Merchants Bancorp — Q3 2019 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2019. Unaudited consolidated results. Merchants Bancorp is an Indiana bank holding company with multi-family mortgage banking, mortgage warehousing, and community banking businesses.
Financial performance and condition
- Q3 earnings: Net income was $20.3 million, up 21% from $16.7 million a year earlier. Net income attributable to common shareholders was $17.2 million; diluted EPS was $0.60, versus $0.55.
- Nine-month earnings: Net income was $47.3 million, slightly below $47.5 million in 2018. Common-shareholder income was $41.7 million versus $45.0 million; diluted EPS was $1.45 versus $1.57.
- Interest income and margin: Q3 net interest income rose 39% to $32.6 million; nine-month net interest income increased 29% to $84.7 million. Net interest margin declined to 2.22% from 2.53% in Q3 and to 2.45% from 2.52% for the nine months. Management attributed margin pressure to the flatter or inverted yield curve and a greater warehouse-loan mix.
- Other income and costs: Q3 noninterest income was $10.9 million, down 9%, partly reflecting lower servicing income and a negative fair-value adjustment to mortgage servicing rights (MSRs). Nine-month noninterest income fell 30% to $24.4 million, including lower loan-sale gains and servicing fees. Noninterest expense increased 25% in Q3 to $15.5 million and 28% over nine months to $44.5 million, driven chiefly by staffing and deposit insurance costs. Nine-month efficiency ratio rose to 40.8% from 34.5%.
- Balance sheet at September 30: Assets were $6.34 billion, up 63% from December 31, 2018. Loans held for sale were $2.50 billion; net loans held for investment were $2.74 billion. Deposits totaled $5.50 billion, borrowings $159.7 million, and shareholders' equity $629.4 million.
- Funding and liquidity: Deposits grew 70% from year-end, with brokered deposits reaching $2.3 billion, or 41% of deposits. Certificates of deposit due within one year totaled $2.2 billion. The company reported access to up to $634.6 million in additional FHLB advances and said it expected sufficient funding for current loan-origination commitments.
- Cash flows, nine months: Operating cash flow was negative $1.67 billion, investing cash flow negative $698.9 million, and financing cash flow positive $2.39 billion. The operating outflow largely reflects the high volume of loans originated or purchased for sale. Cash and equivalents increased $28.5 million to $365.0 million.
- Credit and capital: Allowance for loan losses was $13.7 million, or 0.50% of loans. Nonperforming loans were $6.1 million, up from $2.4 million at year-end; management cited several loans subsequently paid off in October and expected full repayment from a deceased borrower's estate. The company reported a 6.8% common equity Tier 1 ratio, below the 7.0% level needed to satisfy the capital conservation buffer; it said distributions could be limited to 60% of eligible retained income until the buffer is met or an alternative capital rule is elected. Management reported the company and bank subsidiaries as well capitalized under applicable prompt-corrective-action categories.
Material changes and segment trends
- Warehouse lending drove much of the growth: Q3 funded volume rose 132% year over year to $15.0 billion; nine-month volume rose 72% to $29.9 billion. Management compared this with industry increases of 32% and 14%, respectively.
- Warehouse segment net income rose 93% in Q3 to $10.9 million and 31% over nine months to $21.1 million. Banking segment net income increased 8% in Q3 to $7.6 million and 27% over nine months to $24.8 million.
- Multi-family mortgage banking net income declined 44% in Q3 to $2.7 million and 70% over nine months to $4.5 million. Lower loan-sale activity and MSR fair-value declines were important factors; January's federal government shutdown also delayed loan processing.
- During 2019, the company issued preferred stock with net proceeds of approximately $171.1 million after expenses and repurchases. It also issued and later repurchased 874,000 Series A preferred shares for $21.85 million. These transactions contributed to higher equity and funding capacity.
Outlook, risks, and unusual items
- No specific earnings or revenue guidance was provided. Management said lower mortgage rates had supported origination and refinancing activity and could support further warehouse growth if rates fell further.
- Management expects a substantial portion of the $2.2 billion in certificates of deposit maturing within a year to renew. If retention is weaker, replacement funding or higher deposit rates could increase interest expense.
- MSR fair value declined $5.9 million over the first nine months, with management citing lower multi-family rates and higher assumed prepayments; further rate declines could cause additional valuation decreases.
- Interest-rate sensitivity modeling showed estimated one-year net interest income changes of negative 13.5% and negative 18.6% for 100- and 200-basis-point rate declines, and positive 12.2% and 24.2% for corresponding increases. Management said results were within board policy limits.
- Management identified credit quality, real estate values, borrower and construction performance, interest rates, deposit retention, liquidity, regulatory compliance, cybersecurity, and growth execution among key risks. It warned that adoption of the expected-credit-loss standard may increase the loan-loss allowance, but the impact was not yet estimable.
- The filing reported no material change in risk factors from the 2018 Form 10-K, no legal proceedings, and no material changes to internal control over financial reporting. Disclosure controls were reported effective.
Important facts for investors to verify
- Whether warehouse loan growth and fee income remain sustainable, and how falling or rising rates affect funding costs and margins.
- Trends in brokered deposits, upcoming certificate maturities, and available borrowing capacity.
- Subsequent payment or resolution of delinquent and nonperforming loans, and adequacy of the allowance as the loan book expands.
- MSR valuation assumptions and their sensitivity to prepayments and interest rates.
- The company's capital conservation buffer position, distribution limits, and any election to use the community bank leverage ratio.