REPUBLIC BANCORP INC annual report, FY2017

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Republic Bancorp, Inc. — 2017 Form 10-K

Business context and reporting period. This annual filing covers the fiscal year ended December 31, 2017; fourth-quarter figures are included below where notable. Republic Bancorp is a Louisville-based financial holding company operating through Republic Bank & Trust and an insurance subsidiary. Its five reportable segments are Traditional Banking, Warehouse Lending, Mortgage Banking, Tax Refund Solutions (TRS) and Republic Credit Solutions (RCS). Traditional Banking, Warehouse and Mortgage comprise Core Banking; TRS and RCS comprise the Republic Processing Group (RPG). Prior periods were reclassified after RCS became a separate reportable segment in 2017.

Financial performance and condition

  • Earnings and revenue: Pretax income rose 14% to $78.4 million, while net income declined 1% to $45.6 million and diluted Class A EPS fell to $2.20 from $2.22. Net interest income increased 27% to $198.5 million; noninterest income rose 2% to $58.4 million. Net revenue, defined as net interest income plus noninterest income, was approximately $256.9 million, up about 20%.
  • Margins and expenses: Total-company net interest margin expanded to 4.32% from 3.65%; Core Banking margin was 3.55% versus 3.30%. Total noninterest expense rose 16% to $150.8 million. The efficiency ratio improved to 59% from 61%.
  • Credit costs: Provision for loan losses more than doubled to $27.7 million from $14.5 million, primarily reflecting EA losses and RCS growth and charge-offs. Net charge-offs were $17.9 million, or 0.47% of average loans, versus $9.1 million, or 0.25%. The allowance rose to $42.8 million, 1.07% of loans, from $32.9 million, or 0.86%.
  • Balance sheet and asset quality: Assets increased 6% to $5.09 billion; gross loans rose 5% to $4.01 billion; deposits rose 9% to $3.43 billion. Nonperforming loans declined to $15.1 million, or 0.38% of loans, from $16.1 million, or 0.42%. Delinquent loans increased to $14.1 million, or 0.35% of loans, from $9.0 million, or 0.24%; RCS delinquencies were notably higher at 8.43% of its loans.
  • Liquidity and funding: Cash and equivalents were $299.4 million. The Bank had $347 million of additional FHLB borrowing capacity and $125 million of unsecured lines. Its loan-to-deposit ratio excluding brokered deposits was 133%. Management reported compliance with Board-approved liquidity policies at year-end, but said liquidity would likely remain near internal minimums and could occasionally fall below them, particularly during first-quarter EA originations. The 20 largest non-sweep deposit relationships totaled $637 million, 19% of deposits.
  • Debt and capital: Year-end FHLB advances were $737.5 million, repurchase agreements and other short-term borrowings $204.0 million, and the subordinated note $41.2 million. Total stockholders’ equity was $632.4 million. The Bank was categorized as well-capitalized; its total risk-based capital ratio was 13.69%, Common Equity Tier 1 ratio 12.70%, and leverage ratio 11.15%.
  • Cash flow: Operating activities provided $77.8 million; investing activities used $287.1 million; financing activities provided $219.4 million. Cash and equivalents increased $10.0 million during the year.
  • Shareholder returns: Class A dividends declared were $0.869 per share, versus $0.825 in 2016. The company repurchased 26,629 shares during 2017.

Material changes versus 2016

  • Growth in higher-yielding EA and RCS lending drove much of the increase in net interest income and the company-wide margin. EA originations rose to $329 million from $123 million; average RCS loans increased to $46 million from $17 million.
  • Higher credit costs offset revenue growth: RPG provision was $23.9 million versus $10.5 million. RCS provision increased to $17.4 million from $7.8 million; TRS provision increased to $6.5 million from $2.8 million.
  • Traditional Banking loans grew 7% and deposits 8%. Commercial real estate was a major loan-growth driver; owner-occupied residential and correspondent balances declined.
  • Mortgage Banking income fell 33% to $4.6 million. 2016 included a $1.1 million gain from a bulk sale of correspondent loans; secondary-market originations, excluding that sale, declined to $160 million from $217 million.
  • The TCJA prompted a $6.3 million deferred-tax remeasurement charge. Excluding that one-time charge, management presented non-GAAP adjusted net income of $52.0 million and diluted Class A EPS of $2.50, increases of 13% from 2016. These are non-GAAP figures, not reported GAAP results.

Outlook, commentary, risks and unusual items

  • Outlook: The filing gives no specific earnings or revenue guidance. Management expected further Federal Funds Target Rate increases in 2018 and considered them potentially favorable near term, while warning that rising funding costs or a flatter yield curve could pressure margins. Management expected lower mortgage originations and Warehouse line usage in 2018, and continued a shorter-duration investment strategy in anticipation of rising rates.
  • Interest-rate exposure: The Bank’s model projected net interest income changes of -4.6% in a 100-basis-point rate decline and +3.8%, +4.8%, +5.4% and +5.4% under +100, +200, +300 and +400 basis-point scenarios. The Down 100 result breached the Board’s -4.0% policy limit in November and December 2017; management and the Board chose a “wait and see” approach.
  • EA and RCS risks: EA repayment depends on tax refunds, with no recourse to the taxpayer for shortfalls; changes in IRS refund timing, fraud controls or funding patterns could increase losses. For the 2018 tax season, the company increased the maximum EA advance, expecting greater volume and proportionate charge-offs. RCS loans are generally unsecured and made to subprime or near-prime borrowers; revenue and earnings are concentrated in one line-of-credit product and third-party provider.
  • Other key risks: Deposit concentration and reliance on wholesale funding; Warehouse lending sensitivity to mortgage-market volume and fraud; interest-rate, credit and real-estate risks; regulatory and compliance exposure, particularly for RPG products; dependence on Fannie Mae/Freddie Mac mortgage programs and third-party service providers; and cybersecurity and operational interruptions.
  • Unusual items and contingencies: Q4 2017 net income was $4.8 million versus $10.0 million in Q4 2016, with the TCJA charge a significant factor. The company had $1.51 billion of off-balance-sheet commitments, including unused Warehouse lines, home-equity lines and other loan commitments; actual funding needs may be lower because some commitments expire or are unused. Management reported no pending or threatened legal matter expected to materially affect the company. The captive-insurance arrangements could draw IRS scrutiny and potentially result in penalties and interest.
  • Controls and audit: The independent auditor gave an unqualified opinion on the financial statements and internal control over financial reporting; management also concluded controls were effective.

Important facts for investors to verify

  1. Whether EA and RCS growth can be sustained without further increases in charge-offs, delinquency and allowance expense—especially following the 2018 increase in the EA maximum advance.
  2. How much of the 2017 margin and earnings growth came from seasonal or high-yield RPG products, and how those results compare with Core Banking performance.
  3. Deposit stability and funding concentration, including the potential cost and availability of replacement funding if large relationships leave.
  4. The effect of interest-rate and yield-curve changes, including the Bank’s decision not to remediate the Down 100 policy breach.
  5. The final tax accounting impact after the cost-segregation study, and the sustainability of earnings after the one-time TCJA charge.
  6. Whether loan commitments, third-party dependencies, regulatory developments and the captive-insurance tax treatment create material future costs or liquidity needs.