UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
☒
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2017
OR
☐
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ________ to ________
Commission File Number 001-37624
EQUITY BANCSHARES, INC.
(Exact name of registrant as specified in its charter)
Kansas
72-1532188
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
7701 East Kellogg Drive, Suite 300
Wichita, KS
67207
(Address of principal executive offices)
(Zip Code)
Registrant’s telephone number, including area code: 316.612.6000
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. ☒Yes ☐ No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). ☒ Yes ☐ No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer ☐ Accelerated filer ☒
Non-accelerated filer (Do not check is a smaller reporting company) ☐
Smaller reporting company ☐
Emerging growth company ☒
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). ☐ Yes ☒ No
Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.
Shares outstanding as of
August 4, 2017
Class A Common Stock, par value $0.01 per share
12,019,806
Class B Non-Voting Common Stock, par value $0.01 per share
186,513
TABLE OF CONTENTS
PART I
Financial Information
5
Item 1.
Financial Statements
Consolidated Balance Sheets
Consolidated Statements of Income
6
Consolidated Statements of Comprehensive Income
7
Consolidated Statements of Stockholders’ Equity
8
Consolidated Statements of Cash Flows
9
Condensed Notes to Interim Consolidated Financial Statements
11
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
36
Overview
Critical Accounting Policies
38
Results of Operations
40
Financial Condition
51
Liquidity and Capital Resources
64
Non-GAAP Financial Measures
67
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
70
Item 4.
Controls and Procedures
72
Part II
OTHER INFORMATION
73
Legal Proceedings
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
Mine Safety Disclosures
Item 5.
Other Information
Item 6.
Exhibits
Important Notice about Information in this Quarterly Report
Unless we state otherwise or the context otherwise requires, references in this Quarterly Report to “we,” “our,” “us,” “the Company” and “Equity” refer to Equity Bancshares, Inc. and its consolidated subsidiaries, including Equity Bank, which we sometimes refer to as “Equity Bank,” “the Bank” or “our Bank.”
The information contained in this Quarterly Report is accurate only as of the date of this Quarterly Report on Form 10-Q and as of the dates specified herein.
2
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
This Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These forward-looking statements reflect our current views with respect to, among other things, future events and our financial performance. These statements are often, but not always, made through the use of words or phrases such as “may,” “should,” “could,” “predict,” “potential,” “believe,” “will likely result,” “expect,” “continue,” “will,” “anticipate,” “seek,” “estimate,” “intend,” “plan,” “project,” “forecast,” “goal,” “target,” “would” and “outlook,” or the negative variations of those words or other comparable words of a future or forward-looking nature. These forward-looking statements are not historical facts, and are based on current expectations, estimates and projections about our industry, management’s beliefs and certain assumptions made by management, many of which, by their nature, are inherently uncertain and beyond our control. Accordingly, we caution you that any such forward-looking statements are not guarantees of future performance and are subject to risks, assumptions and uncertainties that are difficult to predict. Although we believe that the expectations reflected in these forward-looking statements are reasonable as of the date made, actual results may prove to be materially different from the results expressed or implied by the forward-looking statements. When considering forward-looking statements, you should keep in mind the risk factors and other cautionary statements described under the heading “Item 1A - Risk Factors” in our Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”) on March 16, 2017, and in Item 1A – Risk Factors of this Quarterly Report.
There are or will be important factors that could cause our actual results to differ materially from those indicated in these forward-looking statements, including, but not limited to, the following:
•
an economic downturn, especially one affecting our core market areas;
the occurrence of various events that negatively impact the real estate market, since a significant portion of our loan portfolio is secured by real estate;
difficult or unfavorable conditions in the market for financial products and services generally;
interest rate fluctuations, which could have an adverse effect on our profitability;
external economic and/or market factors, such as changes in monetary and fiscal policies and laws, including the interest rate policies of the Board of Governors of the Federal Reserve System (the “Federal Reserve”), inflation or deflation, changes in the demand for loans, and fluctuations in consumer spending, borrowing and savings habits, which may have an adverse impact on our financial condition;
continued or increasing competition from other financial institutions, credit unions, and non-bank financial services companies, many of which are subject to different regulations than we are;
costs arising from the environmental risks associated with making loans secured by real estate;
losses resulting from a decline in the credit quality of the assets that we hold;
inadequacies in our allowance for loan losses, which could require us to take a charge to earnings and thereby adversely affect our financial condition;
inaccuracies or changes in the appraised value of real estate securing the loans that we originate, which could lead to losses if the real estate collateral is later foreclosed upon and sold at a price lower than the appraised value;
the costs of integrating the businesses we acquire, which may be greater than expected;
challenges arising from unsuccessful attempts to expand into new geographic markets, products, or services;
a lack of liquidity resulting from decreased loan repayment rates, lower deposit balances, or other factors;
restraints on the ability of Equity Bank to pay dividends to us, which could limit our liquidity;
the loss of our largest loan and depositor relationships;
limitations on our ability to lend and to mitigate the risks associated with our lending activities as a result of our size and capital position;
additional regulatory requirements and restrictions on our business, which could impose additional costs on us;
increased capital requirements imposed by banking regulators, which may require us to raise capital at a time when capital is not available on favorable terms or at all;
a failure in the internal controls we have implemented to address the risks inherent to the business of banking;
3
inaccuracies in our assumptions about future events, which could result in material differences between our financial projections and actual financial performance;
the departure of key members of our management personnel or our inability to hire qualified management personnel;
disruptions, security breaches, or other adverse events, failures or interruptions in, or attacks on, our information technology systems;
unauthorized access to nonpublic personal information of our customers, which could expose us to litigation or reputational harm;
disruptions, security breaches, or other adverse events affecting the third-party vendors who perform several of our critical processing functions;
the occurrence of adverse weather or manmade events, which could negatively affect our core markets or disrupt our operations;
an increase in FDIC deposit insurance assessments, which could adversely affect our earnings;
an inability to keep pace with the rate of technological advances due to a lack of resources to invest in new technologies; and
other factors that are discussed in “Item 1A - Risk Factors.”
The foregoing factors should not be construed as exhaustive and should be read in conjunction with other cautionary statements that are included in this Quarterly Report. If one or more events related to these or other risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may differ materially from what we anticipate. Accordingly, you should not place undue reliance on any such forward-looking statements. Any forward-looking statement speaks only as of the date on which it is made, and we do not undertake any obligation to publicly update or review any forward-looking statement, whether as a result of new information, future developments or otherwise. New risks and uncertainties arise from time to time, and it is not possible for us to predict those events or how they may affect us. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. All forward-looking statements, expressed or implied, included in this Quarterly Report on Form 10-Q are expressly qualified in their entirety by this cautionary statement. This cautionary statement should also be considered in connection with any subsequent written or oral forward-looking statements that we or persons acting on our behalf may issue.
4
Item 1: Financial Statements
CONSOLIDATED BALANCE SHEETS
June 30, 2017 and December 31, 2016
(Dollar amounts in thousands)
(Unaudited)
June 30,
December 31,
2017
2016
ASSETS
Cash and due from banks
$
24,193
34,137
Federal funds sold
19
958
Cash and cash equivalents
24,212
35,095
Interest-bearing time deposits in other banks
4,241
3,750
Available-for-sale securities
92,435
95,732
Held-to-maturity securities, fair value of $531,296 and $461,156
532,159
465,709
Loans held for sale
3,463
4,830
Loans, net of allowance for loan losses of $7,568 and $6,432
1,521,828
1,377,173
Other real estate owned, net
11,714
8,656
Premises and equipment, net
54,693
50,515
Bank owned life insurance
48,765
48,055
Federal Reserve Bank and Federal Home Loan Bank stock
19,795
16,652
Interest receivable
9,062
6,991
Goodwill
64,587
58,874
Core deposit intangible, net
5,719
4,715
Other
15,951
15,445
Total assets
2,408,624
2,192,192
LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits
Demand
262,508
207,668
Total non-interest-bearing deposits
Savings, NOW, and money market
901,396
869,625
Time
655,773
553,158
Total interest-bearing deposits
1,557,169
1,422,783
Total deposits
1,819,677
1,630,451
Federal funds purchased and retail repurchase agreements
21,069
20,637
Federal Home Loan Bank advances
257,408
259,588
Subordinated debentures
13,825
13,684
Contractual obligations
2,211
2,504
Interest payable and other liabilities
8,376
7,364
Total liabilities
2,122,566
1,934,228
Commitments and contingent liabilities, see Notes 10 and 11
Stockholders’ equity, see Note 6
Common stock
137
132
Additional paid-in capital
252,469
236,103
Retained earnings
55,546
44,328
Accumulated other comprehensive loss
(2,269
)
(2,702
Employee stock loans
(170
(242
Treasury stock
(19,655
Total stockholders’ equity
286,058
257,964
Total liabilities and stockholders’ equity
See accompanying condensed notes to interim consolidated financial statements.
CONSOLIDATED STATEMENTS OF INCOME
For the Three and Six Months ended June 30, 2017 and 2016
(Dollar amounts in thousands, except per share data)
Three Months Ended
Six Months Ended
Interest and dividend income
Loans, including fees
20,662
11,551
40,062
23,392
Securities, taxable
3,224
1,987
5,948
4,196
Securities, nontaxable
862
332
1,647
660
Federal funds sold and other
334
510
640
994
Total interest and dividend income
25,082
14,380
48,297
29,242
Interest expense
2,894
1,670
5,470
3,277
13
14
25
26
734
345
1,236
677
242
157
474
310
Total interest expense
3,883
2,186
7,205
4,290
Net interest income
21,199
12,194
41,092
24,952
Provision for loan losses
628
532
1,723
1,255
Net interest income after provision for loan losses
20,571
11,662
39,369
23,697
Non-interest income
Service charges and fees
1,224
807
2,376
1,586
Debit card income
1,205
728
2,210
1,405
Mortgage banking
540
335
1,025
577
Increase in value of bank owned life insurance
354
246
709
497
Net gain from securities transactions
83
59
96
479
556
277
885
606
Total non-interest income
3,962
2,452
7,301
5,150
Non-interest expense
Salaries and employee benefits
8,236
5,246
16,042
10,458
Net occupancy and equipment
1,519
1,068
3,018
2,162
Data processing
1,191
869
2,352
1,707
Professional fees
462
568
978
1,017
Advertising and business development
624
330
1,142
548
Telecommunications
287
691
518
FDIC insurance
219
255
325
513
Courier and postage
236
158
303
Free nationwide ATM cost
233
163
445
315
Amortization of core deposit intangible
235
86
444
173
Loan expense
282
168
459
260
Other real estate owned
(58
275
Loss on debt extinguishment
—
58
Merger expenses
136
1,062
1,358
801
2,662
1,590
Total non-interest expense
15,131
9,941
30,357
19,630
Income before income taxes
9,402
4,173
16,313
9,217
Provision for income taxes
3,048
1,327
5,095
2,931
Net income
6,354
2,846
11,218
6,286
Dividends and discount accretion on preferred stock
(1
Net income allocable to common stockholders
6,285
Basic earnings per share
0.52
0.35
0.93
0.77
Diluted earnings per share
0.51
0.34
0.91
0.75
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Other comprehensive income:
Unrealized holding gains (losses) arising during the period on
available-for-sale securities
321
425
533
1,633
Amortization of unrealized losses on held-to-maturity securities
127
152
264
292
Reclassification adjustment for net gains included in net income
(83
(473
(96
(893
Total other comprehensive income (loss)
365
104
701
1,032
Tax effect
(139
(42
(268
(393
Other comprehensive income (loss), net of tax
226
62
433
639
Comprehensive income
6,580
2,908
11,651
6,925
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
For the Six Months ended June 30, 2017 and 2016
Preferred
Stock
Common Stock
Additional
Accumulated
Employee
Total
Series C
Shares
Outstanding
Amount
Paid-In
Capital
Retained
Earnings
Comprehensive
Income (loss)
Loans
Treasury
Stockholders’
Equity
Balance at January 1, 2016
16,372
8,211,727
97
138,077
34,955
(2,371
167,233
Other comprehensive income,
net of tax effects
Retirement of preferred stock
(16,372
Stock based compensation
Common stock issued upon exercise of stock options
7,688
121
Cash dividends declared and
accrued on preferred stock
Balance at June 30, 2016
8,219,415
138,480
41,240
(1,732
158,188
Balance at January 1, 2017
11,680,308
3,712
732
Common stock issued upon
exercise of stock options
42,834
726
Repayments on employee stock loans
Issuance of common stock in connection with the acquisition of Prairie State Bancshares, net of issuance expenses of $329
479,465
14,908
14,913
Balance at June 30, 2017
12,206,319
CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash flows from operating activities
Adjustments to reconcile net income to net cash from operating activities:
Depreciation
1,197
841
Net (accretion) amortization of purchase valuation adjustments
(2,749
192
Amortization of premiums and discounts on securities
1,225
1,265
Amortization of intangibles
447
176
Deferred income taxes
(53
(34
FHLB stock dividends
(380
(327
Loss (gain) on sales and valuation adjustments on other real estate owned
(14
(142
Net loss (gain) on securities transactions
(479
Loss (gain) on disposal of premise and equipment
(10
(39
Loss (gain) on sales of loans
(856
(496
Originations of loans held for sale
(35,180
(21,987
Proceeds from the sale of loans held for sale
37,402
21,985
Increase in the value of bank owned life insurance
(710
(497
Change in fair value of derivatives recognized in earnings
Net change in:
257
217
Other assets
(716
(314
604
(918
Net cash provided by (used in) operating activities
14,040
7,270
Cash flows to investing activities
Purchases of available-for-sale securities
(13,660
(25,576
Purchases of held-to-maturity securities
(89,853
(25,811
Proceeds from sales, calls, pay-downs, and maturities of available-for-sale securities
17,452
82,774
Proceeds from calls, pay-downs and maturities of held-to-maturity securities
26,877
19,677
Net change in interest-bearing time deposits in other banks
(491
Net change in loans
(17,212
(21,038
Purchase of premises and equipment
(2,955
(863
Proceeds from sale of premise and equipment
175
Net redemption (purchase) of FHLB and FRB stock
(2,565
465
Proceeds from sale of other real estate owned
932
2,391
Purchase of Prairie, net of cash acquired
(6,005
Net cash provided by (used in) investing activities
(87,467
32,194
Cash flows (to) from financing activities
Net increase (decrease) in deposits
63,786
(19,153
Net change in federal funds purchased and retail repurchase agreements
432
2,020
Net borrowings (payments) on Federal Home Loan Bank line of credit
(2,180
2,209
Principal payments on bank stock loan
(18,612
Principal payments on employee stock loans
Proceeds from the exercise of employee stock options
109
Redemption of Series C preferred stock
Net change in contractual obligations
(293
(262
Dividends paid on preferred stock
Excess tax benefits recognized on exercise of employee stock options
12
Net cash provided by (used in) financing activities
62,544
(50,091
Net change in cash and cash equivalents
(10,883
(10,627
Cash and cash equivalents, beginning of period
56,829
Ending cash and cash equivalents
46,202
Supplemental cash flow information:
Interest paid
6,441
4,167
Income taxes paid, net of refunds
2,922
1,580
Supplemental noncash disclosures:
Other real estate owned acquired in settlement of loans
3,976
1,336
Securities purchased but not settled
1,161
1,954
Total fair value of assets acquired in purchase of Prairie, net of cash
146,509
Total fair value of liabilities assumed in purchase of Prairie, net of cash
125,591
10
CONDENSED NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2017
NOTE 1 – BASIS OF PRESENTATION
The interim consolidated financial statements include the accounts of Equity Bancshares, Inc., its wholly owned subsidiary, Equity Bank, and Equity Bank’s wholly owned subsidiary, SA Holdings, Inc. These entities are collectively referred to as the “Company”. All significant intercompany accounts and transactions have been eliminated in consolidation.
