Business Context and Reporting Period
This filing is a Form 10-K for Cornerstone Bancshares, Inc. and its wholly owned subsidiary, Cornerstone Community Bank, for the fiscal year ended December 31, 2014. The request metadata identifies SmartFinancial Inc.; however, the filing text is for Cornerstone Bancshares and describes a pending merger with SmartFinancial. The bank operated five full-service branches in Hamilton County, Tennessee, and one loan production office in Dalton, Georgia, with approximately 104 full-time equivalent employees.
The bank primarily gathers deposits and originates commercial, commercial real estate, residential real estate, construction and consumer loans. Eagle Financial operated as a division focused on accounts receivable purchases and commercial loan placement.
Financial Performance and Condition
| Metric | 2014 | 2013 | Change |
|---|---|---|---|
| Total assets | $415.7 million | $432.2 million | Down 3.8% |
| Total loans | $295.4 million | $289.4 million | Up 2.0% |
| Total deposits | $308.7 million | $341.4 million | Down 9.6% |
| Stockholders’ equity | $40.7 million | $40.1 million | Up 1.3% |
| Net interest income | $15.35 million | $14.93 million | Up 2.8% |
| Provision for loan losses | $0.52 million | $0.30 million | Up $0.22 million |
| Noninterest income | $1.82 million | $1.94 million | Down 6.2% |
| Noninterest expense | $14.00 million | $13.85 million | Up 1.1% |
| Net income | $1.64 million | $1.68 million | Down 2.5% |
| Net income available to common shareholders | $66,900 | $109,428 | Down 38.9% |
| Basic and diluted EPS | $0.01 | $0.02 | Lower |
| Net interest margin | 3.90% | 3.80% | Up 10 basis points |
| Return on average assets | 0.39% | 0.39% | Flat |
| Return on average equity | 4.04% | 4.12% | Down 8 basis points |
Interest income declined to $18.14 million from $18.45 million, but interest expense fell more substantially to $2.79 million from $3.52 million. Lower deposit and borrowing costs drove the improvement in net interest income and margin. The loan portfolio yield declined to 5.68% from 5.99%, reflecting competitive lending conditions.
Net income was $1.64 million, but $1.50 million of preferred dividends and $71,000 of preferred stock accretion reduced income available to common shareholders to $66,900. No cash dividends were paid on common stock in 2014 or 2013. Preferred stock dividends were subject to regulatory approval, and $750,000 of preferred dividends had accumulated and were undeclared at year-end 2014.
Cash Flow, Debt and Liquidity
- Cash and cash equivalents declined to $15.5 million from $24.9 million.
- Operating activities provided $3.54 million of cash, compared with $4.42 million in 2013.
- Investing activities provided $5.51 million, principally reflecting security sales, distributions from an equity investment and proceeds from foreclosed assets.
- Financing activities used $18.37 million, primarily because deposits declined by $32.76 million and $1.50 million was paid in preferred dividends.
- Federal Home Loan Bank advances and other borrowings totaled $36.0 million at year-end, compared with $26.7 million in 2013. Federal funds purchased and repurchase agreements totaled $29.4 million.
- The bank reported a 19.8% liquidity ratio, $13.4 million of additional FHLB availability and $30 million of federal funds lines with correspondent banks.
- Approximately $26 million of FHLB advances were scheduled to mature in 2015. Management expected to refinance these advances with shorter-term, lower-cost borrowings.
Asset Quality and Capital
- Nonperforming assets were 2.61% of total assets, down from 3.82% in 2013; nonperforming assets were 3.68% of total loans, down from 5.70%.
- Nonaccrual loans declined to $2.9 million from $3.6 million. Loans delinquent 30 days or more but still accruing were 0.56% of total loans.
- Foreclosed assets declined to $8.0 million from $12.9 million and approximately $20.3 million at December 31, 2012, although related expenses remained elevated.
- Substandard loans declined to $10.4 million from $15.0 million, and special-mention loans declined to $7.8 million from $10.6 million.
- The allowance for loan losses increased to $3.50 million from $3.20 million, equal to 1.19% of average loans. Net charge-offs were approximately $223,000, compared with $3.24 million in 2013.
- The bank was categorized as well capitalized. Its year-end regulatory ratios were 13.45% total risk-based capital, 12.32% Tier 1 risk-based capital and 9.38% Tier 1 leverage.
Material Changes Versus the Prior Comparable Period
- Loans grew modestly while total assets and deposits contracted materially. Core funding fell to 59.2% of total funding from 66.8%, while non-core funding rose to 40.8% from 33.2%.
