Sierra Bancorp — Q2 2020 Form 10-Q
Business context and reporting period
Sierra Bancorp is a California bank holding company operating Bank of the Sierra, with 40 full-service branches and an online branch. This unaudited filing covers the quarter and six months ended June 30, 2020; comparisons are with Q2 and first-half 2019, and balance-sheet changes are generally compared with December 31, 2019. Amounts below are in U.S. dollars.
Financial performance and condition
- Q2 earnings: Net income was $8.3 million, down 6% from $8.8 million; diluted EPS was $0.54 versus $0.57. Annualized return on average assets was 1.19% and return on average equity was 10.30%.
- First-half earnings: Net income was $16.1 million, down 9% from $17.7 million; diluted EPS was $1.05 versus $1.15. Annualized return on average assets was 1.21% and return on average equity was 10.14%.
- Interest income and margin: Q2 net interest income was nearly unchanged at $24.1 million. First-half net interest income declined 1% to $47.9 million. Net interest margin fell to 3.81% in Q2 from 4.21%, and to 3.97% for the first half from 4.25%, reflecting lower asset yields after Federal Reserve rate cuts.
- Credit costs: Loan-loss provision was $2.2 million in Q2 versus $0.4 million, and $4.0 million for the first half versus $0.7 million. The allowance rose to $13.6 million, or 0.61% of gross loans, from $9.9 million at year-end.
- Other income and expenses: Q2 noninterest income increased 18% to $6.9 million, including a $0.7 million gain from termination of a low-income housing tax credit investment, higher bank-owned life insurance income, and a $0.4 million securities-sale gain. Noninterest expense rose 2% to $18.0 million. The efficiency ratio was 57.78% versus 58.17%.
- Balance sheet: Total assets were $3.11 billion, up from $2.59 billion at year-end. Gross loans grew 26% to $2.21 billion; major increases included mortgage warehouse lines, commercial real estate, and SBA Paycheck Protection Program loans. Deposits rose 16% to $2.51 billion, including growth in noninterest-bearing deposits to $949.7 million.
- Liquidity, funding and cash flow: Cash and cash equivalents were $156.6 million, up from $80.1 million at year-end. First-half operating cash flow was $21.8 million; investing activities used $433.9 million, principally reflecting net loan growth; financing activities provided $488.7 million, mainly from deposit growth and borrowings. Short-term borrowings increased to $163.0 million from $20.0 million. Reported primary and secondary liquidity sources totaled $939.6 million.
- Capital and shareholder returns: Shareholders’ equity was $327.4 million, up 6% from year-end. The Bank reported a 10.87% leverage ratio under the Community Bank Leverage Ratio framework; the temporary CARES Act minimum was 8%. First-half dividends were $6.1 million. The company repurchased 112,050 shares in Q1, then suspended repurchases March 16.
Material changes versus comparable periods
- Higher loan balances and sharply lower deposit funding costs largely offset falling loan yields; however, the lower net interest margin and increased credit provision reduced earnings.
- COVID-19-related economic uncertainty drove management’s higher qualitative loss assumptions. First-half net charge-offs were $0.4 million, compared with $0.6 million in first-half 2019.
- Nonperforming assets rose to $8.7 million from $6.5 million at year-end, largely due to a $2.1 million commercial property foreclosure. Nonperforming loans were $5.8 million; their ratio to gross loans was 0.26%, down from 0.33% at year-end as the loan portfolio expanded.
- Accumulated other comprehensive income increased with unrealized securities gains as interest rates declined. The portfolio’s net unrealized gain was $23.0 million at quarter-end, versus $8.4 million at year-end.
Outlook, risks and unusual items
- Management gave no quantified earnings guidance. It said that if economic conditions do not improve, quarterly loan-loss provisions could remain at or exceed first-half levels. It also expects lower net interest income from the low-rate environment and possible further reductions in service-charge and interchange income; the efficiency ratio could increase.
- At June 30, 313 customers had COVID-related payment deferrals covering $386.2 million of loans. About 97% of deferred balances were commercial; hospitality represented $145.0 million. Approximately $4.9 million of accrued interest on these loans had been recognized but not collected. The loans were not classified as nonperforming or TDRs under applicable CARES Act relief, but subsequent repayment difficulty could lead to downgrades, interest reversals, higher provisions or charge-offs.
- The company had $116.2 million of PPP loans, guaranteed 100% by the SBA, and reported no incremental loan-loss provision for those loans. It received approval for a Federal Reserve PPP lending facility but had not drawn on it by quarter-end.
- CECL implementation was deferred under the CARES Act until the earlier of the end of the national emergency or December 31, 2020. Management stated that adoption is expected to have a material adverse effect, particularly on the allowance and equity; it previously estimated a one-time adoption adjustment of approximately $12 million, while the ultimate effect remained uncertain.
- Credit and concentration risks include $222.5 million of hospitality loans, $66.0 million of retail loans and $17.0 million of oil and gas loans. Commercial real estate loans equaled 304% of the Bank’s regulatory capital measure; management characterized the concentration as acceptable and well-managed. Unused commitments to extend credit were $449.0 million.
- Management reported strong liquidity and no COVID-related capital impact to date, but highlighted uncertainties around borrower repayment, collateral values, deposit flows, interest rates, business closures and the duration of the pandemic. A 100-basis-point rate decline scenario projected a 6.3% reduction in 12-month net interest income, exceeding internal policy guidelines.
Important facts for investors to verify
- Track deferral expirations, borrower performance and collection of the $4.9 million in accrued but uncollected interest, especially in hospitality and other affected sectors.
- Assess future provisions, charge-offs, nonperforming assets and collateral values, including the results of the pending sale of the foreclosed commercial property.
- Verify the timing and actual equity and allowance impact of CECL adoption against management’s approximate $12 million estimate.
- Monitor net interest margin, deposit costs, mortgage warehouse utilization and the effect of continued low rates on earnings.
- Confirm continued liquidity and capital adequacy as loans, commitments and funding needs evolve, and monitor whether share repurchases resume.