The accompanying unaudited condensed interim consolidated financial statements have been prepared in accordance with United States Generally Accepted Accounting Principles (“GAAP”) for interim financial information and in accordance with guidance provided by the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial information. The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. In the opinion of management, the interim statements reflect all adjustments necessary for a fair presentation of the financial position, results of operations and cash flows of the Company on a consolidated basis and all such adjustments are of a normal recurring nature. These financial statements and the accompanying notes should be read in conjunction with the Company’s audited financial statements for the year ended December 31, 2016 included in the Company’s Annual Report on Form 10-K filed with the SEC on March 16, 2017. Operating results for the three and six months ended June 30, 2017 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017 or any other period.
Effective January 1, 2017, the Company adopted the provisions of Accounting Standards Update (ASU) 2016-09, Improvements to Employee Share-Based Payment Accounting. In accordance with ASU 2016-09, excess tax benefits and excess tax deficiencies, which are generated when the tax-return deduction for a share-based payment award differs from the compensation cost recognized for financial reporting purposes, are recognized as income tax benefits or expense in the income statement in the period in which the excess tax benefits occur. The provision for income taxes for the six months ended June 30, 2017, was reduced by excess income tax benefits of $216 associated with stock options exercised during the period. This reduction in the provision for income taxes increased net income $216 or $0.02 per fully diluted share. ASU 2016-09 was adopted on a prospective basis. Prior to the adoption of ASU 2016-09, excess tax benefits were recognized in additional paid in capital. There was $12 excess tax benefits recognized in the six months ended June 30, 2016.
Recent Accounting Pronouncements:
In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers, which amended existing guidance related to revenue from contracts with customers. This amendment supersedes and replaces nearly all existing revenue recognition guidance, including industry-specific guidance, establishes a new control-based revenue recognition model, changes the basis for deciding when revenue is recognized over time or at a point in time, provides new and more detailed guidance on specific topics and expands and improves disclosures about revenue. In addition, this amendment specifies the accounting for some costs to obtain or fulfill a contract with a customer. These amendments are effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. Early application is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that period. The amendments should be applied retrospectively to all periods presented or retrospectively with the cumulative effect recognized at the date of initial application. The Company is currently evaluating the impact of this new accounting standard on the consolidated financial statements, although no material impact is expected, it will modify disclosures.
In January 2016, FASB issued ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities, which addresses certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. The main provisions of the update are to eliminate the available-for-sale classification of accounting for equity securities and to adjust fair value disclosures for financial instruments carried at amortized costs such that the disclosed fair values represent an exit price as opposed to an entry price. The amendments are effective for fiscal years beginning after December 15, 2017, including interim periods within those years. Generally, early adoption of the amendments in this update is not permitted. An entity should apply the amendments by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. The Company is currently evaluating the impact of this new accounting standard, but does not expect a material impact on its financial statements.
In February 2016, FASB issued ASU 2016-02, Leases, with the intention of improving financial reporting about leasing transactions. The ASU requires all lessees to recognize lease assets and lease liabilities on the balance sheet. Lessor accounting is
largely unchanged by the ASU, however disclosures about the amount, timing, and uncertainty of cash flows arising from leases are required of both lessees and lessors. The ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. Lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The modified retrospective approach provides for optional practical expedients when applying the ASU to leases that commenced before the effective date of the ASU. The Company is currently evaluating the impact of this new accounting standard on the consolidated financial statements but expects that assets and liabilities will increase to reflect the impact of this standard.
In June 2016, FASB issued ASU 2016-13, Financial Instruments – Credit Losses, which will change how the Company measures credit losses for most of its financial assets. This guidance is applicable to loans held for investment, off-balance-sheet credit exposures, such as loan commitments and standby letters of credit, and held-to-maturity investment securities. The Company will be required to use a new forward-looking expected loss model that is anticipated to result in the earlier recognition of allowances for losses. For available-for-sale securities with unrealized losses, the Company will measure credit losses in a manner similar to current practice, but will recognize those credit losses as allowances rather than reductions in the amortized cost of the securities. In addition, the ASU requires significantly more disclosure including information about credit quality by year of origination for most loans. The ASU is effective for the Company beginning in the first quarter of 2020. Generally, the amendments will be applied through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective. The Company is currently gathering the historical loss data by portfolio and class of financial instrument to estimate the life of financial instrument credit loss and is evaluating the supporting system requirements to routinely generate the reported values. At this time an estimate of the impact to the Company’s financial statements is not known.
In August 2016, FASB issued accounting standards update No. 2016-15, Statement of Cash Flows (Topic 230). This update addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice of how certain cash receipts and cash payments are presented and classified in the statement of cash flow. The amendments in this update are effective for fiscal years and interim periods beginning after December 15, 2017; however early adoption is permitted. Management is currently in the process of evaluating the impact of this new accounting standard, but does not expect a material impact to its financial statements.
In January 2017, the FASB issued ASU 2017-04, Intangibles-Goodwill and Other, which will simplify the subsequent measurement of goodwill. Goodwill and other intangibles must be assessed for impairment annually. If an entity’s assessment determines that the fair value of an entity is less than its carrying amount, including goodwill, currently, the measurement of goodwill impairment requires that the entity’s identifiable net assets be valued following procedures similar to determining the fair value of assets acquired and liabilities assumed in a business combination. Under ASU 2017-04, goodwill impairment is measured to the extent that the carrying amount of an entity exceeds its fair value. The amendments in this update are effective for the Company’s annual goodwill impairment tests beginning in 2020. The amendments will be applied on a prospective basis. The Company is currently evaluating the impact of this new accounting standard, but does not expect a material impact to its financial statements.
In March 2017, the FASB issued ASU 2017-08, Premium Amortization on Purchased Callable Debt Securities, this update shortens the amortization period of certain callable debt securities held at a premium to the earliest call date. The amendments in this update are effective for the Company’s fiscal year beginning after December 15, 2018, and interim periods within that fiscal year; however, early adoption is permitted. If early adoption of this update is elected by the Company, any adjustments will be reflected as of the beginning of the fiscal year. The amendments will be applied on a modified retrospective basis through a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption and the Company will be required to provide change in accounting principle disclosures. The Company is currently evaluating the impact of this new accounting guidance and an estimate of the impact to the Company’s financial statements is not known, at this time.
NOTE 2 – SECURITIES
The amortized cost and fair value of available-for-sale securities and the related gross unrealized gains and losses recognized in accumulated other comprehensive income were as follows:
Amortized
Cost
Gross
Unrealized
Gains
Losses
Fair
Value
Residential mortgage-backed securities (issued by
government-sponsored entities)
92,320
193
(1,259
91,254
Small Business Administration loan pools
182
State and political subdivisions
496
499
Equity securities
500
(11
489
93,498
207
(1,270
December 31, 2016
U.S. Government-sponsored entities
4,766
16
4,782
88,257
93
(1,647
86,703
Corporate
3,000
39
3,039
210
223
486
97,232
161
(1,661
The amortized cost and fair value of held-to-maturity securities and the related gross unrecognized gains and losses were as follows:
Unrecognized
Held-to-maturity securities
998
988
Residential mortgage-backed (securities issued by
government sponsored entities)
382,278
1,000
(3,371
379,907
22,990
23,435
2,229
(6
2,231
123,664
1,802
(731
124,735
3,255
(4,118
531,296
(33
965
338,749
686
(4,702
334,733
12,988
139
(28
13,099
2,398
1
(17
2,382
110,576
1,211
(1,810
109,977
2,037
(6,590
461,156
The tables above present unrecognized losses on held-to-maturity securities since date of designation.
The fair value and amortized cost of debt securities at June 30, 2017, by contractual maturity, is shown below. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Securities not due at a single maturity date, primarily mortgage-backed securities, are shown separately.
Available-for-Sale
Held-to-Maturity
Within one year
196
3,111
3,121
One to five years
300
23,434
23,931
Five to ten years
46,005
47,194
After ten years
77,331
77,143
Mortgage-backed securities
Total debt securities
92,998
91,946
The carrying value of securities pledged as collateral, to secure public deposits and for other purposes, was approximately $438,442 at June 30, 2017 and $439,208 at December 31, 2016.
The following tables show gross unrealized losses and fair value, aggregated by investment category, and length of time that individual securities have been in a continuous unrealized loss position at June 30, 2017 and December 31, 2016:
Less Than 12 Months
12 Months or More
Loss
Residential mortgage-backed (issued by
66,189
Total temporarily impaired securities
66,678
77,414
77,900
989
286,377
(4,346
10,272
296,649
(4,726
1,226
41,285
(765
328,651
(5,121
11,498
(414
340,149
(5,535
291,003
(5,922
10,801
(426
301,804
(6,348
5,407
(16
3,166
8,573
(44
(2
1,314
(45
(47
65,220
(2,122
363,663
(8,095
15,281
(499
378,944
(8,594
The tables above present unrealized losses on held-to-maturity securities since the date of purchase, independent of the impact associated with changes in cost basis upon transfer from the available-for-sale designation to the held-to-maturity designation. As of June 30, 2017, the Company held 19 available-for-sale securities and 247 held-to-maturity securities in an unrealized loss position.
Unrealized losses on securities have not been recognized into income because the security issuers are of high credit quality, management does not intend to sell and it is more likely than not that the Company will not be required to sell the securities prior to their anticipated recovery, and the decline in fair value is largely due to changes in interest rates. The fair value is expected to recover as the securities approach maturity.
The proceeds from sales and the associated gains and losses on available-for-sale securities reclassified from other comprehensive income to income are listed below:
Proceeds
3,083
50,499
6,522
70,957
Gross gains
473
893
Gross losses
Income tax expense on net realized gains
32
181
37
342
NOTE 3 – LOANS AND ALLOWANCE FOR LOAN LOSSES
Categories of loans at June 30, 2017 and December 31, 2016 include:
Commercial real estate
640,539
593,108
Commercial and industrial
360,687
348,465
Residential real estate
326,097
338,387
Agricultural real estate
69,371
38,331
Consumer
43,241
40,902
Agricultural
89,461
24,412
Total loans
1,529,396
1,383,605
Allowance for loan losses
(7,568
(6,432
Net loans
The Company has participated in mortgage finance loans with another institution, (the “originator”). These mortgage finance loans consist of ownership interests purchased in single family residential mortgages funded through the originator’s mortgage finance group. These loans are typically on the Company’s balance sheet for 10 to 20 days. As of June 30, 2017 and December 31, 2016, the Company had balances of $10,000 and $10,000 in mortgage finance loans classified as commercial and industrial.
From time to time the Company has purchased pools of residential real estate loans originated by other financial institutions to hold for investment with the intent to diversify the residential real estate portfolio. As of June 30, 2017 and December 31, 2016, residential real estate loans include $82,239 and $90,705 of purchased residential real estate loans from these pools of residential real estate loans.
The unamortized balance of merger purchase accounting adjustments related to non-purchase credit impaired loans included in the loan totals above are $2,518 at June 30, 2017, and $3,043 at December 31, 2016.
Over-draft deposit accounts are reclassified and included in consumer loans above. These accounts totaled $894 at June 30, 2017 and $567 at December 31, 2016.
15
The following tables present the activity in the allowance for loan losses by class for the three-month periods ended June 30, 2017 and 2016:
Commercial
Real Estate
and
Industrial
Residential
Real
Estate
Allowance for loan losses:
Beginning balance
2,592
2,059
1,875
66
391
65
7,048
(245
397
46
298
74
Loans charged-off
(29
(409
(27
(3
Recoveries
406
23
75
602
Total ending allowance balance
2,724
2,070
1,999
522
144
7,568
June 30, 2016
2,275
1,563
1,940
41
79
82
5,980
(19
(190
(7
(200
(153
(550
27
20
68
2,308
1,574
1,917
63
6,030
The following tables present the activity in the allowance for loan losses by class for the six-month periods ended June 30, 2017 and 2016:
2,420
1,881
1,765
35
266
6,432
(78
585
374
77
650
115
(92
(422
(238
(601
(41
(1,397
98
810
2,051
1,366
1,824
29
187
49
5,506
449
261
179
(224
(62
(248
(23
(281
(841
42
110
The following tables present the recorded investment in loans and the balance in the allowance for loan losses by portfolio and class based on impairment method as of June 30, 2017 and December 31, 2016:
Individually evaluated for impairment
204
358
34
28
710
Collectively evaluated for impairment
2,515
2,019
1,592
69
116
6,797
Purchase credit impaired loans
61
Loan Balance:
2,837
1,542
3,979
398
352
9,400
627,923
354,760
320,081
65,255
42,883
85,326
1,496,228
9,779
4,385
3,718
3,843
23,768
270
22
288
45
627
2,150
1,859
1,477
33
221
5,805
3,182
550
3,321
834
429
8,319
577,863
344,414
332,962
36,668
40,471
24,409
1,356,787
12,063
3,501
2,104
829
18,499
17
The following table presents information related to impaired loans, excluding purchased credit impaired loans which have not deteriorated since acquisition, by class of loans as of June 30, 2017 and December 31, 2016. The recorded investment in loans excludes accrued interest receivable due to immateriality.
Unpaid
Principal
Balance
Recorded
Investment
Allowance for
Loan Losses
Allocated
With no related allowance recorded:
1,023
1,005
904
676
1,231
309
648
1,230
980
824
812
53
Subtotal
3,005
2,501
3,521
2,828
With an allowance recorded:
2,388
1,884
209
4,493
2,506
545
517
265
240
4,330
4,072
407
2,433
2,341
503
399
458
378
280
8,504
7,510
771
7,666
5,491
11,509
10,011
11,187
The tables below present average recorded investment and interest income related to impaired loans for the three months and six months ended June 30, 2017 and 2016. Interest income recognized in the following table was substantially recognized on the cash basis. The recorded investment in loans excludes accrued interest receivable due to immateriality.
As of and for the three months ended
Average
Interest
Income
Recognized
1,099
1,464
1,034
716
652
31
698
3,648
2,036
558
117
3,563
911
339
383
150
7,222
3,342
9,723
6,990
18
As of and for the six months ended
1,233
667
845
688
662
437
100
2,665
2,195
2,516
3,207
877
211
368
177
141
6,500
3,714
9,165
50
6,969
The following tables present the aging of the recorded investment in past due loans as of June 30, 2017 and December 31, 2016, by portfolio and class of loans:
30 - 59
Days
Past Due
60 - 89
Greater
Than
90 Days
Past
Due Still On
Accrual
Nonaccrual
Loans Not
651
250
6,980
632,644
387
5,922
354,123
4,849
320,521
3,638
65,707
293
91
42,499
608
21
4,135
84,697
1,851
1,201
271
25,882
1,500,191
2,955
788
12,258
577,107
419
4,051
343,995
847
4,285
332,887
1,664
36,667
43
40,124
52
24,357
4,097
1,678
22,693
1,355,137
Credit Quality Indicators
The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt, such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. Consumer loans are considered pass credits unless downgraded due to payment status or reviewed as part of a larger credit relationship. The Company uses the following definitions for risk ratings:
Pass: Loans classified as pass do not have any noted weaknesses and repayment of the loan is expected. These loans are considered unclassified.
Special Mention: Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the Company’s credit position at some future date. These loans are considered classified.
Substandard: Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. These loans are considered classified.
Doubtful: Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. These loans are considered classified.
The risk category of loans by class of loans is as follows as of June 30, 2017 and December 31, 2016:
Unclassified
Classified
616,362
24,177
346,510
14,177
321,091
5,006
63,906
5,465
42,871
370
85,168
4,293
1,475,908
53,488
576,070
17,038
341,307
7,158
333,298
5,089
36,190
2,141
40,382
520
24,134
278
1,351,381
32,224
Purchased Credit Impaired Loans
The Company has acquired loans, for which there was, at acquisition, evidence of deterioration of credit quality since origination and it was probable, at acquisition, that all contractually required payments would not be collected. The recorded investments in purchase credit impaired loans as of June 30, 2017 and December 31, 2016 were as follows:
Contractually required principal payments
32,584
27,413
Discount
(8,816
(8,914
Recorded investment
The remaining estimated accretable yield associated with these loans was $1,920 and $1,063 as of June 30, 2017 and December 31, 2016. The interest income recognized on these loans for the three-month and six-month periods ended June 30, 2017 and 2016 was $699, $1,412, $86 and $238. For the three-month and six periods ended June 30, 2017 there was an $8 provision for loan loss
reversal and a $61 provision for loan losses recorded for these loans. For the three and six-month periods ended June 30, 2016, there was a provision for loan losses of $0 and $0 recorded for these loans.