- Net interest margin improved because interest-bearing liability costs declined, despite lower loan and investment yields.
- Provision expense increased, but net charge-offs fell sharply and credit-quality indicators improved.
- Foreclosed assets and related expense declined, but foreclosed-asset expense remained a significant earnings drag at $1.84 million.
- Noninterest income declined primarily because loan and other asset-sale gains were lower, partly offset by higher securities-sale gains and customer service fees.
- Compensation expense rose to $7.05 million from $6.56 million, contributing to higher noninterest expense.
- The company distributed approximately $2.39 million from its Appalachian Fund for Growth II investment as the fund wound down. The investment was dissolved during 2014.
Guidance, Outlook, Risks and Unusual Items
Merger with SmartFinancial
On December 5, 2014, Cornerstone, Cornerstone Community Bank, SmartFinancial and SmartBank entered into a merger agreement. The surviving company was expected to be renamed SmartFinancial, Inc., with the banks initially continuing to operate separately. The announced exchange ratio was 4.20 Cornerstone shares for each SmartFinancial common share, subject to an anticipated reverse stock split that would adjust the ratio to approximately 1.05 Cornerstone shares per SmartFinancial share. SmartFinancial preferred stock was to be converted into preferred stock with similar rights and preferences.
Completion required shareholder and regulatory approvals, redemption of Cornerstone preferred stock, charter and bylaw amendments, possible financing transactions and other customary conditions. Termination fees of $1.2 million plus expenses could apply under specified circumstances. The filing states that SmartFinancial would be treated as the accounting acquirer, meaning the post-merger historical financial statements would be those of SmartFinancial.
Management Outlook
- Management expected loan growth to continue in 2015, particularly as construction loans converted to permanent commercial real estate financing, but acknowledged that competitive pressure could further reduce loan yields.
- Management expected approximately $300,000 of annual interest-cost savings from refinancing maturing FHLB advances.
- Management expected foreclosed-asset expense to remain elevated in 2015 while reducing the remaining foreclosed-asset balance.
- Management expected asset quality and nonaccrual loans to continue improving, but acknowledged that special-mention loans could temporarily rise as substandard loans were reassessed.
- Management identified strengthening core deposits and improving liquidity as high priorities for 2015.
Principal Risks and Contingencies
- Credit losses, particularly in commercial real estate, construction and land-development lending, could increase if local economic or real estate conditions deteriorate.
- The bank remains exposed to elevated foreclosed assets, appraisal risk and valuation losses on collateral-dependent loans.
- Liquidity depends materially on customer deposits, loan repayments, borrowings and dividends from the bank to the holding company. Bank dividends require prior regulatory approval.
- Interest-rate changes could reduce net interest income, asset values and loan demand. Almost all variable-rate loans had repriced to contractual floors.
- The company had a $1.8 million net deferred tax asset without a valuation allowance; failure to generate sufficient taxable income could require a valuation allowance and reduce earnings.
- New Basel III requirements and continuing federal and state regulation could increase capital, compliance and operating costs.
- Undisbursed loan commitments and standby letters of credit totaled approximately $46.5 million and $330,000, respectively, at year-end.
- The filing reports no material litigation, but ordinary-course claims remain possible.
- The merger could result in integration challenges, dilution, regulatory conditions, preferred-stock redemption requirements and termination fees.
Most Important Facts an Investor Should Verify
- Entity and period: Confirm whether the intended filing is Cornerstone Bancshares’ fiscal 2014 Form 10-K or a separate SmartFinancial filing; the supplied text is not filed under the name SmartFinancial.
- Merger status: Verify subsequent shareholder and regulatory approvals, closing date, final exchange ratio, reverse stock split and treatment or redemption of preferred stock.
- Deposit and liquidity trends: Monitor the significant deposit decline, increased reliance on non-core funding and maturity or refinancing of $26 million of FHLB advances in 2015.
- Credit quality: Verify whether declines in nonaccrual loans, substandard loans and foreclosed assets continued, and whether the $3.50 million allowance remains adequate.
- Common shareholder economics: Assess the effect of $1.5 million of annual preferred dividends, accumulated undeclared dividends, conversion rights and merger-related dilution on common shareholders.
- Deferred tax asset: Confirm continued realization support for the $1.8 million net deferred tax asset.
- Post-merger accounting: Review purchase accounting, fair-value adjustments, goodwill and identifiable intangibles once the transaction closes.