First Business Financial Services, Inc. — Q1 2018 Form 10-Q
Reporting period: Three months ended March 31, 2018. The company is a Wisconsin-based commercial bank focused on business clients in Wisconsin and the greater Kansas City area, with trust, investment, SBA lending, equipment finance and other services.
Financial performance and position
- Revenue and earnings: Net interest income was $16.2 million, up 8.8% from $14.9 million. Non-interest income rose 14.9% to $4.7 million; combined top-line revenue increased 10.1% to $20.9 million. Net income was $3.65 million, versus $3.40 million, and diluted EPS was $0.42 versus $0.39.
- Margins and returns: Net interest margin increased to 3.65% from 3.51%. Annualized return on average assets was 0.78% versus 0.77%; return on average equity was 8.88% versus 8.31%. The efficiency ratio improved to 67.45% from 70.85%.
- Credit costs and asset quality: Provision for loan and lease losses rose to $2.48 million from $0.57 million. Net charge-offs were $2.60 million, compared with net recoveries of $0.18 million in Q1 2017; management attributed most current-quarter charge-offs to three legacy SBA loan relationships. Non-accrual loans declined to $20.0 million from $26.4 million at year-end, and non-performing assets to total assets fell to 1.15% from 1.53%. The allowance was $18.6 million, or 1.19% of gross loans, versus $18.8 million, or 1.25%.
- Balance sheet and funding: Total assets rose to $1.878 billion from $1.794 billion at December 31, 2017, primarily from loan growth. Gross loans and leases were $1.565 billion, up about $62 million from year-end. Deposits declined 1.7% to $1.371 billion, while FHLB advances and other borrowings increased to $308.9 million from $207.9 million. Stockholders’ equity was $171.5 million.
- Liquidity and cash flow: Cash and cash equivalents were $61.3 million, up from $52.5 million at year-end. Q1 operating cash flow was $8.6 million; investing activities used $76.4 million and financing activities provided $76.6 million, primarily reflecting loan growth funded through increased FHLB advances. Management reported immediate on-balance-sheet liquidity of $325.5 million, down from $401.1 million at year-end, and said available liquidity exceeded policy minimums.
- Capital and debt: The Bank remained “well capitalized,” and the company reported regulatory capital above minimum requirements. The company was in compliance with its secured senior line-of-credit covenants. Junior subordinated notes were $10.0 million; total liabilities were $1.707 billion.
Material changes and notable items
- Higher loan balances and yields drove interest income growth, while increased funding costs partially offset the benefit. The company cited a rising-rate environment and anticipated further pressure on deposit costs amid competition.
- Trust and investment service fees increased 16.5% to $1.9 million. Commercial loan swap fees rose to $0.63 million from $0.20 million; gains on SBA loan sales declined to $0.27 million from $0.36 million.
- The effective income tax rate fell to 18.7% from 29.5%, reflecting the federal corporate tax rate reduction effective January 1, 2018. Net income benefited despite the substantially higher credit-loss provision.
- Available-for-sale securities had $1.36 million of pre-tax unrealized losses in Q1, largely attributed to interest rates. Management reported no other-than-temporary impairment and did not expect to be required to sell the securities.
- The SBA recourse reserve recorded a $295,000 benefit, versus a $6,000 expense a year earlier; the reserve balance was $2.52 million. Management noted reserve changes may cause future expense volatility.
- ASC 606 was adopted in Q1 without a cumulative adjustment or change to accounting practices for in-scope revenue streams. The company plans to adopt the expected-credit-loss standard in 2020 and was evaluating its impact.
Outlook, commentary and risks
- No specific full-year earnings guidance was provided. Management expects modest loan and lease growth and said it aims to maintain net interest margin at or above 3.50%.
- Management expects a rebuilt SBA platform to support moderate production growth. Its long-term efficiency-ratio goal is 58%–62%; the current-quarter ratio remained above that range. Charter consolidation and core-system conversions are expected to create operating capacity.
- The company identified risks including competition, adverse economic conditions and borrower defaults, interest-rate and market-price changes, growth-management challenges, regulatory and tax changes, fraud or cybersecurity breaches, and compliance with SBA requirements. It reported no material change to previously disclosed risk factors.
- Management did not anticipate material losses from ordinary-course legal proceedings. No material changes to contractual obligations or off-balance-sheet arrangements were reported.
Important facts for investors to verify
- Whether the elevated credit provision and charge-offs tied to legacy SBA loans recur, and how the allowance changes relative to portfolio growth and non-accrual loans.
- Whether loan growth, deposit gathering and funding costs sustain the reported 3.65% net interest margin as rates and competition evolve.
- Whether the $325.5 million reported immediate on-balance-sheet liquidity and increased reliance on FHLB funding remain adequate as loans grow and deposits fluctuate.
- Whether SBA loan production improves as management expects, and whether the $2.52 million recourse reserve adequately reflects repurchase and guaranty risks.
- Whether management makes progress toward the 58%–62% efficiency-ratio goal and whether unrealized securities losses or adoption of the expected-credit-loss standard materially affect capital or earnings.