Troubled Debt Restructurings
The Company had no loans modified under troubled debt restructurings as of June 30, 2017 or December 31, 2016.
NOTE 4 – DERIVATIVE FINANCIAL INSTRUMENTS
The Company is exposed to interest-rate risk primarily from the effect of interest rate changes on its interest-earning assets and its sources of funding these assets. The Company will periodically enter into interest rate swaps or interest rate caps/floors to manage certain interest rate risk exposure.
Interest Rate Swaps Designated as Fair Value Hedges:
The Company periodically enters into interest rate swaps to hedge the fair value of certain commercial real estate loans. These transactions are designated as fair value hedges. In this type of transaction, the Company typically receives from the counterparty a variable-rate cash flow based on the one-month London Interbank Offered Rate (“LIBOR”) plus a spread to this index and pays a fixed-rate cash flow equal to the customer loan rate. At June 30, 2017, the portfolio of interest rate swaps had a weighted average maturity of 9.1 years, a weighted average pay rate of 4.93% and a weighted average rate received of 3.83%. At December 31, 2016, the portfolio of interest rate swaps had a weighted average maturity of 9.0 years, a weighted average pay rate of 4.82% and a weighted average rate received of 3.50%.
Stand-Alone Derivatives:
In 2009, the Company purchased an interest rate cap derivative to assist with interest rate risk management. This derivative is not designated as a hedging instrument but rather as a stand-alone derivative. At June 30, 2017, the interest rate cap had a term of 2.4 years and a cap rate of 4.50%. At December 31, 2016, the interest rate cap had a term of 2.9 years and a cap rate of 4.50%.
Reconciliation of Derivative Fair Values and Gains/(Losses):
The notional amount of a derivative contract is a factor in determining periodic interest payments or cash flows received or paid. The notional amount of derivatives serves as a level of involvement in various types of derivatives. The notional amount does not represent the Company’s overall exposure to credit or market risk, generally, the exposure is significantly smaller.
The following table shows the notional balances and fair values (including net accrued interest) of the derivatives outstanding by derivative type at June 30, 2017 and December 31, 2016:
Notional
Derivative
Assets
Liabilities
Derivatives designated as hedging instruments:
Interest rate swaps
17,432
206
15,923
Total derivatives designated as hedging relationships
Derivatives not designated as hedging instruments:
Interest rate caps/floors
2,745
2,865
Total derivatives not designated as hedging
instruments
20,177
18,788
Cash collateral
Netting adjustments
151
Net amount presented in Balance Sheet
For the three-month and six-month periods ended June 30, 2017 and 2016, the Company recorded net gains/(losses) on derivatives and hedging activities:
Three months ended
Six months ended
Total net gain (loss) related to fair value hedge
ineffectiveness
Economic hedges:
Total net gains (losses) related to derivatives not
designated as hedging instruments
Net gains (losses) on derivatives and hedging activities
The following table shows the recorded net gains (losses) on derivatives and the related hedged items in fair value hedging relationships and the impact of those derivatives on the Company’s net interest income for the three-month periods ended June 30, 2017 and 2016.
Gain/(Loss)
on Derivatives
on Hedged
Items
Net Fair Value
Hedge
Ineffectiveness
Effect of
Derivatives on
Net Interest
Commercial real estate loans
(162
162
(37
(325
The following table shows the recorded net gains (losses) on derivatives and the related hedged items in fair value hedging relationships and the impact of those derivatives on the Company’s net interest income for the six-month periods ended June 30, 2017 and 2016.
(93
(84
(850
850
(86
NOTE 5 – BORROWINGS
Federal funds purchased and retail repurchase agreements as of June 30, 2017 and December 31, 2016 were as follows:
Federal funds purchased
Retail repurchase agreements
The Company has available federal funds lines of credit with its correspondent banks.
Securities sold under agreements to repurchase (retail repurchase agreements) consist of obligations of the Company to other parties. The obligations are secured by residential mortgage-backed securities held by the Company with a fair value of $21,829 and $23,389 at June 30, 2017 and December 31, 2016. The agreements are on a day-to-day basis and can be terminated on demand.
Year-to-date average daily balance during the period
20,133
22,599
Maximum month-end balance during the period
22,782
25,382
Weighted average interest rate at period-end
0.25
%
0.27
Federal Home Loan Bank advances as of June 30, 2017 and December 31, 2016 were as follows:
Federal Home Loan Bank line of credit advances
Federal Home Loan Bank fixed rate term advances
Total Federal Home Loan Bank advances
At June 30, 2017, the Company had $257,408 drawn against its line of credit at a weighted average rate of 1.24%. At December 31, 2016, the $259,588 drawn against the Federal Home Loan Bank line of credit was at a weighted average rate of 0.72%.
The advances, Mortgage Partnership Finance credit enhancement obligations and letters of credit were collateralized by certain qualifying loans totaling $467,472 and $454,025 at June 30, 2017 and December 31, 2016. Based on this collateral and the Company’s holdings of Federal Home Loan Bank stock, the Company was eligible to borrow an additional $204,561 and $193,674 at June 30, 2017 and December 31, 2016.
Bank stock loan
On January 28, 2016, the Company entered into an agreement with an unaffiliated financial institution that provided for a maximum borrowing facility of $20,000, secured by the Company’s stock in Equity Bank. At December 31, 2016, there was no outstanding balance on this loan. The borrowing facility matured on January 26, 2017, and was subsequently extended, at which time the Company entered into a new agreement with the same lender that provides for a maximum borrowing facility of $30,000, secured by the Company’s stock in Equity Bank. At June 30, 2017, there was no outstanding balance on this loan. The borrowing facility will mature on March 12, 2018. Each draw of funds on the facility will create a separate note that is repayable over a term of five years. Each note will bear interest at a variable interest rate equal to the prime rate published in the “Money Rates” section of The Wall Street Journal (or any generally recognized successor), floating daily. Accrued interest and principal payments will be due quarterly with one final payment of unpaid principal and interest due at the end of the five year term of each separate note. The Company is also required to pay an unused commitment fee in an amount equal to 20 basis points per annum on the unused portion of the maximum borrowing facility.
The terms of the borrowing facility require the Company and Equity Bank to maintain minimum capital ratios and other covenants. The Company believes it is in compliance with the terms of the borrowing facility and has not been otherwise notified of noncompliance.
NOTE 6 – STOCKHOLDERS’ EQUITY
Preferred stock
The Company’s articles of incorporation provide for the issuance of 10,000,000 shares of preferred stock. At June 30, 2017 and December 31, 2016, there was no preferred stock outstanding.
The Company’s articles of incorporation provide for the issuance of 45,000,000 shares of Class A voting common stock (“Class A common stock”) and 5,000,000 shares of Class B non-voting common stock (“Class B common stock”), both of which have a par value of $0.01.
The following table presents shares that were issued and were held in treasury or were outstanding at June 30, 2017 and December 31, 2016:
Class A common stock – issued
13,290,849
12,393,124
Class A common stock – held in treasury
(1,271,043
Class A common stock – outstanding
11,122,081
Class B common stock – issued
421,416
793,130
Class B common stock – held in treasury
(234,903
Class B common stock – outstanding
558,227
Treasury stock is stated at cost, determined by the first-in, first-out method.
On March 10, 2017, the Company completed its acquisition of Prairie State Bancshares, Inc. (“Prairie”) of Hoxie, Kansas. There were a total of 479,465 shares of Class A common stock issued in connection with this acquisition.
Agreements with certain owners of Class B common stock require the Company to issue Class A common stock to replace an equal number of Class B common stock in the event of a future transfer from the owner to an unaffiliated party. The Class B common stock owner may require this exchange in certain stipulated transactions including the transfer of shares of Class B common stock to: (1) the Company or its bank subsidiary, (2) in a widespread public distribution, (3) a transfer in which no transferee receives two percent or more of any class of the Company’s voting securities, or (4) to a transferee that would control more than fifty percent of the Company’s voting securities without any transfer from the purchaser.
Restricted stock unit plan termination loans
In May 2015, in connection with the termination of the Company’s restricted stock unit plan (“RSUP”), 203,216 shares of Class A common stock were issued to employees with vested restricted stock units. Also in connection with the termination of the RSUP, the Company agreed to loan electing participants an amount equal to each participant’s federal and state income tax withholding obligation associated with the stock issuance. These loans totaling $170 at June 30, 2017 and $242 at December 31, 2016, are collateralized with the shares received, have a maturity date of December 31, 2017 and have an interest rate of 0.96%.
Accumulated other comprehensive income (loss)
At June 30, 2017 and December 31, 2016, accumulated other comprehensive income consisted of (i) the after tax effect of unrealized gains (losses) on available-for-sale securities and (ii) the after tax effect of unamortized unrealized gains (losses) on securities transferred from the available-for-sale designation to the held-to-maturity designation.
24
Components of accumulated other comprehensive income as of June 30, 2017 and December 31, 2016 were as follows:
Available-for-
Sale
Securities
Held-to-
Maturity
Net unrealized or unamortized gains (losses)
(1,063
(2,612
(3,675
999
1,406
(656
(1,613
(1,500
(2,876
(4,376
574
1,100
1,674
(926
(1,776
NOTE 7 – REGULATORY MATTERS
Banks and bank holding companies (on a consolidated basis) are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action. The final rules implementing Basel Committee on Banking Supervision’s capital guidelines for U.S. banks (Basel III rules) became effective for the Company on January 1, 2015 with full compliance with all of the requirements being phased in over a multi-year schedule, and fully phased in by January 1, 2019. Beginning in January 2016, the implementation of the capital conservation buffer was effective for the Company starting at the 0.625% level and increasing 0.625% each year thereafter, until it reaches 2.5% on January 1, 2019. The capital conservation buffer is designed to absorb losses during periods of economic stress and requires increased capital levels for the purpose of capital distributions and other payments. Failure to meet the full amount of the buffer will result in restrictions on the Company's ability to make capital distributions, including dividend payments and stock repurchases, and to pay discretionary bonuses to executive officers.
Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as are asset growth and acquisitions, and capital restoration plans are required.
As of June 30, 2017, management believes that the Company meets all capital adequacy requirements to which they are subject and the most recent notifications from the federal regulatory agencies categorized Equity Bank as well capitalized under the regulatory framework for prompt corrective action, including the capital conservation buffer. To be categorized as well capitalized, Equity Bank must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed Equity Bank’s category.
The Company’s and Equity Bank’s capital amounts and ratios at June 30, 2017 and December 31, 2016 are presented in the table below. Ratios provided for Equity Bancshares, Inc. represent the ratios of the Company on a consolidated basis.
Actual
Minimum Required for
Capital Adequacy Under Basel III Phase-In
Capital Adequacy Under Basel III Fully Phased-In
To Be Well
Capitalized Under
Prompt Corrective
Provisions
Ratio
Total capital to risk weighted assets
Equity Bancshares, Inc.
242,616
14.34
156,517
9.25
177,667
10.50
N/A
Equity Bank
224,162
13.25
156,522
177,674
169,213
10.00
Tier 1 capital to risk weighted assets
235,048
13.89
122,675
7.25
143,826
8.50
216,594
12.80
122,680
143,831
135,371
8.00
Common equity Tier 1 capital to risk weighted assets
221,223
13.07
97,294
5.75
118,445
7.00
97,298
118,449
109,989
6.50
Tier 1 leverage to average assets
10.15
92,628
4.00
9.35
92,634
115,793
5.00
221,779
14.67
130,372
8.63
158,714
196,478
13.01
130,283
158,606
151,053
10.0
215,347
14.25
100,141
6.63
128,483
190,046
12.58
100,073
128,395
120,842
201,663
13.34
77,468
5.13
105,809
77,415
105,737
98,184
11.81
72,920
10.42
72,924
91,155
Equity Bank is subject to certain restrictions on the amount of dividends that it may declare without prior regulatory approval.
NOTE 8 – EARNINGS PER SHARE
The following table presents earnings per share for the three and six months ended June 30, 2017 and 2016:
Basic:
Weighted average common shares outstanding
12,205,095
8,216,097
12,010,538
8,213,912
Weighted average vested restricted stock units
Weighted average shares
Basic earnings per common share
Diluted:
Weighted average common shares outstanding for:
Dilutive effects of the assumed exercise of stock options
239,764
113,202
253,618
112,703
Average shares and dilutive potential common shares
12,444,859
8,329,299
12,264,156
8,326,615
Diluted earnings per common share
Average outstanding stock options of 205,269 and 128,921 for the three-month periods ended June 30, 2017 and 2016 and 162,986 and 130,973 for the six-month periods ended June 30, 2017 and 2016 were not included in the computation of diluted earnings per share because the options were antidilutive.
NOTE 9 – FAIR VALUE
The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities and to disclose the fair value of its financial instruments. Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. For disclosure purposes, the Company groups its financial and non-financial assets and liabilities into three different levels based on the nature of the instrument and the availability and reliability of the information that is used to determine fair value. The three levels of inputs that may be used to measure fair values are defined as follows:
Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.
Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
Level 1 inputs are considered to be the most transparent and reliable. The Company assumes the use of the principal market to conduct a transaction of each particular asset or liability being measured and then considers the assumptions that market participants would use when pricing the asset or liability. Whenever possible, the Company first looks for quoted prices for identical assets or liabilities in active markets (Level 1 inputs) to value each asset or liability. However, when inputs from identical assets or liabilities on active markets are not available, the Company utilizes market observable data for similar assets and liabilities. The Company maximizes the use of observable inputs and limits the use of unobservable inputs to occasions when observable inputs are not available. The need to use unobservable inputs generally results from the lack of market liquidity of the actual financial instrument or of the underlying collateral. Although, in some instances, third party price indications may be available, limited trading activity can challenge the implied value of those quotations.
The following is a description of the valuation methodologies used for assets and liabilities measured at fair value, as well as the general classification of each instrument under the hierarchy:
Fair Value of Assets and Liabilities Measured on a Recurring Basis
The fair values of securities available-for-sale are carried at fair value on a recurring basis. To the extent possible, observable quoted prices in an active market are used to determine fair value and, as such, these securities are classified as Level 1. For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities, generally determined by matrix pricing, which is a mathematical technique widely used in the industry to value securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs). The Company’s available-for-sale securities, including U.S. Government sponsored agencies, residential mortgage-backed securities (all of which are issued or guaranteed by government sponsored agencies), corporate securities, Small Business Administration securities, and State and Political Subdivision securities are classified as Level 2.
The fair values of derivatives are determined based on a valuation pricing model using readily available observable market parameters such as interest rate yield curves (Level 2 inputs) adjusted for credit risk attributable to the seller of the interest rate derivative. Cash collateral received from or delivered to a derivative counterparty is classified as Level 1.
Assets and liabilities measured at fair value on a recurring basis are summarized below:
(Level 1)
(Level 2)
(Level 3)
Assets:
Available-for-sale securities:
Liabilities:
Derivative liabilities:
Cash collateral held by counterparty
Total derivative liabilities (included in other
liabilities)
U.S. government-sponsored entities
Derivative assets:
Derivative assets (included in other assets)
Total derivative assets
637
95,247
Interest rate swaps (included in other liabilities)
Total derivative liabilities
There were no material transfers between levels during the six months ended June 30, 2017 or the year ended December 31, 2016. The Company’s policy is to recognize transfers into or out of a level as of the end of a reporting period.
