, up 17.7% from year-end 2019. Gross loans and leases were $2.065 billion; deposits were $1.710 billion, up 11.8%. Cash and cash equivalents were $42.4 million, down from $67.1 million at year-end. Management reported $611.6 million of on-balance-sheet liquidity and available liquidity sources, including short-term investments, borrowing capacity and unencumbered collateral; this is not cash on hand alone.
- Funding, debt and capital: FHLB advances and other borrowings were $465.0 million, versus $319.4 million at year-end; junior subordinated notes were $10.1 million. The detailed borrowing table also includes subordinated notes. The company prepaid $59.5 million of FHLB advances and recorded a $744,000 extinguishment loss. Consolidated total capital, Tier 1, common equity Tier 1 and leverage ratios were 11.97%, 9.57%, 9.08% and 8.29%, respectively. The Bank remained classified as well capitalized.
- Cash flow and shareholder returns: For the first half, operating cash flow was $1.3 million, investing cash flow was negative $347.4 million, and financing cash flow was positive $321.3 million; cash and cash equivalents decreased $24.7 million. The quarterly dividend declared was $0.165 per share. The share repurchase program was suspended in March 2020.
Material changes versus the prior comparable period
- Earnings declined substantially year over year, primarily as pandemic-related expected credit losses drove a sharp increase in loan-loss provisioning, despite higher top-line revenue.
- Funding costs fell: second-quarter interest expense declined to $3.9 million from $8.5 million, supporting higher net interest income. Loan yields also declined, and reported net interest margin narrowed.
- Portfolio growth included $327.9 million of PPP loans; excluding PPP loans and lines of credit, period-end gross loans and leases were $1.516 billion, up 11.6% annualized from year-end 2019.
- Non-performing assets rose to $25.5 million from $23.5 million at year-end, while non-accrual loans were 1.17% of gross loans versus 1.20%. The allowance increased substantially to address pandemic-related risk and specific legacy SBA exposures.
- Fee income rose, particularly commercial loan swap fees, which totaled $1.7 million in Q2 versus $1.1 million a year earlier. Historic tax-credit investment impairment expense was $1.8 million for Q2; related tax credits contributed to an income tax benefit.
Outlook, management commentary, risks and contingencies
- Management stated it believes it can achieve an average net interest margin of at least 3.50%, supported by in-market deposit growth, loan pricing and specialty finance production. This is a management target, not formal earnings guidance; management cautioned that loan fees, PPP activity, non-accrual recoveries and deposit inflows may make quarterly margin volatile.
- COVID-19’s duration and ultimate effects on borrowers and the economy were described as highly uncertain. The company identified $185.1 million of exposure to retail, hospitality, entertainment, and restaurant and food-service industries, or 10.7% of gross loans excluding PPP loans.
- At June 30, 448 COVID-related deferral requests covered $323.2 million of loans, or 18.6% of gross loans and leases. Most deferrals were for three or six months; management anticipated modifications could continue through 2020. Deferred loans were not reported past due during the deferral period.
- The company had disbursed $327.9 million in PPP loans and received $8.7 million in SBA processing fees, which are deferred and recognized over the loan term or accelerated upon forgiveness. PPP loans carry a 100% SBA guarantee subject to lender compliance and were excluded from the allowance calculation.
- Other risks include potential further deterioration in credit quality, borrower defaults, interest-rate and market changes, competition, regulatory and tax changes, cybersecurity and fraud, and compliance with SBA requirements. Management said it could not assure the ultimate effects of the pandemic and that additional provisions or charge-offs may be needed.
- Management did not expect pending or threatened legal proceedings to have a material adverse effect. The filing reported no material changes to previously disclosed risk factors and no significant subsequent events requiring adjustment or disclosure. Disclosure controls were assessed as effective as of June 30, 2020.
Important facts for investors to verify
- Track performance and payment resumption of the $323.2 million in deferred loans, especially hospitality, real estate and other stressed industries.
- Assess whether the $27.5 million allowance remains adequate as pandemic conditions, portfolio ratings, delinquencies and charge-offs evolve; distinguish reported loan ratios from ratios excluding guaranteed PPP loans.
- Monitor PPP forgiveness, fee recognition timing and the extent to which pandemic-related deposit and loan balances persist.
- Compare the 3.50% average net interest margin target with subsequent reported margins, including the effects of low rates, funding mix and variable loan fees.
- Review the composition and availability of the reported $611.6 million liquidity sources, as well as wholesale funding levels and capital ratios.
- Consider the effect of tax-credit investment impairments, related tax benefits and the $744,000 early debt-extinguishment charge when evaluating recurring earnings.