Old Second Bancorp, Inc. — Third-Quarter 2014 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2014. Amounts are in U.S. dollars; financial statement amounts are in millions unless noted. The company is an Illinois-based bank holding company providing commercial, retail, trust and wealth-management services.
Financial performance and position
- Third-quarter results: Net interest income was $14.7 million, noninterest income $8.3 million, and noninterest expense $18.3 million. Pretax income was $4.65 million; net income was $2.92 million and net income available to common shareholders was $1.86 million, or $0.06 per diluted share.
- Nine-month results: Net income was $7.15 million and diluted EPS was $0.41. Net income available to common shareholders was $9.94 million, including the effects of waived preferred dividends and a preferred-stock redemption gain.
- Net interest margin: Third-quarter margin was 3.26% on a tax-equivalent basis (3.24% GAAP), versus 3.25% (3.23% GAAP) a year earlier. Nine-month tax-equivalent margin was 3.14%, versus 3.17% in 2013.
- Balance sheet at September 30: Assets were $2.03 billion; loans were $1.14 billion, with an allowance for loan losses of $23.3 million; deposits were $1.66 billion; and stockholders’ equity was $192.7 million. Cash and cash equivalents were $44.1 million and total securities were $625.3 million.
- Cash flow, first nine months: Operating activities used $14.4 million, investing activities used $34.4 million, and financing activities provided $45.2 million. Cash and cash equivalents declined $3.6 million to $44.1 million.
- Debt and funding: Reported borrowings totaled $173.3 million, including $58.4 million of junior subordinated debentures, $45.0 million of subordinated debt, $40.0 million of FHLB advances, and $29.4 million under repurchase agreements. Deposits declined $25.4 million, or 1.5%, from year-end 2013.
- Capital: The Bank’s Tier 1 leverage ratio was 11.67% and total risk-based capital ratio 18.47%, above the board’s respective 8% and 12% objectives. A $64.4 million common-stock offering contributed to the increase in equity and capital.
Changes versus comparable periods
- Third-quarter pretax income rose to $4.65 million from $2.93 million in 2013. Net interest income increased $0.38 million, noninterest income increased $0.85 million, and noninterest expense declined $2.24 million year over year. Higher securities-sale gains and lower expenses contributed to the improvement.
- Reported net income fell sharply from $72.9 million in third-quarter 2013, which included a $70.0 million tax benefit, principally from reversing a deferred-tax-asset valuation allowance. The prior-year headline profit is therefore not directly comparable to 2014 operating earnings.
- For the first nine months, net interest income increased modestly to $41.9 million from $41.6 million, while noninterest income fell to $22.1 million from $27.3 million and noninterest expense fell to $54.9 million from $63.1 million. The 2013 period also included the $70.0 million tax benefit.
- Loans increased $39.6 million, or 3.6%, from December 31, 2013; commercial and construction lending grew while residential real estate loans declined. Deposits decreased $25.4 million, including a $44.7 million reduction in certificates of deposit.
- The allowance for loan losses declined from $27.3 million at year-end to $23.3 million. No provision or release was recorded in the third quarter, compared with a $1.75 million reserve release in third-quarter 2013 and a $1.0 million release in second-quarter 2014.
Outlook, risks and notable items
- Management described local economic conditions as improving but lackluster, with low loan demand and intense competition. It cited modest growth among existing commercial customers and said its loan pipeline was expected to support future growth; no quantified earnings or revenue guidance was provided.
- Nonperforming loans increased to $32.3 million from $28.9 million at June 30, driven by a small number of relationships. Classified loans increased to $48.2 million from $38.5 million at June 30. Management considered the reserve adequate, but cautioned that actual losses could exceed estimates.
- Other real estate owned was $40.9 million, with a $19.0 million valuation allowance. Additions and valuation adjustments exceeded disposals during the third quarter; management noted uncertainty around future sale values and costs.
- Debt covenant concern: The company was out of compliance with two financial covenants under its correspondent-bank credit agreement at September 30, versus one at June 30. The lender may terminate commitments, raise rates, accelerate the $0.5 million term debt, or pursue collateral remedies. The covenants concern return on average assets and nonperforming assets relative to primary capital.
- The company completed a $64.4 million common-stock offering and redeemed $24.3 million of Series B preferred stock in 2014. It also paid $19.7 million of previously deferred trust-preferred interest and resumed current payments. Series B preferred dividends increased from 5% to 9% in February 2014; the company said it was evaluating future redemption options.
- The investment portfolio included $83.8 million of Level 3 asset-backed securities. The company reported no other-than-temporary impairment on securities; it attributed unrealized losses primarily to interest-rate fluctuations. It purchased approximately $94.2 million of collateralized loan obligations during the quarter while reducing asset-backed securities holdings.
- Interest-rate sensitivity modeling showed estimated annual pretax income declines of $0.44 million under an immediate 0.5% rate increase and $0.20 million under a 1% increase; a 2% increase showed a $0.48 million increase. Management cautioned that modeled results are not forecasts and exclude potential management actions.
- The Federal Reserve terminated the company’s Written Agreement in January 2014, though management expected to continue seeking approval before dividends or additional indebtedness. The company was preparing for Basel III capital requirements effective January 1, 2015.
- Management announced that James L. Eccher would become company CEO and president on January 1, 2015, succeeding William B. Skoglund, who would remain chairman. The New Lenox branch property was transferred to OREO after the decision to close the branch in October 2014.
- Management reported effective disclosure controls and no material change in internal control over financial reporting during the quarter. It said there were no material changes to the risk factors disclosed in the 2013 Form 10-K; ordinary-course legal proceedings were not expected to have a material adverse effect.
Key facts investors should verify
- Underlying earnings trends excluding the 2013 deferred-tax benefit, 2014 securities gains, and preferred-stock redemption and dividend-waiver effects.
- Progress in resolving the two credit-agreement covenant breaches, lender actions or waivers, and the status of the remaining term and subordinated debt.
- Whether the rise in nonperforming and classified loans persists, and whether the allowance and OREO valuations remain adequate as collateral is resolved or sold.
- Loan growth, deposit retention and funding mix, including use of FHLB advances and repurchase agreements, and the company’s liquidity under changing conditions.
- Credit quality, valuation assumptions and concentration exposure in the securities portfolio, including Level 3 asset-backed securities and newly purchased collateralized loan obligations.
- Capital and dividend restrictions, preferred-stock redemption plans, and the effect of Basel III implementation.