First Business Financial Services, Inc. — 2018 Form 10-K
Reporting period: Fiscal year ended December 31, 2018. The company is a Wisconsin bank holding company focused on commercial banking, specialty lending, treasury management, and trust and investment services, primarily in Wisconsin and the Kansas City region.
Financial performance and condition
- Profit and revenue: Net income was $16.3 million, up 36.9% from $11.9 million in 2017; diluted EPS was $1.86 versus $1.36. Top-line revenue (net interest income plus non-interest income) rose 10.7% to $85.5 million.
- Net interest: Net interest income increased 11.1% to $67.3 million. Net interest margin rose 14 basis points to 3.72%, supported by loan growth, higher loan yields and fees. Funding costs also rose: cost of funds increased to 1.63% from 1.11%.
- Fees and expenses: Non-interest income increased 9.0% to $18.2 million, including trust fees of $7.7 million and swap fees of $1.7 million. Non-interest expense increased 9.7% to $62.4 million, primarily reflecting higher compensation, equipment and software costs. The efficiency ratio increased to 67.77%; management’s long-term goal is 58%–62%.
- Returns and tax: Return on average assets was 0.86% and return on average equity was 9.41%, compared with 0.67% and 7.16% in 2017. The effective tax rate fell to 7.7%, partly reflecting the federal rate reduction and historic tax credits.
- Balance sheet and funding: Assets grew 9.6% to $1.966 billion. Gross loans and leases increased 7.7% to $1.619 billion; deposits rose to $1.455 billion. Stockholders’ equity was $180.7 million. Borrowings were $309.0 million, including $274.5 million of FHLB advances; wholesale funds were 31.8% of total bank funding.
- Liquidity and cash flow: Management reported immediate on-balance-sheet liquidity of $390.9 million. Operating cash flow was $25.7 million, investing cash outflow was $138.3 million, and financing cash inflow was $146.6 million.
- Capital: The Bank was well-capitalized; its year-end total capital ratio was 11.49%, CET1 ratio 10.27%, and leverage ratio 10.20%. The holding company became eligible for the small bank holding company policy exemption from Basel III capital requirements, though it continued calculating consolidated ratios.
- Shareholder returns: The company declared dividends of $0.56 per share for 2018. A $5 million share repurchase authorization was announced in December; 11,920 shares were repurchased under the program by year-end.
Changes versus 2017
- Profitability rebounded: net income rose 36.9% after declining in 2017, with stronger net interest income, trust and swap fees, and lower loan-loss provision expense contributing.
- Average loans and leases grew 8.0%; year-end in-market deposits increased 8.6%. In contrast, average in-market deposits were approximately flat year over year.
- Net charge-offs fell to 0.24% of average loans and leases from 0.57%; non-performing loans declined to $25.3 million from $26.4 million. Non-performing assets were $27.8 million, slightly above $27.5 million, but fell as a share of assets to 1.42% from 1.53%.
- Funding costs rose amid higher rates and competition. FHLB advances increased, while wholesale deposits declined year over year; the company also reported renewed use of brokered CDs later in 2018.
Outlook, risks and unusual items
- Management expects to maintain net interest margin at 3.50% or better and seeks stable margins through funding and asset-liability management. It also aims to grow in-market deposits, fee income and lending, while returning the efficiency ratio toward its 58%–62% long-term goal. These are management expectations, not guaranteed results.
- Credit exposure is concentrated: commercial real estate loans were 67.6% of the gross loan portfolio. Construction and land-development exposure, local economic conditions, collateral values, and the performance of larger commercial borrowers are important risks.
- The allowance for loan and lease losses was $20.4 million, or 1.26% of gross loans. Management attributed a reduction in 2018 provision expense in part to a collateral liquidation that lowered provision by approximately $4.1 million. Future provisions and charge-offs remain uncertain.
- The SBA recourse reserve was $3.0 million, up from $2.8 million. The company may face repurchase or guaranty-recovery exposure if SBA loans were originated, funded or serviced improperly.
- Tax-credit investment impairment expense was $2.1 million. Historic tax credits lowered 2018 income tax expense by approximately $2.3 million; project compliance and potential credit recapture are risks.
- CECL is scheduled for adoption in 2020 and could increase the allowance; the filing does not provide a clear estimate of its financial impact. The company expected its 2019 lease-accounting adoption to add an estimated $8.8 million lease liability and $8.5 million right-of-use asset.
- Other identified risks include rising deposit costs and interest-rate sensitivity, LIBOR transition, liquidity and wholesale-funding availability, cybersecurity and third-party service disruptions, regulatory requirements, and competitive pressure. Outstanding loan commitments were $553.8 million and standby letters of credit were $12.4 million.
- The filing reports no material pending litigation. The independent auditor gave an unqualified opinion on the financial statements and internal control over financial reporting; management also concluded controls were effective.
Important facts for investors to verify
- Whether loan growth and deposit gathering can sustain margins as funding costs rise, and whether wholesale funding remains within management’s target range.
- Trends in CRE concentration, construction and land-development lending, non-performing commercial loans, collateral values, and future charge-offs or allowance needs.
- Whether the $4.1 million collateral-liquidation benefit and the low effective tax rate are repeatable; assess the ongoing effects of historic tax credits and their related impairments.
- Progress toward the stated efficiency-ratio goal, given 2018 expense growth and added producer headcount.
- The eventual CECL allowance impact, LIBOR-linked contract transition, and the terms and capacity of borrowing facilities as they mature.
- Dividend and repurchase capacity, including the Bank’s ability to upstream dividends while maintaining regulatory capital and liquidity.