SOUTHSIDE BANCSHARES INC quarterly report, Q2 FY2018

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Southside Bancshares, Inc. — Q2 2018 Form 10-Q

Reporting period: Three and six months ended June 30, 2018. Comparisons are primarily with the same periods in 2017; balance-sheet comparisons are with December 31, 2017. Amounts are in U.S. dollars; financial statement figures are in millions unless stated otherwise.

Business context and reporting period

Southside Bancshares is a Texas bank holding company. The results include the effects of its November 2017 acquisition of Diboll State Bancshares and First Bank & Trust East Texas (“Diboll”), which expanded its East Texas presence. The filing is unaudited; interim results are not necessarily indicative of full-year results.

Financial results and position

  • Q2 earnings: Net income was $20.2 million, up 39.5% year over year; diluted EPS was $0.57 versus $0.49. For the first half, net income was $36.5 million, up 23.7%, and diluted EPS was $1.04 versus $1.00.
  • Interest income and margins: Q2 net interest income was $43.1 million, up 21.7%; first-half net interest income was $87.2 million, up 23.4%. Fully taxable-equivalent net interest margin was 3.19% for both Q2 and the first half, compared with 3.07% in the respective 2017 periods. Rising loan yields and the Diboll-related increase in average earning assets supported income; higher deposit and other funding costs partly offset the benefit.
  • Other income and expenses: Q2 noninterest income was $11.0 million, up 18.4%; first-half income was $20.6 million, up 8.7%. Q2 noninterest expense rose 14.6% to $29.3 million; first-half expense rose 18.6% to $60.9 million, reflecting acquisition integration, staffing, occupancy, and higher intangible amortization. 2018 and 2017 noninterest-income comparisons are affected by a new accounting presentation that nets certain debit-card and brokerage costs against revenue.
  • Credit costs and asset quality: Provision for loan losses was $1.3 million in Q2 and $5.0 million in the first half, compared with $1.3 million and $2.4 million in 2017. The June 30 allowance was $25.1 million, or 0.77% of loans, versus $20.8 million, or 0.63%, at year-end. Nonperforming assets increased to $42.4 million (0.68% of assets) from $10.5 million (0.16%); nonaccrual loans rose to $35.4 million from $2.9 million. The filing attributes most of the increase to two large commercial real estate relationships comprising three loans placed on nonaccrual in Q1.
  • Balance sheet and liquidity: Total assets were $6.25 billion, down 3.8% from year-end. Loans were $3.27 billion, down 0.7%; deposits were $4.51 billion, nearly unchanged. Cash and cash equivalents totaled $232.1 million. Management reported approximately $1.08 billion of additional FHLB borrowing capacity, net of required stock purchases; short-term investments were 5.9% of assets, down from 6.9% at year-end.
  • Funding and debt: FHLB borrowings decreased to $776.5 million from $1.02 billion. Brokered deposits increased to $114.3 million from $62.7 million. Subordinated notes were $98.3 million and trust preferred subordinated debentures were $60.2 million at June 30.
  • Cash flow: First-half operating activities provided $70.5 million and investing activities provided $230.5 million; financing activities used $267.6 million. Cash and cash equivalents increased $33.4 million to $232.1 million. Investing cash flow included substantial securities sales and maturities; financing included $240.9 million net repayment of FHLB borrowings and $20.3 million of dividends.
  • Capital and shareholder returns: Shareholders’ equity was $751.8 million, or 12.0% of assets, versus $754.1 million, or 11.6%, at year-end. At June 30, consolidated CET1, Tier 1, total capital, and Tier 1 leverage ratios were 15.49%, 17.02%, 20.31%, and 10.76%, respectively. The company reported meeting applicable capital requirements. First-half dividends were $0.58 per share.

Material changes and unusual items

  • Compared with year-end 2017, the securities portfolio fell by $246.0 million to $2.20 billion, primarily from sales of lower-yielding available-for-sale securities and portfolio realignment. First-half securities sales generated a net loss of $1.2 million.
  • Under its early adoption of ASU 2017-12, the company reclassified approximately $743.4 million of securities from held-to-maturity to available-for-sale. This was an accounting classification change, not a sale of those securities.
  • Accumulated other comprehensive loss increased by $21.0 million in the first half, primarily reflecting unrealized securities losses; this contributed to the slight decline in shareholders’ equity despite reported net income.
  • The Tax Cuts and Jobs Act reduced the federal corporate tax rate. The effective tax rate was 14.3% in Q2 and 13.0% for the first half, versus 18.8% and 17.8% in 2017. Management expected to realize a $3.5 million alternative minimum tax credit in 2018.
  • Q2 bank-owned life insurance income included death benefits related to a retired covered officer. The company also recorded acquisition integration costs, including change-in-control and severance payments and systems-related professional fees.

Outlook, risks, and contingencies

The filing provides no specific earnings or revenue guidance. Management says its balance-sheet strategy will continue to be reassessed as interest rates, yield curves, loan and deposit levels, funding costs, and securities economics change. Principal risks include the sharp rise in nonaccrual commercial real estate loans; borrower and collateral deterioration; interest-rate, yield-curve, and mortgage prepayment risk; liquidity and funding costs; and acquisition integration. Management noted that higher rates can improve modeled net interest income in some scenarios but can also reduce the fair value of available-for-sale securities and affect equity.

Interest-rate simulations projected that an immediate 100- or 200-basis-point increase would raise net interest income by 2.48% or 1.53%, respectively, over the next 12 months versus the base case; decreases of 100 or 200 basis points projected declines of 0.94% or 5.64%. These are model estimates, not guidance, and depend on assumptions. The company reported $803.1 million of unused commitments and standby letters of credit. Management believes ordinary-course litigation will not materially affect financial position, results, or liquidity; it reported no material change in previously disclosed risk factors.

Important facts for investors to verify

  1. Developments, collateral values, charge-offs, and reserve adequacy relating to the two large commercial real estate relationships behind the increase in nonaccrual loans.
  2. Whether credit quality stabilizes and the allowance and provision remain adequate as the portfolio evolves.
  3. The effects of deposit pricing, brokered-deposit growth, and FHLB funding changes on net interest margin and liquidity.
  4. Progress and remaining costs from Diboll integration, including whether acquired operations deliver expected revenue and expense benefits.
  5. How securities sales, market-value changes, and interest-rate hedges affect earnings, accumulated other comprehensive loss, and capital.
  6. Assumptions behind the interest-rate sensitivity simulations and the company’s forthcoming implementation of expected-credit-loss accounting (CECL), planned for January 1, 2020.