Fair Value of Assets and Liabilities Measured on a Non-recurring Basis
Certain assets are measured at fair value on a non-recurring basis when there is evidence of impairment. The fair value of impaired securities is determined as discussed previously for available-for-sale securities. The fair values of impaired loans with specific allocations of the allowance for loan losses are generally based on recent real estate appraisals of the collateral less estimated cost to sell. Declines in the fair values of other real estate owned subsequent to their initial acquisitions are also based on recent real estate appraisals less selling costs.
Real estate appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value.
Assets measured at fair value on a non-recurring basis are summarized below:
Impaired loans:
1,675
466
3,665
359
Other real estate owned:
2,251
2,236
218
2,053
336
2,400
The Company did not record any liabilities for which the fair value was measured on a non-recurring basis at June 30, 2017 or at December 31, 2016.
Valuations of impaired loans and other real estate owned utilize third party appraisals or broker price opinions, and were classified as Level 3 due to the significant judgment involved. Appraisals may include the utilization of unobservable inputs, subjective factors, and quantitative data to estimate fair market value.
The following table presents additional information about the unobservable inputs used in the fair value measurement of financial assets measured on a nonrecurring basis that were categorized with Level 3 of the fair value hierarchy:
Fair Value
Valuation
Technique
Unobservable
Input
Range
(weighted average)
Impaired loans
6,739
Sales Comparison
Approach
Adjustments for
differences between
comparable sales
23%-31% (4%)
4,864
7%-26% (9%)
Measurable inputs for other real estate owned were not material.
Carrying amount and estimated fair values of financial instruments at period end were as follows as of the date indicated:
Carrying
Estimated
Level 1
Level 2
Level 3
Financial assets:
Interest bearing deposits
Loans, net of allowance for loan losses
1,532,981
Federal Reserve Bank and Federal Home
Loan Bank stock
2,207,195
2,197,690
24,701
640,008
Financial liabilities:
1,826,240
Federal funds purchased and retail
repurchase agreements
Interest payable
1,268
Derivative liabilities
Cash collateral held by derivative counterparty
2,115,474
2,122,037
2,122,227
30
95,246
1,374,700
Derivative assets
2,006,084
1,982,406
35,732
571,974
1,635,881
1,927,592
1,933,022
1,933,061
The methods and assumptions, not previously presented, used to estimate fair values are described as follows:
Cash and cash equivalents and interest-bearing deposits: The carrying amounts of cash and short-term instruments approximate fair values.
Held-to-maturity securities: The fair value of held-to-maturity securities are determined in a manner consistent with available-for-sale securities which has been previously discussed.
Loans held for sale: The fair values of loans held for sale are based on quoted market prices for loans with similar characteristics.
Loans: Fair values of variable rate loans that reprice frequently and with no significant change in credit risk are based on carrying values. Fair values of other loans are estimated using discounted cash flows analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.
Federal Reserve Bank and Federal Home Loan Bank stock: It is not practical to determine the fair value of Federal Reserve Bank and Federal Home Loan Bank stock due to restrictions placed on its transferability.
Interest receivable and interest payable: The carrying amounts of accrued interest receivable and payable approximate their fair values.
Deposits: The fair values disclosed for demand deposits are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amount). The carrying amount of variable rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flows calculation that applies interest rates currently being offered.
Federal funds purchased and retail repurchase agreements: Federal funds purchased and retail repurchase agreements mature daily and may be terminated at any time. The carrying amounts of these financial instruments approximate their fair values.
Federal Home Loan Bank Advances: The carrying amounts of draws against the Company’s line of credit at the Federal Home Loan Bank approximate their fair values. The fair values of fixed rate term advances are determined using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements.
Bank stock loan: The fair value of the bank stock loan was estimated using a discounted cash flow analysis based on current borrowing rates for similar types of borrowing arrangements.
Subordinated debentures: Subordinated debentures are carried at the outstanding principal balance less an unamortized fair value adjustment from the date of assumption. The outstanding principal balance, net of this adjustment, approximates their fair value.
Contractual obligations: The carrying value of contractual obligations approximates their fair value.
The fair value of off-balance-sheet items is not considered material.
NOTE 10 – COMMITMENTS AND CREDIT RISK
The Company extends credit for commercial real estate mortgages, residential mortgages, working capital financing and loans to businesses and consumers.
Commitments to Originate Loans and Available Lines of Credit: Commitments to originate loans and available lines of credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments and lines of credit generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since a portion of the commitments and lines of credit may expire without being drawn upon, the total commitment and lines of credit amounts do not necessarily represent future cash requirements. Each customer’s creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if deemed necessary, is based on management’s credit evaluation of the counterparty. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, commercial real estate, and residential real estate. Mortgage loans in the process of origination represent amounts that the Company plans to fund within a normal period of 60 to 90 days, and which are intended for sale to investors in the secondary market.
The contractual amounts of commitments to originate loans and available lines of credit as of June 30, 2017 and December 31, 2016 were as follows:
Fixed
Rate
Variable
Commitments to make loans
14,393
61,151
24,988
50,362
Mortgage loans in the process of origination
9,321
4,599
7,267
2,696
Unused lines of credit
60,524
82,678
45,251
68,085
The fixed rate loan commitments have interest rates ranging from 3.75% to 6.99% and maturities ranging from 1 month to 122 months.
Standby Letters of Credit: Standby letters of credit are irrevocable commitments issued by the Company to guarantee the performance of a customer to a third party once specified pre-conditions are met. Financial standby letters of credit are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. Performance standby letters of credit are issued to guarantee performance of certain customers under non-financial contractual obligations. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loans to customers.
The contractual amounts of standby letters of credit as of June 30, 2017 and December 31, 2016 were as follows:
Standby letters of credit
4,399
2,799
5,762
2,769
NOTE 11 – LEGAL MATTERS
The Company is party to various matters of litigation in the ordinary course of business. The Company periodically reviews all outstanding pending or threatened legal proceedings and determines if such matters will have an adverse effect on the business, financial condition or results of operations or cash flows. A loss contingency is recorded when the outcome is probable and reasonably able to be estimated. The following loss contingency has been identified by the Company as reasonably possible to result in an unfavorable outcome for the Company or the Bank.
Equity Bank is a party to a February 3, 2015 lawsuit filed against it by CitiMortgage, Inc. The lawsuit involves an alleged breach of contract related to loan repurchase obligations and damages of $2,700 plus pre-judgment and post-judgment interest. At this stage of the litigation it is difficult to estimate any potential loss, however Equity Bank believes it has numerous and meritorious defenses to the claims and anticipates contesting the matter vigorously. The Company currently does not believe that it is probable that this legal matter will result in an unfavorable outcome for the Company or Equity Bank.
Except for the above mentioned lawsuit, there are no other outstanding claims for potential repurchase or indemnification demands regarding mortgage loans originated by Equity Bank and sold to investors. However, the Company believes there is possible risk it may face similar demands based on comparable demands loan aggregators are facing from their investors, including Government Sponsored Entities such as Freddie Mac and Fannie Mae, and or settlement agreements loan aggregators have entered into with those investors. The amount of potential loss and outcome of such possible litigation, if it were commenced, is uncertain and the Company would vigorously contest any claims.
NOTE 12 – SUBSEQUENT EVENTS
On July 14, 2017, the Company entered into an agreement and plan of reorganization with Eastman National Bancshares, Inc. (ENBI). ENBI is the holding company of The Eastman National Bank (Eastman), which has four branch locations in Oklahoma: Ponca City (3) and Newkirk. The transaction is expected to close in the fourth quarter of 2017, subject to customary closing conditions, including the receipt of regulatory approval and the approval of ENBI’s stockholders. In their June 30, 2017, unaudited Consolidated Report of Condition, Eastman reported total assets of $258,130, which included total loans of $183,940 and securities of $62,358. At June 30, 2017, total liabilities of $231,717 were reported by Eastman, which included deposits of $221,120. Eastman reported $3,021 in net income before income taxes for the six months ended June 30, 2017. The Company anticipates there will be goodwill and core deposit intangibles recorded with this acquisition. Goodwill is calculated as the excess of the cash consideration transferred over the net of the acquisition-date fair values of identifiable assets acquired and liabilities assumed.
Also on July 14, 2017, the Company entered into an agreement and plan of reorganization with Cache Holdings, Inc. (CHI). CHI is the holding company of Patriot Bank, which has one branch location in Tulsa, Oklahoma. This transaction also is expected to close in the fourth quarter of 2017, subject to customary closing conditions, including the receipt of regulatory approval and the approval of CHI’s stockholders. In their June 30, 2017, unaudited Consolidated Balance Sheets, CHI reported total assets of $346,705, which included total loans of $327,666. At June 30, 2017, total liabilities of $312,462 were reported by CHI, which included deposits of $288,245. CHI reported $3,635 in net income before income taxes for the six months ended June 30, 2017. The Company anticipates there will be goodwill and core deposit intangibles recorded with this acquisition.
NOTE 13 – BUSINESS COMBINATIONS
On March 10, 2017, the Company acquired 100% of the outstanding common shares of Prairie State Bancshares, Inc., based in Hoxie, Kansas, referred to as “Prairie”. Results of operations of Prairie were included in the Company’s results of operations beginning March 11, 2017. There were acquisition-related costs of $926 associated with this merger ($572 on an after-tax basis) that were included in merger expenses in the Company’s income statement for the three and six months ended June 30, 2017.
Information necessary to recognize the fair value of assets acquired and liabilities assumed is complete. The fair value of consideration exchanged exceeded the recognized amounts of the identifiable net assets and resulted in goodwill of $5,713. Goodwill resulted from a combination of expected synergies, expansion in western Kansas with the addition of three branch locations, growth opportunities and increases in stock prices after the stock exchange ratios were negotiated. The following table summarizes the consideration paid for Prairie and the amounts of the assets acquired and liabilities assumed recognized at the acquisition date:
Fair value of consideration:
15,242
Cash
12,255
27,497
Recognized amounts of identifiable assets acquired and
liabilities assumed:
6,579
3,427
971
198
129,997
Premises and equipment
2,424
Core deposit intangible
1,448
2,331
Total assets acquired
147,375
125,353
238
Total liabilities assumed
Total identifiable net assets
21,784
5,713
The fair value of net assets acquired includes fair value adjustments to certain loans that were not considered impaired as of the acquisition date. The fair value adjustments were determined using discounted contractual cash flows. However, the Company believes that all contractual cash flows related to these financial instruments will be collected. As such, these loans were not considered impaired at the acquisition date and were not subject to the guidance relating to purchased credit impaired loans, which have shown evidence of credit deterioration since origination. Cash flows associated with purchase credit impaired loans are not considered reasonably predictable and as such these loans are classified nonaccrual.
The following table presents information about the loans acquired in the Prairie acquisition as of the date of acquisition:
Non-Credit Impaired
Purchase Credit Impaired
Contractually required principal
123,519
11,430
Non-accretable difference (expected losses)
(2,673
Cash flows expected to be collected
8,757
Accretable yield
(2,279
Fair value of acquired loans
121,240
The following table presents the carrying value of the loans acquired in the Prairie acquisition by class, as of the date of acquisition:
9,224
9,368
11,203
974
12,177
25,593
2,960
28,553
1,451
73,632
4,679
78,311
Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained in our Annual Report on Form 10-K filed with the SEC on March 16, 2017 and our consolidated financial statements and related notes appearing elsewhere in this Quarterly Report. The following discussion contains “forward-looking statements” that reflect our future plans, estimates, beliefs and expected performance. We caution that assumptions, expectations, projections, intentions or beliefs about future events may, and often do, vary from actual results and the differences can be material. See “Cautionary Note Regarding Forward-Looking Statements.” Also, see the risk factors and other cautionary statements described under the heading “Item 1A: Risk Factors” included in the Annual Report on Form 10-K and in Item 1A of this Quarterly Report. We do not undertake any obligation to publicly update any forward-looking statements except as otherwise required by applicable law.
This discussion and analysis of our financial condition and results of operation includes the following sections:
Overview – a general description of our business and financial highlights;
Critical Accounting Policies – a discussion of accounting policies that require critical estimates and assumptions;
Results of Operations – an analysis of our operating results, including disclosures about the sustainability of our earnings;
Financial Condition – an analysis of our financial position;
Liquidity and Capital Resources – an analysis of our cash flows and capital position; and
Non-GAAP Financial Measures – a reconciliation of non-GAAP measures.
We are a bank holding company headquartered in Wichita, Kansas. Our wholly owned banking subsidiary, Equity Bank, provides a broad range of financial services primarily to businesses and business owners as well as individuals through our network of 37 full service branches located in Arkansas, Kansas and Missouri. As of June 30, 2017, we had consolidated total assets of $2.41 billion, total loans held for investment of $1.52 billion (net of allowances), total deposits of $1.82 billion and total stockholders’ equity of $286.1 million. During the three-month periods ended June 30, 2017 and June 30, 2016, net income was $6.4 million and $2.8 million and for the six-month periods ended June 30, 2017 and June 30, 2016, net income was $11.2 million and $6.3 million.
Selected Financial Data for the periods indicated (dollars in thousands, except per share amounts):
March 31,
September 30,
Statement of Income Data (for the quarterly period
ended)
23,215
18,307
14,250
3,322
2,644
2,268
19,893
15,663
11,982
1,095
760
Other non-interest income
3,879
3,326
2,789
2,527
2,393
926
5,057
237
Other non-interest expense
14,995
14,300
11,654
10,497
6,911
981
3,671
2,047
564
417
2,671
0.41
0.04
0.32
0.40
Balance Sheet Data (at period end)
35,321
21,847
103,178
102,391
74,976
519,239
349,915
317,509
4,021
3,071
4,002
Gross loans held for investment
1,518,576
956,070
980,110
6,080
Loans held for investment, net of allowance for loan losses
1,511,528
949,990
974,080
Goodwill and core deposit intangibles, net
70,306
70,475
63,589
19,419
19,506
Other intangible assets
1,302
1,315
2,399,256
1,557,082
1,544,857
1,821,090
1,177,732
1,196,767
Borrowings
292,302
288,521
293,909
203,569
179,801
2,120,050
1,395,834
1,386,669
279,206
161,248
Tangible common equity*
214,450
207,416
194,352
141,804
138,656
Performance ratios
Return on average assets (ROAA) annualized
1.07
0.88
0.09
0.64
0.69
Return on average equity (ROAE) annualized
9.00
7.45
0.81
6.65
7.32
Return on average tangible common equity (ROATCE)
annualized*
12.36
10.17
1.28
7.94
8.64
Yield on loans annualized
5.45
5.61
5.21
4.72
4.89
Cost of interest-bearing deposits annualized
0.72
0.68
0.66
Net interest margin annualized
3.91
3.96
3.60
3.06
3.18
Efficiency ratio*
59.79
61.59
63.16
72.35
68.15
Non-interest income / average assets annualized
0.67
0.61
0.59
0.60
Non-interest expense / average assets annualized
2.55
2.76
3.52
2.56
2.42
Capital Ratios
Tier 1 Leverage Ratio
10.52
9.42
9.32
Common Equity Tier 1 Capital Ratio
12.69
13.57
13.04
Tier 1 Risk Based Capital Ratio
13.51
14.45
13.90
Total Risk Based Capital Ratio
13.93
15.02
Equity / Assets
11.88
11.64
11.77
10.36
10.24
Tangible common equity to tangible assets*
9.18
8.91
9.13
9.22
9.09
Book value per share
23.44
22.88
22.09
19.62
19.25
Tangible common book value per share*
17.57
17.00
16.64
17.25
16.87
Tangible common book value per diluted share*
17.24
16.66
16.37
16.95
* The value noted is considered a Non-GAAP financial measure. For a reconciliation of Non-GAAP financial measures see “Non-GAAP Financial Measures” in this Item 2.
Our significant accounting policies are integral to understanding the results reported. Our accounting policies are described in detail in Note 1 to the December 31, 2016 audited financial statements included in our Annual Report on Form 10-K filed with the SEC on March 16, 2017. We believe that of our significant accounting policies, the following may involve a higher degree of judgement and complexity. We have identified the following accounting policies and estimates that, due to the difficult, subjective or complex judgements and assumptions inherent in those policies and estimates and the potential sensitivity of our financial statements to those judgements and assumptions, are critical to an understanding of our financial condition and results of operations. We believe that the judgments, estimates and assumptions used in the preparation of our financial statements are appropriate.
