First Merchants Corporation — Q2 2017 Form 10-Q
Reporting period: Three and six months ended June 30, 2017. Financial statements are unaudited; amounts below are in millions unless otherwise noted.
Business context and reporting period
First Merchants is an Indiana-based community banking holding company. Its banking operations provide commercial, consumer and real estate lending, deposits, wealth management and related services. Results include Arlington Bank from its May 19, 2017 acquisition; the acquired bank contributed approximately $338.7 million of assets and $252.8 million of deposits at acquisition.
Key financial results
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Net interest income | $63.1 | $56.0 | $124.1 | $110.4 |
| Provision for loan losses | $2.9 | $0.8 | $5.3 | $1.3 |
| Other income | $18.4 | $16.4 | $33.3 | $32.2 |
| Other expenses | $47.3 | $44.8 | $90.4 | $91.3 |
| Net income available to common stockholders | $24.1 | $20.0 | $47.3 | $37.7 |
| Diluted earnings per share | $0.57 | $0.49 | $1.13 | $0.92 |
- Q2 revenue, defined by management as net interest income plus other income, was approximately $81.5 million. Q2 net income rose about 20.6%; diluted EPS rose 16.3%. For the six months, net income rose about 25.5% and diluted EPS rose 22.8%.
- Fully taxable equivalent net interest margin was 3.95% in Q2, versus 3.86% a year earlier; the six-month margin was 3.96%, versus 3.85%. Management attributed improvement to higher earning-asset yields, loan growth, the Arlington acquisition and recent Federal Reserve rate increases. Purchased-loan fair-value accretion contributed $2.3 million in Q2 and $6.6 million year to date.
- Q2 other income benefited from $2.2 million of life-insurance benefits, compared with $0.4 million a year earlier. The filing does not identify this as a recurring source of income.
- Q2 other expenses increased 5.5%, including approximately $2.5 million of Arlington merger, integration and system-conversion costs. Six-month expenses declined 1.0% year over year, reflecting efficiency efforts and lower FDIC assessments, partly offset by higher processing and acquisition-related costs.
Financial position, cash flow and capital
- At June 30, total assets were $7.805 billion, up 8.2% from year-end 2016; gross loans were $5.613 billion, deposits $6.017 billion, and stockholders’ equity $1.035 billion. Arlington accounted for a substantial portion of the growth.
- Cash and cash equivalents were $142.7 million, compared with $127.9 million at December 31. For the first six months, operating cash flow was $57.5 million, investing cash outflow was $247.7 million and financing cash flow was $204.9 million.
- Total borrowings were $703.9 million, up $9.8 million from year-end. This included $312.7 million of FHLB advances, $134.6 million of federal funds purchased, $127.9 million of repurchase agreements and $128.7 million of subordinated debentures and term loans. Remaining FHLB borrowing capacity was $560.9 million.
- Management reported all bank regulatory ratios above “well-capitalized” thresholds. At June 30, the Bank’s total risk-based capital ratio was 13.19%, CET1 ratio 12.13% and Tier 1 leverage ratio 11.05%. The Corporation’s tangible common equity to tangible assets ratio, a non-GAAP measure, was 9.68%.
- Common dividends were $0.18 per share in Q2 and $0.33 per share for the first half, compared with $0.14 and $0.25, respectively, in 2016.
Material changes, outlook, risks and unusual items
- Credit quality: The allowance for loan losses was $70.5 million, or 1.25% of loans, versus $66.0 million and 1.28% at year-end. Non-accrual loans were $27.3 million; non-performing loans were $27.7 million; and non-performing assets plus loans 90 days delinquent were $40.3 million, down from $43.8 million at year-end. The allowance covered non-accrual loans by 257.7%. Management said the higher provision primarily reflected organic loan growth and considered the allowance adequate.
- Arlington acquisition: The company issued approximately 2.1 million shares valued at $82.6 million. Preliminary purchase accounting recorded $48.2 million of goodwill and a $4.5 million core deposit intangible. Management expected the acquisition to be accretive, but the filing does not quantify expected accretion.
- Subsequent acquisition: On July 14, 2017, First Merchants completed its acquisition of Independent Alliance Banks (IALB), after the reporting date. Approximately 6.0 million shares were issued for the remaining shares; the stated transaction value was approximately $238.9 million. IALB had $1.1 billion of assets, $754.2 million of loans and $863.5 million of deposits at June 30. Full integration under the First Merchants brand was expected in Q4 2017; fair-value and purchase-price allocations remained incomplete. A $50,000 loss related to remeasurement of First Merchants’ previously held IALB stake was expected in Q3.
- Interest-rate sensitivity: Management’s 12-month simulation at June 30 estimated net interest income would rise 8.21% under an immediate 200-basis-point increase and fall 11.44% under a 100-basis-point decrease versus the modeled base case. These are scenario estimates, not guidance; actual results may differ.
- Principal risks and contingencies: The filing cites sensitivity to rates and loan/deposit pricing, economic and credit deterioration, real estate values, competition, regulation, acquisition integration, liquidity and capital availability. Loan commitments and standby/commercial letters of credit totaled $2.653 billion, much of which may expire unused. Management said ordinary-course litigation and regulatory examinations were not expected to have a material adverse effect; no material change to previously disclosed risk factors was reported.
- Accounting outlook: The company was evaluating CECL, effective for it beginning in 2020, and said the eventual effect could materially affect the allowance and earnings, but could not yet be estimated. Adoption of the new lease standard was also under evaluation; management did not provide a quantified impact. No formal earnings guidance was provided.
Important facts for investors to verify
- Whether Arlington and IALB integration proceeds as planned and delivers the expected accretion, synergies and cost savings; monitor remaining purchase-accounting adjustments.
- Whether loan growth continues without weakening credit quality; track provision expense, charge-offs, non-accruals, criticized loans, troubled restructurings and other real estate owned.
- How deposit pricing and borrowing costs respond to rate changes, and whether actual net interest margin and income track management’s simulations.
- The durability of earnings excluding acquisition costs, purchased-loan accretion and life-insurance gains, alongside ongoing technology and integration expenses.
- Any CECL transition estimate, capital implications, liquidity changes or material developments in contingencies and regulatory matters.