Business context and reporting period
Capitol Federal Financial, Inc. is a Kansas-focused community bank holding company whose principal subsidiary, Capitol Federal Savings Bank, historically emphasized residential mortgage lending and retail deposits. This Form 10-K covers the fiscal year ended September 30, 2018; it is an annual report, not a standalone fourth-quarter filing. The unaudited fourth-quarter results are noted separately below.
On August 31, 2018, the Company acquired Capital City Bancshares, Inc. (CCB), issuing 3.0 million shares for consideration of $39.1 million. The acquisition added $299.7 million of loans and $352.5 million of deposits at fair value, and expanded the Bank into commercial banking, trust and brokerage services. The Company recorded $8.0 million of goodwill and approximately $9.8 million of core deposit and other intangibles.
Financial and operating metrics
| Metric | FY 2018 | FY 2017 |
|---|---|---|
| Interest and dividend income | $321.9 million | $313.2 million |
| Net interest income | $198.8 million | $195.4 million |
| Net income | $98.9 million | $84.1 million |
| Diluted EPS | $0.73 | $0.63 |
| Net interest margin | 1.95% | 1.79% |
| Efficiency ratio | 43.89% | 41.21% |
FY 2018 net income increased 17.6%. The principal driver was lower income tax expense, rather than a comparable increase in pre-tax earnings: income before tax was $123.9 million, down from $127.9 million. The effective tax rate fell to 20.2% from 34.2%; the Tax Act deferred-tax remeasurement reduced expense by $7.5 million. Net interest margin excluding the leverage strategy was 2.24%, up from 2.15%.
For the fourth quarter of FY 2018, net interest income was $50.1 million and net income was $21.4 million, or $0.16 per diluted share. The comparable fourth-quarter FY 2017 figures were $49.7 million, $20.6 million and $0.15, respectively.
At September 30, 2018, total assets were $9.45 billion, net loans $7.51 billion, deposits $5.60 billion, borrowings $2.29 billion and stockholders’ equity $1.39 billion. The year-over-year asset increase of $256.6 million was primarily acquisition-related. The Bank’s securities-and-cash-to-assets ratio was 15.5%, against a management target of approximately 15%; cash and cash equivalents were $139.1 million. The Bank reported $670.8 million of eligible, unused securities collateral for borrowing or other liquidity needs.
Total FY 2018 operating cash flow was $124.2 million; investing cash flow was negative $21.6 million and financing cash flow was negative $315.2 million. Cash and cash equivalents declined by $212.6 million to $139.1 million. The financing cash-flow statement includes large, largely offsetting short-term borrowing proceeds and repayments associated with the leverage strategy.
FHLB borrowings were approximately $2.18 billion and repurchase agreements were $100 million. Total borrowings were about 24% of assets, below the Bank’s 55% internal limit. The Bank reported a 13.0% Tier 1 leverage ratio and was considered well capitalized. Commercial loans totaled $569.6 million, about 7.7% of loans; commercial real estate represented most of that portfolio.
Asset quality remained favorable by the reported measures: non-performing loans were 0.15% of loans, non-performing assets were 0.14% of assets, and the allowance for credit losses was $8.5 million, or 0.11% of net loans. The Bank recorded no provision for credit losses and reported $65,000 of net recoveries during FY 2018.
Material changes versus the prior comparable period
- CCB’s acquisition expanded the branch network to 58 locations and introduced commercial and industrial lending, commercial deposits, and related services. Commercial loans increased from $270.0 million to $569.6 million, partly reflecting the acquisition.
- Net interest margin rose 16 basis points, mainly as earning-asset yields increased. Deposit interest expense rose $9.7 million, while total interest expense increased $5.3 million.
- Non-interest expense increased 8.1% to $96.9 million, including higher payroll, technology costs, acquisition expenses and intangible amortization. The efficiency ratio consequently worsened.
- Cash dividends paid totaled $118.3 million, or $0.88 per share, including a $0.25-per-share special dividend. The acquisition added 3.0 million common shares.
- The fair value of HTM securities was $11.2 million below amortized cost at year-end, versus a $5.3 million unrealized gain in FY 2017; management attributed the change primarily to higher market interest rates and reported no other-than-temporary impairment.
Outlook, management commentary and risks
Management estimated an effective tax rate of approximately 22% for FY 2019 and anticipated CCB employee costs of about $5.6 million and deposit-intangible amortization of about $2.4 million. Systems integration was expected to finish early in the second calendar quarter of 2019; management planned to review the branch network afterward. The Company stated its intent to distribute 100% of FY 2019 earnings through regular quarterly dividends and a true-up dividend, subject to results, capital needs and regulatory limits. This is an intention, not a guarantee.
The Bank used a leverage strategy involving up to $2.10 billion of short-term FHLB funding deposited at the Federal Reserve. It was suspended at times when the spread was negative; FY 2018 net income attributed to the strategy was $1.7 million, down from $2.8 million. Management said it may resume the strategy if it becomes profitable.
Interest-rate risk is significant given the Bank’s long-term fixed-rate mortgage assets and shorter-term funding. Its modeled FY 2018 net interest income declined 4.67% under an immediate +200-basis-point rate scenario; modeled market value of portfolio equity declined 24.73%. These are scenario estimates, not earnings guidance. The Bank also disclosed $831.1 million of LIBOR-indexed adjustable-rate loans and $475.0 million of LIBOR-linked swaps, with LIBOR expected to be phased out by the end of 2021.
Other key risks include the performance and integration of CCB’s commercial real estate and acquired commercial and industrial loans; local and correspondent-market economic and property-value changes; deposit competition and funding costs; cyber and technology disruptions; regulatory changes; and dependence on Bank capital distributions to fund holding-company dividends. The Company reported no material cybersecurity breach and said pending litigation was not expected to have a material adverse effect. The auditor issued unqualified opinions on the financial statements and internal control; the CCB operation was excluded from the internal-control assessment during the permitted first year after acquisition.
Important facts for investors to verify
- Whether CCB integration, expected cost savings and branch-network decisions proceed as planned, and how acquired commercial credits perform.
- Whether the planned 100% earnings payout remains affordable and receives any required regulatory non-objection.
- How rising rates, deposit repricing, the leverage strategy and LIBOR transition affect net interest income and capital-value sensitivity.
- Whether FY 2018 earnings growth persists after the $7.5 million deferred-tax benefit and as the effective tax rate normalizes.
- Whether the allowance for credit losses remains adequate as commercial lending grows and acquired-loan purchase discounts are absorbed.