Business Combinations: We apply the acquisition method of accounting for business combinations. Under the acquisition method, the acquiring entity in a business combination recognizes 100% of the assets acquired and liabilities assumed at their acquisition date fair values. We use valuation techniques appropriate for the asset or liability being measured in determining these fair values. Any excess of the purchase price over amounts allocated to assets acquired, including identified intangible assets and liabilities assumed is recorded as goodwill. Where amounts allocated to assets acquired and liabilities assumed is greater than the purchase price, a bargain purchase gain is recognized. Acquisition-related costs are expensed as incurred.
Loans: Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of previous charge-offs and an allowance for loan losses, and for purchased loans, net of unamortized purchase premiums and discounts. Interest income is accrued on the unpaid principal balance.
Purchased Credit Impaired Loans: As a part of acquisitions, we acquired certain loans for which there was, at acquisition, evidence of deterioration of credit quality since origination. These purchased credit impaired loans were recorded at the amount paid, such that there is no carryover of the seller’s allowance for loan losses. After acquisition, losses are recognized by an increase in the allowance for loan losses. Such purchased credit impaired loans are accounted for individually. We estimate the amount and timing of expected cash flows for each loan, and the expected cash flows in excess of the amount paid are recorded as interest income over the remaining life of the loan (accretable yield). The excess of the loan’s contractual principal and interest over expected cash flows is not recorded (non-accretable difference). Over the life of the loan, expected cash flows continue to be estimated. If the present value of the expected cash flows is less than the carrying amount, a loss is recorded. If the present value of the expected cash flows is greater than the carrying amount, it is recognized as part of future interest income.
Nonaccrual Loans: Generally, loans are designated as nonaccrual when either principal or interest payments are 90 days or more past due based on contractual terms unless the loan is well secured and in the process of collection. Consumer loans are typically charged off no later than 180 days past due. In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful. When a loan is placed on nonaccrual status, unpaid interest credited to income is reversed against income. Future interest income may be recorded on a cash basis after recovery of principal is reasonably assured. Nonaccrual loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
Impaired Loans: A loan is considered impaired when, based on current information and events, it is probable that we will be unable to collect all contractual principal and interest due according to the terms of the loan agreement. All loans are individually evaluated for impairment. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or on the value of the underlying collateral if the loan is collateral dependent. We evaluate the collectability of both principal and interest when assessing the need for a loss accrual.
Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls
on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.
Troubled Debt Restructurings: In cases where a borrower experiences financial difficulties and we make certain concessionary modifications to contractual terms, the loan is classified as a troubled debt restructured loan and classified as impaired. Generally, a nonaccrual loan that is a troubled debt restructuring remains on nonaccrual until such time that repayment of the remaining principal and interest is not in doubt, and the borrower has a period of satisfactory repayment performance.
Allowance for Loan Losses: The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes the collectability of a loan balance is unlikely. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. A loan review process, independent of the loan approval process, is utilized by management to verify loans are being made and administered in accordance with company policy, to review loan risk grades and potential losses, to verify that potential problem loans are receiving adequate and timely corrective measures to avoid or reduce losses, and to assist in the verification of the adequacy of the loan loss reserve. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off.
The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported net at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the sale of the collateral. Troubled debt restructurings are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a troubled debt restructuring is considered to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral. For troubled debt restructurings that subsequently default, we determine the amount of reserve in accordance with the accounting policy for the allowance for loan losses.
The general component of the allowance for loan losses covers non-impaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by portfolio and class and is based on the actual loss history experienced by us. This actual loss experience is then adjusted by comparing current conditions to the conditions that existed during the loss history. We consider the changes related to (i) lending policies, (ii) economic conditions, (iii) nature and volume of the loan portfolio and class, (iv) lending staff, (v) volume and severity of past due, non-accrual, and risk graded loans, (vi) loan review system, (vii) value of underlying collateral for collateral dependent loans, (viii) concentration levels, and (ix) effects of other external factors.
Goodwill and Core Deposit Intangibles: Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Core deposit intangibles are acquired customer relationships arising from whole bank and branch acquisitions. Core deposit intangibles are initially measured at fair value and then are amortized over their estimated useful lives using an accelerated method. The useful lives of the core deposits are estimated to generally be between seven and ten years. Goodwill and core deposit intangibles are assessed at least annually for impairment and any such impairment is recognized and expensed in the period identified. We have selected December 31 as the date to perform our annual goodwill impairment test. Goodwill is the only intangible asset with an indefinite useful life.
Fair Value: Fair values of assets and liabilities are estimated using relevant market information and other assumptions. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, collateral values and other factors, especially in the absence of broad markets for particular assets and liabilities. Changes in assumptions or in market conditions could materially affect the estimates.
Emerging Growth Company: Pursuant to the JOBS Act, an emerging growth company is provided the option to adopt new or revised accounting standards that may be issued by the FASB or the SEC either (i) within the same periods as those otherwise applicable to non-emerging growth companies or (ii) within the same time periods as private companies. We have irrevocably elected to adopt new accounting standards within the public company adoption period.
We may take advantage of some of the reduced regulatory and reporting requirements that are available to us so long as the Company qualifies as an emerging growth company, including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation, and exemptions from the requirements of holding non-binding advisory votes on executive compensation and golden parachute payments.
There have been no material changes in our critical accounting policies from those disclosed in our Annual Report on Form 10-K filed with the SEC on March 16, 2017.
We generate most of our revenue from interest income and fees on loans, interest and dividends on investment securities and non-interest income, such as service charges and fees, debit card income and mortgage banking income. We incur interest expense on deposits and other borrowed funds and non-interest expense, such as salaries and employee benefits and occupancy expenses. On November 10, 2016, we completed our acquisition of Community First Bancshares, Inc., of Harrison, Arkansas. The acquisition of Community First added five branch locations in northern Arkansas. Results of operations of Community First were included in our financial results beginning November 11, 2016. On March 10, 2017, we completed our acquisition of Prairie State Bancshares, Inc. of Hoxie, Kansas. The acquisition of Prairie added an additional three branch locations in western Kansas. Results of operations of Prairie were included in our financial results beginning March 11, 2017.
Changes in interest rates earned on interest-earning assets or incurred on interest-bearing liabilities, as well as the volume and types of interest-earning assets, interest-bearing and non-interest-bearing liabilities and stockholders’ equity, are usually the largest drivers of periodic change in net interest income. Fluctuations in interest rates are driven by many factors, including governmental monetary policies, inflation, deflation, macroeconomic developments, changes in unemployment, the money supply, political and international conditions and conditions in domestic and foreign financial markets. Periodic changes in the volume and types of loans in our loan portfolio are affected by, among other factors, economic and competitive conditions in Arkansas, Kansas and Missouri, as well as developments affecting the commercial, consumer and real estate sectors within these markets.
Net Income
Three months ended June 30, 2017 compared with three months ended June 30, 2016:
Net income for the three months ended June 30, 2017 was $6.4 million as compared to net income of $2.8 million for the three months ended June 30, 2016. Net income allocable to common stockholders also was $6.4 million for the three months ended June 30, 2017, compared to $2.8 million for the three months ended June 30, 2016, an increase of $3.5 million, or 123.3%. During the three-month period ended June 30, 2017, increases in net interest income of $9.0 million and non-interest income of $1.5 million were partially offset by an increase in non-interest expense of $5.2 million when compared to the three-month period ended June 30, 2016. The changes in the components of net income are discussed in more detail in the following sections of “Results of Operations.”
Six months ended June 30, 2017 compared with six months ended June 30, 2016:
Net income for the six months ended June 30, 2017 was $11.2 million as compared to net income of $6.3 million for the six months ended June 30, 2016. Net income allocable to common stockholders also was $11.2 million for the six months ended June 30, 2017, compared to $6.3 million for the six months ended June 30, 2016, an increase of $4.9 million, or 78.5%. On January 4, 2016, we redeemed the Series C preferred stock initially issued to the U.S. Treasury in 2011 as part of the Small Business Lending Fund. The Series C preferred stock paid dividends at a rate of 1.0% on the $16.4 million outstanding. Net income allocable to common stockholders was decreased by $1 thousand during the first six months of 2016 due to redemption of the preferred stock. During the six-month period ended June 30, 2017, increases in net interest income of $16.1 million and non-interest income of $2.2 million were partially offset by an increase in non-interest expense of $10.7 million when compared to the six-month period ended June 30, 2016. The changes in the components of net income are discussed in more detail in the following sections of “Results of Operations.”
Net Interest Income and Net Interest Margin Analysis
Net interest income is the difference between interest income on interest-earning assets, including loans and securities, and interest expense incurred on interest-bearing liabilities, including deposits and other borrowed funds. To evaluate net interest income, management measures and monitors (1) yields on loans and other interest-earning assets, (2) the costs of deposits and other funding sources, (3) the net interest spread and (4) net interest margin. Net interest spread is the difference between rates earned on interest-earning assets and rates paid on interest-bearing liabilities. Net interest margin is calculated as net interest income divided by average interest-earning assets. Because non-interest-bearing sources of funds, such as non-interest-bearing deposits and stockholders’ equity also fund interest-earning assets, net interest margin includes the benefit of these non-interest-bearing sources of funds. Net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as a “volume change,” and it is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and other borrowed funds, referred to as a “yield/rate change.”
Three months ended June 30, 2017 compared with three months ended June 30, 2016: The following table shows the average balance of each principal category of assets, liabilities, and stockholders’ equity and the average yields on interest-earning assets and average rates on interest-bearing liabilities for the three months ended June 30, 2017 and 2016. The yields and rates are calculated by dividing annualized income or annualized expense by the average daily balances of the associated assets or liabilities.
Average Balance Sheets and Net Interest Analysis
For the Three Months Ended June 30,
(Dollars in thousands)
Income/
Expense
Yield/
Rate(3)(4)
Interest-earning assets:
Loans(1)
1,519,289
950,243
Taxable securities
500,758
2.58
362,724
2.20
Nontaxable securities
113,156
49,371
2.71
42,314
3.16
179,067
1.15
Total interest-earning assets
2,175,517
4.62
1,541,405
3.75
Non-interest-earning assets:
8,417
6,069
54,100
38,861
48,532
32,890
Goodwill and core deposit intangible, net
71,720
19,570
Other non-interest-earning assets
24,599
16,522
2,382,885
1,655,317
Interest-bearing liabilities:
Interest-bearing demand deposits
435,712
516
0.48
295,516
Savings and money market
470,375
592
313,545
323
Savings, NOW and money market
906,087
1,108
0.49
609,061
521
Certificates of deposit
633,676
1,786
1.13
436,723
1,149
1.06
1,539,763
1,045,784
FHLB term and line of credit advances
275,643
253,067
0.55
Subordinated borrowings
13,790
7.03
9,334
6.74
Other borrowings
20,155
22,230
0.24
Total interest-bearing liabilities
1,849,351
0.84
1,330,415
Non-interest-bearing liabilities and
stockholders’ equity:
Non-interest-bearing checking accounts
241,418
159,077
Non-interest-bearing liabilities
8,929
9,422
Stockholders’ equity
283,187
156,403
Interest rate spread
3.78
3.09
Net interest margin(2)
Total cost of deposits, including non-interest
bearing deposits
1,781,181
0.65
1,204,861
0.56
Average interest-earning assets to
interest-bearing liabilities
117.64
115.86
(1)
Average loan balances include nonaccrual loans.
(2)
Net interest margin is calculated by dividing annualized net interest income by average interest-earnings assets for the period.
(3)
Tax exempt income is not included in the above table on a tax equivalent basis.
(4)
Actual unrounded values are used to calculate the reported yield or rate disclosed. Accordingly, recalculations using the amounts in thousands as disclosed in this report may not produce the same amounts.
Increases and decreases in interest income and interest expense result from changes in average balances (volume) of interest-earning assets and interest-bearing liabilities, as well as changes in average interest yields/rates. The following table analyzes the change in volume variances and yield/rate variances for the three-month periods ended June 30, 2017 and 2016.
Analysis of Changes in Net Interest Income
For the Three Months Ended June 30, 2017 and 2016
Increase (Decrease) Due to:
Increase /
Volume(1)
Yield/Rate(1)
(Decrease)
7,603
1,508
9,111
390
1,237
481
530
(597
421
(176
8,334
2,368
10,702
587
87
859
356
389
78
85
969
1,697
Net Interest Income
7,365
1,640
9,005
The effect of changes in volume is determined by multiplying the change in volume by the previous year’s average rate. Similarly, the effect of rate changes is calculated by multiplying the change in average rate by the prior year’s volume. The changes attributable to both volume and rate, which cannot be segregated, have been allocated to the volume variance and the rate variance in proportion to the relationship of the absolute dollar amount of the change in each.
Net interest income before the provision for loan losses for the three months ended June 30, 2017 was $21.2 million compared with $12.2 million for the three months ended June 30, 2016, an increase of $9.0 million, or 73.8%. Interest income for the three months ended June 30, 2017 was $25.1 million, an increase of $10.7 million, or 74.4%, from $14.4 million for the three months ended June 30, 2016. Interest income increased primarily due to an increase in the average volume of interest-earning assets due in large part to growth in loan balances during the period. Interest expense for the three months ended June 30, 2017 was $3.9 million, an increase of $1.7 million, or 77.6%, from $2.2 million for the three months ended June 30, 2016. The increase in interest expense was primarily due to an increase the average volume of interest-bearing liabilities and an increase in the average rate paid on interest-bearing liabilities.
Interest income on loans, including loan fees which consist of fees for loan origination, renewal, prepayment, covenant breakage and loan modification, was $20.7 million for the three months ended June 30, 2017; an increase of $9.1 million, or 78.9%, compared with the three months ended June 30, 2016. This increase was due to an increase in average loans and to a lesser extent, an increase in the average yield on the loan portfolio. The increase in average loan volume was primarily from the Community First and Prairie acquisitions. Average loan volume increased $192.2 million in commercial real estate loans, $130.6 million in agricultural loans, $111.8 million in commercial and industrial loans, $109.7 million in mortgage loans, and $24.8 million in consumer loans. The average yield on loans was 5.45% for the three months ended June 30, 2017 and 4.89% for the three months ended June 30, 2016. The average yield on loans excluding loan fees was 5.22% for the three months ended June 30, 2017 and 4.67% for the three months ended June 30, 2016. The increase in yield excluding loan fees was primarily due to an overall increasing rate environment and amortization of merger related fair value adjustment accretion. Interest income on all securities was $4.1 million for the quarter ended June 30, 2017; an increase of $1.8 million when compared to the quarter ended June 30, 2016. The increase was due to the increase in average total securities of $201.8 million and a 41 basis point increase in the average yield on the securities portfolio. The increase in the average volume of securities was due to the purchase of additional mortgage-backed securities, corporate securities, and municipal securities.
Interest expense was $3.9 million for the three months ended June 30, 2017, an increase of $1.7 million over interest expense of $2.2 million for the three months ended June 30, 2016. The change in interest expense was primarily due to an increase of $518.9 million in the average volume of interest-bearing liabilities. Average savings, NOW and money market deposits increased $297.0
million for the three months ended June 30, 2017 when compared to the three months ended June 30, 2016, and the average rate on these interest-bearing deposits increased from 0.34% to 0.49% for the same periods. The average balance increase in interest-bearing deposits is primarily due to the Community First and Prairie acquisitions and to a lesser extent, the result of actively managing deposits as a funding vehicle and expansion of our customer base. The increase in rate on interest-bearing deposits was the result of actively managing the rates on this funding source to remain competitive in the market place. Average certificates of deposit increased $197.0 million for the three months ended June 30, 2017 compared to the three months ended June 30, 2016, and the average rate increased from 1.06% to 1.13% for the same period. The increase in interest expense on certificates of deposit was primarily due to an overall increasing rate environment. Total cost of funds increased 18 basis points to 0.84% for the three months ended June 30, 2017 from 0.66% for the three months ended June 30, 2016.
Net interest margin was 3.91% for the three months ended June 30, 2017; an increase of 73 basis points when compared with net interest margin of 3.18% for the three months ended June 30, 2016. The increase in our net interest margin for the three months ended June 30, 2017 is primarily due to the increase in overall yield on interest-earnings assets. Also, during the second quarter of 2016, we utilized a “leverage” or “spread” opportunity. The spread opportunity involved borrowing overnight on our line of credit with the Federal Home Loan Bank (“FHLB”) and investing the proceeds in FHLB stock, federal funds sold and other overnight assets, such as money market accounts in other financial institutions. Our net interest margin would have been approximately 3.48% without the spread opportunity for the three months ended June 30, 2016. The spread opportunity was terminated at September 30, 2016 and would not have impacted the net interest margin reported for the three months ended June 30, 2017. These changes resulted in an increase in net interest income of $9.0 million, an increase in average interest-earning assets of $634.1 million and an increase in net interest margin of 73 basis points when comparing the three-month periods ended June 30, 2017 and 2016.
Six months ended June 30, 2017 compared with six months ended June 30, 2016: The following table shows the average balance of each principal category of assets, liabilities, and stockholders’ equity and the average yields on interest-earning assets and average rates on interest-bearing liabilities for the six-month periods ended June 30, 2017 and 2016. The yields and rates are calculated by dividing annualized income or annualized expense by the average daily balances of the associated assets or liabilities.
For the Six Months Ended June 30,
1,461,503
5.53
947,305
4.97
488,727
2.45
369,565
2.28
108,556
49,200
2.70
47,445
2.72
176,031
1.14
2,106,231
1,542,101
3.81
8,453
5,934
52,801
38,938
48,357
32,766
68,471
19,617
25,649
17,130
2,309,962
1,656,486
455,594
1,018
0.45
306,284
400
0.26
438,108
1,033
309,766
893,702
0.46
616,050
1,027
605,459
3,419
437,151
2,250
1.03
1,499,161
0.74
1,053,201
0.63
265,503
0.94
251,009
0.54
307
13,751
6.95
9,306
6.69
21,742
1,798,548
1,335,565
228,346
156,598
9,058
9,157
274,010
155,166
3.93
3.25
1,727,507
1,209,799
Average interest-earning assets to interest-bearing
117.11
115.46
44
Increases and decreases in interest income and interest expense result from changes in average balances (volume) of interest-earning assets and interest-bearing liabilities, as well as changes in average interest yields/rates. The following table analyzes the change in volume variances and yield/rate variances for the six-month periods ended June 30, 2017 and 2016.
For the Six Months Ended June 30, 2017 and 2016
13,859
2,811
16,670
1,433
319
1,752
891
987
(1,073
719
(354
15,110
3,945
19,055
541
483
1,024
933
1,169
1,474
2,193
559
153
164
1,666
1,249
2,915
13,444
16,140
Net interest income before the provision for loan losses for the six months ended June 30, 2017 was $41.1 million compared with $25.0 million for the six months ended June 30, 2016, an increase of $16.1 million, or 64.7%. Interest income for the six months ended June 30, 2017 was $48.3 million, an increase of $19.1 million, or 65.2%, from $29.2 million for the six months ended June 30, 2016. Interest income increased primarily due to an increase in the average volume of interest-earning assets due in large part to growth in loan balances during the period, primarily from the Community First and Prairie acquisitions. Interest expense for the six months ended June 30, 2017 was $7.2 million, an increase of $2.9 million, or 67.9%, from $4.3 million for the six months ended June 30, 2016. The increase in interest expense was primarily due to an increase in the average volume of interest-bearing liabilities and an increase in the average rate paid on interest-bearing liabilities.
Interest income on loans, including loan fees which consist of fees for loan origination, renewal, prepayment, covenant breakage and loan modification, was $40.1 million for the six months ended June 30, 2017; an increase of $16.7 million, or 71.3%, compared with the six months ended June 30, 2016. This increase was due to an increase in average loans and to a lesser extent, an increase in the average yield on the loan portfolio. The increase in average loan volume was primarily from loans acquired in the Community First and Prairie acquisitions. Loans increased an average of $187.0 million in commercial real estate loans, $93.5 million in commercial and industrial loans, $93.2 million in agricultural loans, $116.4 million in mortgage loans, and $24.2 million in consumer loans. The average yield on loans was 5.53% for the six months ended June 30, 2017 and 4.97% for the six months ended June 30, 2016. The average yield on loans excluding loan fees was 5.29% for the six months ended June 30, 2017 and 4.71% for the six months ended June 30, 2016. The increase in yield excluding loan fees was primarily due to an overall increasing rate environment and amortization of merger related fair value adjustment accretion. Interest income on all securities was $7.6 million for the six-months ended June 30, 2017; an increase of $2.7 million when compared to the six-months ended June 30, 2016. The increase was due to the increase in average total securities of $178.5 million and a 23 basis point increase in the average yield on the securities portfolio. The increase in the average volume of securities was due to the purchase of additional mortgage-backed securities, corporate securities, and municipal securities.
Interest expense was $7.2 million for the six months ended June 30, 2017, an increase of $2.9 million over interest expense of $4.3 million for the six months ended June 30, 2016. The change in interest expense was primarily due to an increase of $463.0 million in the average volume of interest-bearing liabilities. Average savings, NOW and money market deposits increased $277.7 million for the six months ended June 30, 2017 when compared to the six months ended June 30, 2016, and the average rate on these interest-bearing deposits increased from 0.34% to 0.46% for the same periods. The average balance increase in interest-bearing deposits was primarily a result of the Community First and Prairie acquisitions. Additionally, we have grown our interest-bearing deposits by actively managing them as a funding vehicle and expanding our customer base. The increase in rate on interest-bearing deposits is the result of actively managing the rates on this funding source to remain competitive in the market place. Average certificates of deposit increased $168.3 million for the six months ended June 30, 2017 compared to the six months ended June 30, 2016, and the average rate increased from 1.03% to 1.14% for the same period. The increase in interest expense on certificates of deposit was primarily due to an overall increasing rate environment. Primarily due to the factors discussed above, total cost of funds increased 16 basis points to 0.81% for the six months ended June 30, 2017 from 0.65% for the six months ended June 30, 2016.
Net interest margin was 3.93% for the six months ended June 30, 2017; an increase of 68 basis points when compared with net interest margin of 3.25% for the six months ended June 30, 2016. The increase in our net interest margin for the six months ended June 30, 2017 is primarily due to the increase in overall yield on interest-earnings assets. Also, during the first six months of 2016, we utilized a “leverage” or “spread” opportunity. The spread opportunity involved borrowing overnight on our line of credit with the FHLB and investing the proceeds in FHLB stock, federal funds sold and other overnight assets, such as money market accounts in other financial institutions. Our net interest margin without the spread opportunity would have been approximately 3.55% for the six months ended June 30, 2016. The spread opportunity was terminated at September 30, 2016 and would not have impacted the net interest margin reported for the six months ended June 30, 2017. These changes resulted in an increase in net interest income of $16.1 million, an increase in average interest-earning assets of $564.1 million and an increase in net interest margin of 68 basis points when comparing the six-month periods ended June 30, 2017 and 2016.
Provision for Loan Losses
We maintain an allowance for loan losses for probable incurred credit losses. The allowance for loan losses is increased by a provision for loan losses, which is a charge to earnings, and subsequent recoveries of amounts previously charged-off, but is decreased by charge-offs when the collectability of a loan balance is unlikely. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the loan portfolio, information about specific borrower situations and estimated collateral values, discounted cash flows, economic conditions, and other factors including regulatory guidance, as described in ”Financial Condition—Allowance for loan losses.” As these factors change, the amount of the loan loss provision changes.
Three months ended June 30, 2017 compared with three months ended June 30, 2016: The provision for loan losses for the three months ended June 30, 2017 was $628 thousand compared with $532 thousand for the three months ended June 30, 2016. Net charge-offs for the three months ended June 30, 2017 were $108 thousand compared to net charge-offs of $482 thousand for the three months ended June 30, 2016. For the three months ended June 30, 2017, gross charge-offs were $710 thousand offset by gross recoveries of $602 thousand. In comparison, gross charge-offs were $550 thousand for the three months ended June 30, 2016 offset by gross recoveries of $68 thousand.
Six months ended June 30, 2017 compared with six months ended June 30, 2016: The provision for loan losses for the six months ended June 30, 2017 was $1.7 million compared with $1.3 million for the six months ended June 30, 2016. Net charge-offs for the six months ended June 30, 2017 were $587 thousand compared to net charge-offs of $731 thousand for the six months ended June 30, 2016. For the six months ended June 30, 2017, gross charge-offs were $1.4 million offset by gross recoveries of $810 thousand. In comparison, gross charge-offs were $841 thousand for the six months ended June 30, 2016 offset by gross recoveries of $110 thousand.
Non-Interest Income
The primary sources of non-interest income are service charges and fees, debit card income, mortgage banking income, increases in the value of bank owned life insurance, investment referral income, the recovery of zero-basis purchased loans, and net gain from securities transactions. Non-interest income does not include loan origination or other loan fees which are recognized as an adjustment to yield using the interest method.
Three months ended June 30, 2017 compared with three months ended June 30, 2016: The following table provides a comparison of the major components of non-interest income for the three months ended June 30, 2017 and 2016:
2017 vs. 2016
Change
51.7
477
65.5
205
61.2
108
43.9
Investment referral income
107
120
(13
-10.8
Recovery on zero-basis purchased loans
333.3
384
142
170.4
Sub-Total
1,486
62.1
40.7
1,510
61.6
For the three months ended June 30, 2017, non-interest income totaled $4.0 million, an increase of $1.5 million, or 61.6%, compared with the three months ended June 30, 2016. The increase was primarily due to increases in debit card income, service charges and fees, other income, mortgage banking income, and increase in value of bank owned life insurance. Debit card income increased $477 thousand from $728 thousand at June 30, 2016 to $1.2 million at June 30, 2017, service charges and fees income increased $417 thousand for the same period from $807 thousand at June 30, 2016 to $1.2 million at June 30, 2017, other income increased $242 thousand from $142 thousand at June 30, 2016 to $384 thousand at June 30, 2017, mortgage banking income increased $205 thousand for the same period from $335 thousand at June 30, 2016 to $540 thousand at June 30, 2017, and increase in value of bank owned life insurance increased $108 thousand from $246 thousand at June 30, 2016 to $354 thousand at June 30, 2017. Our principal source of service charges and fees is non-sufficient funds charges, which are cyclical in nature and generally fluctuate with the change in volume of transaction deposit accounts and economic conditions impacting our customers. Other income includes such items as wire fees, ATM surcharge fees, safe deposit box fees, and other miscellaneous fees. In addition, $336 thousand of the increase in service charges and fees and $338 thousand of the increase in debit card income are attributable to the addition of accounts and higher transaction volumes associated with the Community First acquisition. The acquisition of Prairie, in March 2017, contributed $64 thousand in service charges and fees and $32 thousand in debit card income. The increase in mortgage banking income was associated with greater mortgage loan sales in the current quarter.
Six months ended June 30, 2017 compared with six months ended June 30, 2016: The following table provides a comparison of the major components of non-interest income for the six months ended June 30, 2017 and 2016:
790
49.8
805
57.3
448
77.6
212
42.7
208
243
(35
-14.4
76
185.4
560
322
73.9
4,671
2,534
54.2
(383
-80.0
2,151
41.8
For the six months ended June 30, 2017, non-interest income totaled $7.3 million, an increase of $2.2 million, or 41.8%, compared with the six months ended June 30, 2016. The increase was primarily due to increases in debit card income, service charges and fees, mortgage banking income, other income, and increase in value of bank owned life insurance. In connection with
47
acquisitions, we receive the rights to certain loans that were previously charged off by the acquired bank. At acquisition, there was no expectation of future cash flows from these previously charged-off loans and thus they were assigned a zero basis. Subsequent to acquisition, we have received cash payments on certain of these loans. Timing and receipt of such payments, if any, are not easily predictable.
Debit card income increased $805 thousand from $1.4 million at June 30, 2016 to $2.2 million at June 30, 2017, service charges and fees income increased $790 thousand for the same period from $1.6 million at June 30, 2016 to $2.4 million at June 30, 2017, mortgage banking income increased $448 thousand from $577 thousand at June 30, 2016 to $1.0 million at June 30, 2017, other income increased $238 thousand for the same period from $322 thousand at June 30, 2016 to $560 thousand at June 30, 2017, and increase in value of bank owned life insurance increased $212 thousand from $497 thousand at June 30, 2016 to $709 thousand at June 30, 2017. Our principal source of service charges and fees is non-sufficient funds charges, which are cyclical in nature and generally fluctuate with the change in volume of transaction deposit accounts and economic conditions impacting our customers. In addition, $672 thousand of the increase in service charges and fees and $625 thousand of the increase in debit card income are attributable to the addition of accounts and higher transaction volumes associated with the Community First acquisition. The March 2017 Prairie acquisition contributed $75 thousand in service charges and fees and $50 thousand in debit card income.
Non-Interest Expense
Three months ended June 30, 2017 compared with three months ended June 30, 2016: For the three months ended June 30, 2017, non-interest expense totaled $15.1 million, an increase of $5.2 million, or 52.2%, compared with the three months ended June 30, 2016. The overall increase was primarily due to an increase in salaries and employee benefits of $3.0 million, an increase in other expense of $557 thousand, an increase in net occupancy and equipment of $451 thousand, an increase in data processing of $322 thousand, and an increase in advertising and business development of $294 thousand. Non-interest expense for the three-month period ended June 30, 2017 includes $2.0 million of incremental operating expenses attributable to the five branch locations acquired with the Community First acquisition and $511 thousand attributable to the three branch locations acquired with the March 2017 Prairie acquisition. These items and other changes in the various components of non-interest expense are discussed in more detail below.
The following table provides a comparison of the major components of non-interest expense for the three months ended June 30, 2017 and 2016.
2,990
57.0
451
42.2
37.1
(106
-18.7
294
89.1
15.0
(36
-14.1
49.4
42.9
114
67.9
149
173.3
128
-220.7
557
69.5
5,054
50.8
100.0
5,190
52.2
Salaries and employee benefits: Salaries and benefits were $8.2 million for the three months ended June 30, 2017, as compared to $5.2 million for the three months ended June 30, 2016. The increase in salaries and benefits of $3.0 million includes approximately $1.2 million directly allocable to the Community First acquisition and $330 thousand directly allocable to the Prairie acquisition. Included in salaries and employee benefits is stock based compensation expense of $133 thousand for the three months ended June 30, 2017 and $67 thousand in the comparable period of 2016. The remaining $1.7 million increase in salaries and benefits reflect cost-of-living/merit raises and the addition of lending, customer service and operations staff.
48
Net occupancy and equipment: Net occupancy and equipment includes expenses related to the use of premises and equipment, such as depreciation, operating lease payments, repairs and maintenance, insurance, property taxes and utilities, and is net of incidental rental income of excess facilities. Occupancy expenses were $1.5 million for the three months ended June 30, 2017 and $1.1 million for the three months ended June 30, 2016. The 2017 expenses include expenses of $286 thousand for five branches that were part of the acquisition of Community First and $46 thousand for three branches that were part of the March 2017 acquisition of Prairie.
Data processing: Data processing expenses were $1.2 million and $869 thousand for the three-month periods ended June 30, 2017 and 2016. The increase of $322 thousand was principally due to increased debit card processing costs as usage has increased.
Advertising and business development: Advertising and business development expenses were $624 thousand for the three months ended June 30, 2017 and $330 thousand for the three months ended June 30, 2016. Advertising and business development includes media advertising, community sponsorships, customer appreciation expenses and other forms of advertising. The increase is due to additional advertising and business development in new markets added from the previously mentioned mergers.
Other real estate owned: Other real estate owned expenses, including provision for unrealized losses were $142 thousand for the three months ended June 30, 2017, offset by gains on the sale of other real estate owned of $72 thousand. For the three months ended June 30, 2016, other real estate owned expenses, including provision for unrealized losses were $100 thousand, offset by gains on the sale of other real estate owned of $158 thousand.
Other: Other non-interest expenses, which consist of, subscriptions; memberships and dues; employee expenses including travel, meals, entertainment and education; supplies; printing; insurance; account related losses; correspondent bank fees; customer program expenses; losses net of gains on the sale of fixed assets and other operating expenses such as settlement of claims, were $1.4 million for the three months ended June 30, 2017 and $801 thousand for the three months ended June 30, 2016. The $557 thousand increase in other non-interest expenses includes incremental operating costs attributable to the acquired Community First and Prairie branches.
Six months ended June 30, 2017 compared with six months ended June 30, 2016: For the six months ended June 30, 2017, non-interest expense totaled $30.4 million, an increase of $10.7 million, or 54.6%, compared with the six months ended June 30, 2016. The overall increase was primarily due to an increase in salaries and employee benefits of $5.6 million, an increase in other expense of $1.1 million, an increase in merger expenses of $1.1 million, an increase in net occupancy and expense of $856 thousand, an increase in data processing of $645 thousand, an increase in advertising and business development of $594 thousand, an increase in amortization of core deposit intangible of $271 thousand, and an increase in other real estate owned expenses of $267 thousand. Non-interest expense for the six-month period ended June 30, 2017 includes $3.8 million of incremental operating expenses directly allocable to the five branch locations acquired with the Community First acquisition and $622 thousand of incremental operating expenses directly allocable to the Prairie acquisition. These items and other changes in the various components of non-interest expense are discussed in more detail below.
The following table provides a comparison of the major components of non-interest expense for the six months ended June 30, 2017 and 2016.
5,584
53.4
856
39.6
645
37.8
-3.8
594
108.4
33.4
(188
-36.6
159
52.5
130
41.3
199
76.5
156.6
267
3337.5
1,072
67.4
29,295
19,572
49.7
-100.0
10,727
54.6
Salaries and employee benefits: Salaries and benefits were $16.0 million for the six months ended June 30, 2017, as compared to $10.5 million for the six months ended June 30, 2016. The increase in salaries and benefits of $5.6 million includes approximately $2.4 million allocable to the Community First acquisition and $395 thousand allocable to the Prairie acquisition. Included in salaries and employee benefits is stock-based compensation expense of $244 thousand for the six months ended June 30, 2017 and $135 thousand in the comparable period of 2016. The remaining $2.9 million increase in salaries and benefits reflect cost-of-living/merit raises and the addition of lending, customer service and operations staff.
Net occupancy and equipment: Net occupancy and equipment includes expenses related to the use of premises and equipment, such as depreciation, operating lease payments, repairs and maintenance, insurance, property taxes and utilities, and is net of incidental rental income of excess facilities. Occupancy expenses were $3.0 million for the six months ended June 30, 2017 and $2.2 million for the six months ended June 30, 2016. The 2017 expenses include expenses of $556 thousand for five branches that were part of the acquisition of Community First and expenses of $58 thousand for three branches that were part of the acquisition of Prairie.
Data processing: Data processing expenses were $2.4 million and $1.7 million for the six-month periods ended June 30, 2017 and 2016. The increase of $645 thousand was principally due to increased debit card processing costs as usage has increased.
Advertising and business development: Advertising and business development expenses were $1.1 million for the six months ended June 30, 2017 and $548 thousand for the six months ended June 30, 2016. Advertising and business development includes media advertising, community sponsorships, customer appreciation expenses and other forms of advertising. The increase is due to additional advertising and business development in new markets added from the previously described mergers.
Other real estate owned: Other real estate owned expenses, including provision for unrealized losses were $319 thousand for the six months ended June 30, 2017, offset by gains on the sale of other real estate owned of $44 thousand. For the six months ended June 30, 2016, other real estate owned expenses, including provision for unrealized losses were $168 thousand, offset by gains on the sale of other real estate owned of $160 thousand.
Other: Other non-interest expenses, which consist of, subscriptions; memberships and dues; employee expenses including travel, meals, entertainment and education; supplies; printing; insurance; account related losses; correspondent bank fees; deposit customer program expenses; losses net of gains on the sale of fixed assets and other operating expenses such as settlement of claims, were $2.7 million for the six months ended June 30, 2017 and $1.6 million for the six months ended June 30, 2016. The $1.1 million increase in other non-interest expenses includes incremental operating costs attributable to the acquired Community First and Prairie branches.
Merger expenses: Merger expenses were $1.1 million for the six months ended June 30, 2017. There were no merger expenses during the first six months of 2016. The $1.1 million in merger expenses for the six month period ended June 30, 2017 consisted of $136 thousand associated with the acquisition of Community First and $926 thousand associated with the acquisition of Prairie.
Efficiency Ratio
The efficiency ratio is a supplemental financial measure utilized in the internal evaluation of our performance and is not defined under GAAP. For a reconciliation of Non-GAAP financial measures see “Non-GAAP Financial Measures” in this Item 2. Our efficiency ratio is computed by dividing non-interest expense, excluding merger expenses and loss on debt extinguishment by the sum of net interest income and non-interest income, excluding net gain from securities transactions. Generally, an increase in the efficiency ratio indicates that more resources are being utilized to generate the same volume of income, while a decrease would indicate a more efficient allocation of resources.
Our efficiency ratio was 59.8% for the three months ended June 30, 2017, compared with 68.2% for the three months ended June 30, 2016. The decrease was primarily due to increased net interest income, partially offset by increased non-interest expense, as discussed in “Results of Operations – Non-Interest Expense.”
Our efficiency ratio was 60.7% for the six months ended June 30, 2017, compared with 66.1% for the six months ended June 30, 2016. The decrease was primarily due to increased net interest income, partially offset by increased non-interest expense, as discussed in “Results of Operations – Net Interest Income and Net Interest Margin Analysis,” and increased non-interest expense.
Income Taxes
The amount of income tax expense is influenced by the amount of pre-tax income, the amounts of tax-exempt investment income, non-taxable life insurance income, non-deductible expenses and available federal income tax credits.
Three months ended June 30, 2017 compared with three months ended June 30, 2016: For the three months ended June 30, 2017, income tax expense was $3.0 million compared with $1.3 million for the three months ended June 30, 2016. Our effective tax rate for the second quarter of 2017 was higher at 32.4% as compared to 31.8% for the second quarter of 2016. The U.S. statutory rate was 35.0% for both periods.
Six months ended June 30, 2017 compared with six months ended June 30, 2016: For the six months ended June 30, 2017, income tax expense was $5.1 million compared with $2.9 million for the six months ended June 30, 2016. Our effective tax rate for the first six months of 2017 was 31.2% as compared to 31.8% for the first six months of 2016. The effective tax rates for each of the comparable periods reflect the levels of tax-exempt income, non-taxable life insurance income and federal income tax credits estimated to be included in our financial results for the applicable full fiscal years.
Impact of Inflation
Our consolidated financial statements and related notes included elsewhere in this Quarterly Report have been prepared in accordance with GAAP, which requires the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative value of money over time due to inflation or recession.
Unlike many industrial companies, substantially all of our assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on our performance than the effects of general levels of inflation. Interest rates may not necessarily move in the same direction or in the same magnitude as the prices of goods and services. However, other operating expenses do reflect general levels of inflation.
Our total assets increased $216.4 million, or 9.9%, from $2.19 billion at December 31, 2016, to $2.41 billion at June 30, 2017. The increase in total assets was primarily from increases of $144.7 million in net loans held for investment, primarily acquired in the Prairie acquisition, and $66.5 million in held-to-maturity securities. Our total liabilities increased $188.3 million, or 9.7%, from $1.93 billion at December 31, 2016 to $2.12 billion at June 30, 2017. The increase in total liabilities was primarily from increases in total deposits of $189.2 million, largely due to the Prairie acquisition. Our total stockholders’ equity increased $28.1 million, or 10.9%, from $258.0 million at December 31, 2016 to $286.1 million at June 30, 2017. The increase in total stockholders’ equity was primarily from an increase in additional paid-in capital of $16.4 million, largely related to the Prairie acquisition, and an increase in retained earnings of $11.2 million.
Loan Portfolio
Loans are our largest category of earning assets and typically provide higher yields than other types of earning assets. At June 30, 2017, our gross loans held for portfolio totaled $1.53 billion, an increase of $145.8 million, or 10.5%, primarily acquired in the Prairie acquisition, compared with December 31, 2016. The overall increase in loan volume consisted of $65.0 million from agricultural, $37.2 million from commercial real estate, $31.0 from agricultural real estate, $12.2 million from commercial and industrial, $10.2 million from real estate construction, and $2.3 million from consumer, partially offset by a decrease of $12.3 million in residential real estate. We also had loans classified as held for sale totaling $3.5 million at June 30, 2017.
Our loan portfolio consists of various types of loans, most of which are made to borrowers located in the Wichita and Kansas City Metropolitan Statistical Areas (“MSAs”), as well as various community markets throughout Arkansas, Kansas and Missouri. The majority of our loan portfolio consists of commercial and industrial and commercial real estate loans and a substantial portion of our borrowers’ ability to honor their obligations is dependent on local economic conditions in Arkansas, Kansas and Missouri. As of June 30, 2017, there was no concentration of loans to any one type of industry exceeding 10% of total loans.
At June 30, 2017, gross total loans were 84.0% of deposits and 63.5% of total assets. At December 31, 2016, gross total loans were 84.9% of deposits and 63.1% of total assets.
The organic, or non-acquired, changes in our loan portfolio are attributable to our ability to attract new customers from other financial institutions and overall growth in our markets. Several new lenders have been hired in our markets, and we believe these lenders have been successful in transitioning their former clients and attracting new clients. Lending activities originate from the efforts of our lenders, with an emphasis on lending to individuals, professionals, small to medium-sized businesses and commercial companies located in the Wichita and Kansas City MSAs, as well as community markets in Arkansas, Kansas and Missouri.
We provide commercial lines of credit, working capital loans, commercial real estate-backed loans (including loans secured by owner occupied commercial properties), term loans, equipment financing, acquisition, expansion and development loans, borrowing base loans, real estate construction loans, homebuilder loans, SBA loans, agricultural and agricultural real estate loans, letters of credit and other loan products to national and regional companies, real estate developers, mortgage lenders, manufacturing and industrial companies and other businesses. The types of loans we make to consumers include residential real estate loans, home equity loans, home equity lines of credit, installment loans, unsecured and secured personal lines of credit, overdraft protection and letters of credit.
The following table summarizes our loan portfolio by type of loan as of the dates indicated:
Composition of Loan Portfolio
Percent
23.6
25.2
Real estate loans:
515,998
33.8
478,815
34.6
Real estate construction
124,541
8.1
114,293
8.3
21.3
24.4
4.5
2.8
Total real estate loans
1,036,007
67.7
969,826
70.1
2.9
5.9
1.8
Total loans held for investment
Total loans (net of allowances)
Total loans held for sale
Commercial and industrial: Commercial and industrial loans include loans used to purchase fixed assets, provide working capital, or meet other financing needs of the business. Our commercial and industrial portfolio totaled $360.7 million at June 30, 2017, an increase of $12.2 million, or 3.5%, compared to December 31, 2016.
Commercial real estate: Commercial real estate loans include all loans secured by nonfarm nonresidential properties and by multifamily residential properties, as well as 1-4 family investment-purpose real estate loans. Our commercial real estate loans were $516.0 million at June 30, 2017, an increase of $37.2 million, or 7.8%, compared to December 31, 2016.
Real estate construction: Real estate construction loans include loans made for the purpose of acquisition, development, or construction of real property, both commercial and consumer. Our real estate construction portfolio totaled $124.5 million at June 30, 2017, an increase of $10.2 million, or 9.0%, compared to December 31, 2016.
Residential real estate: Residential real estate loans include loans secured by primary or secondary personal residences. Our residential real estate portfolio totaled $326.1 million at June 30, 2017, a decrease of $12.3 million, or 3.6%, compared to December 31, 2016. Our purchased residential real estate loans totaled $82.2 million at June 30, 2017, a decrease of $8.5 million compared to December 31, 2016, or 68.9% of the overall decrease in residential real estate loans.
Agricultural real estate, Agricultural, Consumer and other: Agricultural real estate loans are loans related to farmland. Agricultural loans are primarily operating lines subject to annual farming revenues including productivity/yield of the agricultural commodities produced. Consumer loans are generally secured by consumer assets, but may be unsecured.
The contractual maturity ranges of loans in our loan portfolio and the amount of such loans with predetermined interest rates and floating rates in each maturity range as of June 30, 2017 are summarized in the following table:
Loan Maturity and Sensitivity to Changes in Interest Rates
As of June 30, 2017
One year
or less
After one year
through five
years
After five
114,223
157,925
88,539
Real Estate:
87,915
274,849
153,234
49,739
46,225
28,577
8,835
12,357
304,905
23,912
27,877
17,582
Total real estate
170,401
361,308
504,298
7,416
28,944
6,881
65,528
18,635
5,298
357,568
566,812
605,016
Loans with a predetermined fixed interest rate
202,839
348,830
192,735
744,404
Loans with an adjustable/floating interest rate
154,729
217,982
412,281
784,992
The contractual maturity ranges of loans in our loan portfolio and the amount of such loans with predetermined interest rates and floating rates in each maturity range as of December 31, 2016 are summarized in the following table:
As of December 31, 2016
115,467
130,409
102,589
74,721
262,774
141,320
45,375
52,105
16,813
11,141
16,780
310,466
7,381
18,973
11,977
138,618
350,632
480,576
6,662
26,814
7,426
12,723
2,289
273,470
517,255
592,880
154,518
364,177
194,905
713,600
118,952
153,078
397,975
670,005
We categorize loans into risk categories based on relevant information about the ability of borrowers to service their debt, such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. Loans are analyzed individually and classified based on credit risk. Consumer loans are considered pass credits unless downgraded due to payment status or reviewed as part of a larger credit relationship. We use the following definitions for risk ratings:
Special Mention: Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of our credit position at some future date. These loans are considered classified.
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The risk category of loans by class of loans is as follows as of June 30, 2017:
Risk Category of Loans by Class
Real estate:
505,433
10,565
110,929
13,612
1,001,359
34,648
The risk category of loans by class of loans is as follows as of December 31, 2016:
464,095
14,720
111,975
2,318
945,558
24,268
At June 30, 2017, loans considered pass rated credits decreased to 96.5% of total loans, down from 97.7% of total loans at December 31, 2016. Classified loans were $53.5 million at June 30, 2017, an increase of $21.3 million, or 66.0%, from $32.2 million at December 31, 2016. Of this increase, $7.7 million was directly attributable to loans acquired with the Prairie merger.
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Nonperforming Assets
The following table presents information regarding nonperforming assets at the dates indicated:
Nonaccrual loans
Accruing loans 90 or more days past due
Restructured loans-accruing
OREO acquired through foreclosure, net
Total nonperforming assets
37,867
31,349
Ratios:
Nonperforming assets to total assets
1.57
1.43
Nonperforming assets to total loans plus OREO
2.46
2.25
Nonperforming assets (“NPAs”) include loans on nonaccrual status, accruing loans 90 or more days past due, restructured loans, and other real estate acquired through foreclosure. Impaired loans do not include purchased loans that were identified upon acquisition as having experienced credit deterioration since origination (“purchased credit impaired loans” or “PCI loans”). See the “Critical Accounting Policies” section for information regarding the review of loans for determining the allowance for loan loss and impairment.
Generally, loans are designated as nonaccrual when either principal or interest payments are 90 days or more past due based on contractual terms, unless the loan is well secured and in the process of collection. Consumer loans are typically charged off no later than 180 days past due. In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful. When a loan is placed on nonaccrual status, unpaid interest credited to income is reversed against income. Future interest income may be recorded on a cash basis after recovery of principal is reasonably assured. Nonaccrual loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
We had $26.2 million in nonperforming loans at June 30, 2017, compared with $22.7 million at December 31, 2016. The nonperforming loans at June 30, 2017 consisted of 212 separate credits and 155 separate borrowers. We had four non-performing loan relationships with an outstanding balance in excess of $1.0 million as of June 30, 2017.
There are several procedures in place to assist us in maintaining the overall quality of our loan portfolio. We have established underwriting guidelines to be followed by lenders, and also monitor delinquency levels for any negative or adverse trends. In accordance with applicable regulation, appraisals or evaluations are required to independently value real estate and, as an important element, to consider when underwriting loans secured in part or in whole by real estate. The value of real estate collateral provides additional support to the borrower’s credit capacity. There can be no assurance, however, that our loan portfolio will not become subject to increasing pressures from deteriorating borrower credit due to general economic conditions.
Potential Problem Loans
Potential problem loans consist of loans that are performing in accordance with contractual terms, but for which management has concerns about the borrower’s ability to comply with repayment terms because of the borrower’s potential financial difficulties. Potential problem loans are assigned a grade of special mention or substandard. At June 30, 2017, the Company had $27.3 million in potential problem loans which were not included in either non-accrual or 90 days past due categories, compared to $9.5 million at December 31, 2016.
With respect to potential problem loans, all monitored and under-performing loans are reviewed and evaluated to determine if they are impaired. If we determine that a loan is impaired, then we evaluate the borrower’s overall financial condition to determine the need, if any, for possible write downs or appropriate additions to the allowance for loan losses based on the unlikelihood of full repayment of principal and interest in accordance with the contractual terms or the net realizable value of the pledged collateral.
Please see “Critical Accounting Policies – Allowance for Loan Losses” for additional discussion of our allowance policy.
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In connection with our review of the loan portfolio, risk elements attributable to particular loan types or categories are considered when assessing the quality of individual loans. Some of the risk elements include:
Commercial and industrial loans are dependent on the strength of the industries of the related borrowers and the success of their businesses. Commercial and industrial loans are advanced for equipment purchases, to provide working capital, or to meet other financing needs of the business. These loans may be secured by accounts receivable, inventory, equipment, or other business assets. Financial information is obtained from the borrower to evaluate the debt service coverage and ability to repay the loans.
Commercial real estate loans are dependent on the industries tied to these loans as well as the local commercial real estate market. The loans are secured by the real estate, and appraisals are obtained to support the loan amount. An evaluation of the project’s cash flows is performed to evaluate the borrower’s ability to repay the loan at the time of origination and periodically updated during the life of the loan. Residential real estate loans are affected by the local residential real estate market, the local economy, and movement in interest rates. We evaluate the borrower’s repayment ability through a review of credit reports and debt to income ratios. Appraisals are obtained to support the loan amount.
Agricultural real estate loans are real estate loans related to farmland, and are affected by the value of farmland. We evaluate the borrower’s ability to repay based on cash flows from farming operations.
Consumer loans are dependent on the local economy. Consumer loans are generally secured by consumer assets, but may be unsecured. We evaluate the borrower’s repayment ability through a review of credit scores and an evaluation of debt to income ratios.
Agricultural loans are primarily operating lines subject to annual farming revenues including productivity/yield of the agricultural commodities produced and the market pricing at the time of sale.
Purchased credit impaired loans: As part of previous acquisitions, we acquired certain loans for which there was, at acquisition, evidence of deterioration of credit quality since origination. These purchased credit impaired loans were recorded at the amount paid, such that there is no carryover of the seller’s allowance for loan losses. After acquisition, losses are recognized by an increase in the allowance for loan losses. Purchased credit impaired loans are accounted for individually. We estimate the amount and timing of expected cash flows for each loan, and the expected cash flows in excess of the amount paid are recorded as interest income over the remaining life of the loan (accretable yield). The excess of the loan’s contractual principal and interest over expected cash flows is not recorded (non-accretable difference). Over the life of the loan, expected cash flows continue to be estimated. If the present value of the expected cash flows is less than the carrying amount, a loss is recorded. If the present value of the expected cash flows is greater than the carrying amount, it is recognized as part of future interest income.
The table below shows the contractually required principal loan payments and the associated purchase discount on our purchased credit impaired portfolio.
Recorded Investment in Purchased Credit Impaired Loans
Contractually required payments
Analysis of allowance for loan losses: At June 30, 2017, the allowance for loan losses totaled $7.6 million, or 0.49% of total loans. At December 31, 2016, the allowance for loan losses aggregated $6.4 million, or 0.46% of total loans.
The allowance for loan losses on loans collectively evaluated for impairment totaled $6.8 million, or 0.45%, of the $1.50 billion in loans collectively evaluated for impairment at June 30, 2017, compared to an allowance for loan losses of $5.8 million, or 0.43% of the $1.36 billion in loans collectively evaluated for impairment at December 31, 2016. The increases in the allowance for loan losses as a percentage of total loans and of loans collectively evaluated for impairment principally reflect management’s evaluation of current environmental conditions and changes in the composition and quality of our loan portfolio. Also considered by management in evaluating the allowance for loan losses are applied loss factors which are based in part on historical loss experience.
Annualized net losses as a percentage of average loans decreased to 0.03% for the three months ended June 30, 2017, as compared to 0.20% for the three months ended June 30, 2016. Annualized net losses as a percentage of average loans decreased to 0.08% for the six months ended June 30, 2017, as compared to 0.16% for the six months ended June 30, 2016.
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The following table presents, as of and for the periods indicated, an analysis of the allowance for loan losses and other related data:
Allowance for Loan Losses
As of and for the Three Months
Ended June 30,
As of and for the Six Months
Average loans outstanding
Gross loans outstanding at end of period(1)
Allowance for loan losses at beginning of
the period
Charge-offs:
―
Total charge-offs
Recoveries:
Total recoveries
Net recoveries (charge-offs)
(108
(482
(587
Allowance for loan losses at end of the
period
Ratio of allowance to period-ended loans
0.62
Annualized ratio of net charge-offs
(recoveries) to average loans
0.03
0.20
0.08
0.16
Excluding loans held for sale.
The following table shows the allocation of the allowance for loan losses among our loan categories and certain other information as of the dates indicated. The total allowance is available to absorb losses from any loan category.
Analysis of the Allowance for Loan Losses
% of
Allowance
Balance of allowance for loan losses applicable to:
27.4
29.3
2,074
1,808
28.1
8.6
612
9.5
26.4
1.4
0.6
6.9
4.1
1.9
1.0
Total allowance for loan losses
Management believes that the allowance for loan losses at June 30, 2017 was adequate to cover probable incurred losses in the loan portfolio as of such date. There can be no assurance, however, that we will not sustain losses in future periods, which could be substantial in relation to the size of the allowance at June 30, 2017.
We use our securities portfolio to provide a source of liquidity, to provide an appropriate return on funds invested, to manage interest rate risk, to meet pledging requirements and to meet regulatory capital requirements. At June 30, 2017, the carrying amount of investment securities totaled $624.6 million, an increase of $63.2 million, or 11.2%, compared with December 31, 2016. At June 30, 2017, securities represented 25.9% of total assets compared with 25.6% at December 31, 2016.
At the date of purchase, debt and equity securities are classified into one of two categories, held-to-maturity or available-for-sale. We do not purchase securities for trading purposes. At each reporting date, the appropriateness of the classification is reassessed. Investments in debt securities are classified as held-to-maturity and carried at cost, adjusted for the amortization of premiums and the accretion of discounts, in the financial statements only if management has the positive intent and ability to hold those securities to maturity. Debt securities not classified as held-to-maturity are classified as available-for-sale and measured at fair value in the financial statements with unrealized gains and losses reported, net of tax, as accumulated comprehensive income or loss until realized. Interest earned on securities is included in total interest and dividend income. Also included in total interest and dividend income are dividends received on stock investments in the Federal Reserve Bank of Kansas City and the FHLB of Topeka. These stock investments are stated at cost.
The following table summarizes the amortized cost and fair value by classification of available-for-sale securities as of the dates shown:
Available-For-Sale Securities
Total available-for-sale securities
The following table summarizes the amortized cost and fair value by classification of held-to-maturity securities as of the dates shown:
Held-To-Maturity Securities
Total held-to-maturity securities
At June 30, 2017 and December 31, 2016, we did not own securities of any one issuer (other than the U.S. government and its agencies or sponsored entities) for which aggregate adjusted cost exceeded 10% of the consolidated stockholders’ equity at the reporting dates noted.
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The following tables summarize the contractual maturity of debt securities and their weighted average yields as of June 30, 2017 and December 31, 2016. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Securities not due at a single maturity date, primarily mortgage-backed securities, are shown separately. Available-for-sale securities are shown at fair value and held-to-maturity securities are shown at cost, adjusted for the amortization of premiums and the accretion of discounts.
Due in one year
Due after one
year through
five years
Due after five
years through
10 years
Due after 10
Yield
Residential mortgage-backed
securities (issued by
—%
3,538
1.83
2.38
87,498
Small Business Administration
loan pools
State and political subdivisions(1)
1.11
1.76
1.50
3,841
87,691
2.77
Held-to-maturity securities:
U.S. government-sponsored
entities
1.65
6,422
2.62
12,893
2.65
362,963
2.82
5,270
2.74
17,720
4.59
4.17
2.61
2.49
17,166
2.86
28,285
3.08
75,102
3.24
3.13
29,856
58,898
3.44
440,294
2.89
2.94
3,307
2.41
33,697
2.64
59,116
527,985
2.87
624,105
2.91
The calculated yield is not presented on a tax equivalent basis.
U.S. government-
sponsored entities
2.48
Residential mortgage-
backed securities
(issued by government-
sponsored entities)
3,601
1.87
82,832
2.66
2.63
1.96
Small Business
Administration loan pools
4,100
8,091
2.29
83,055
2.67
2.60
4,190
2.50
8,751
2.75
325,808
5,304
7,684
2.68
2,812
15,122
30,942
61,700
3.28
3.14
25,614
2.73
39,693
2.99
397,590
2.83
29,714
47,784
480,645
2.80
560,955
2.79
Mortgage-backed securities are securities that have been developed by pooling a number of real estate mortgages and which are principally issued by federal agencies such as Ginnie Mae, Fannie Mae and Freddie Mac. Unlike U.S. Treasury and U.S. government agency securities, which have a lump sum payment at maturity, mortgage-backed securities provide cash flows from regular principal and interest payments and principal prepayments throughout the lives of the securities. Premiums and discounts on mortgage-backed securities are amortized and accreted over the expected life of the security and may be impacted by prepayments. As such, mortgage-backed securities which are purchased at a premium will generally produce decreasing net yields as interest rates drop because home owners tend to refinance their mortgages resulting in prepayments and an acceleration of premium amortization. Securities purchased at a discount will reflect higher net yields in a decreasing interest rate environment as prepayments result in an acceleration of discount accretion.
The contractual maturity of mortgage-backed securities is not a reliable indicator of their expected lives because borrowers have the right to prepay their obligations at any time. Monthly pay downs on mortgage-backed securities cause the average lives of these securities to be much different than their stated lives. At June 30, 2017 and December 31, 2016, 95.1% and 96.0% of the mortgage-backed securities held by us had contractual final maturities of more than ten years with a weighted average life of 4.7 years and 5.4 years and a modified duration of 4.2 years and 4.8 years.
Our lending and investing activities are primarily funded by deposits. A variety of deposit accounts are offered with a wide range of interest rates and terms including demand, savings, money market and time deposits. We rely primarily on competitive pricing policies, convenient locations, comprehensive marketing strategy and personalized service to attract and retain these deposits.
The following table shows our composition of deposits at June 30, 2017 and December 31, 2016:
Composition of Deposits
of Total
Non-interest-bearing demand
14.4
12.8
Interest-bearing demand
422,306
23.2
492,583
30.2
479,090
26.3
377,042
23.1
36.1
33.9
Total deposits at June 30, 2017 were $1.82 billion, an increase of $189.2 million, or 11.6%, compared to total deposits of $1.63 billion at December 31, 2016. The increase in total deposits is primarily due to increases in non-interest-bearing demand deposits of $54.8 million, or 26.4%, savings and money market deposits of $102.0 million, or 27.1%, and time deposits of $102.6 million, or 18.6%, partially offset by decreases in interest-bearing deposits of $70.3 million, or 14.3%. The Prairie acquisition added $30.8 million in non-interest-bearing deposits, $49.3 million in savings deposits, and $45.3 million in time deposits. The remaining increase in non-interest-bearing demand deposits is primarily from small business checking, basic checking, commercial analysis checking and public fund customer balances. The decrease in interest-bearing demand accounts is largely due to the decrease in public fund balances related to distribution of tax monies at the local level. The remaining increase in savings and money market deposits is mainly a result of ongoing business development. The remaining increase in time deposits is primarily the result of growth in public funds customer balances.
Included in the savings and money market deposits are brokered deposit balances of $2.8 million as of June 30, 2017 and $2.7 million as of December 31, 2016. These balances represent customer funds placed in the Insured Cash Sweep (“ICS”) service that allows Equity Bank to break large money market deposits into smaller amounts and place them in a network of other ICS banks to ensure FDIC insurance coverage on the entire deposit. Although classified as brokered deposits for regulatory purposes, funds placed through the ICS service are Equity Bank’s customer relationships that management views as core funding. Brokered certificates of deposit as of June 30, 2017 were $4.1 million and $5.4 million at December 31, 2016. These balances were customer funds placed in the Certificate of Deposit Account Registry Service (“CDARS”) program. CDARS allows Equity Bank to break large time deposits into smaller amounts and place them in a network of other CDARS banks to ensure FDIC insurance coverage on the entire deposit. Although classified as brokered deposits for regulatory purposes, funds placed through the CDARS program are Equity Bank’s customer relationships that management views as core funding.
The following table provides information on the maturity distribution of time deposits of $100 thousand or more as of June 30, 2017 and December 31, 2016:
3 months or less
64,046
52,799
Over 3 through 6 months
67,351
41,555
Over 6 through 12 months
115,497
96,606
Over 12 months
167,948
138,860
Total Time Deposits
414,842
329,820
Other Borrowed Funds
We utilize borrowings to supplement deposits to fund our lending and investing activities. Short-term borrowings and long-term borrowings include federal funds purchased and retail repurchase agreements, FHLB advances, a bank stock loan, and subordinated debentures.
Federal funds purchased and retail repurchase agreements: We have available federal funds lines of credit with our correspondent banks. As of June 30, 2017 and December 31, 2016, there were no federal funds purchased outstanding. Retail repurchase agreements outstanding represent the purchase of interests in securities by banking customers. Retail repurchase agreements are stated at the amount of cash received in connection with the transaction. We do not account for any of our repurchase agreements as sales for accounting purposes in our financial statements. Repurchase agreements with banking customers are settled on the following business day. Retail repurchase agreements are secured by investment securities held by us totaling $21.8 million at June 30, 2017 and $23.4 million at December 31, 2016. The agreements are on a day-to-day basis and can be terminated on demand. At June 30, 2017 and December 31, 2016, we had retail repurchase agreements with banking customers of $21.1 million and $20.6 million.
FHLB advances: FHLB advances include both draws against our line of credit and fixed rate term advances. Each term advance is payable in full at its maturity date and contains provision for prepayment penalties. At June 30, 2017 and December 31, 2016 we had no term advances with the FHLB. Our FHLB borrowings are used for operational liquidity needs for originating and purchasing loans, purchasing investments and general operating cash requirements. Our FHLB borrowings were collateralized by certain qualifying loans totaling $467.5 million at June 30, 2017. Based on this collateral and our holdings of FHLB stock, we were eligible to borrow an additional $204.6 million at June 30, 2017.
Bank stock loan: On January 28, 2016, we entered into an agreement with an unaffiliated financial institution that provided for a maximum borrowing facility of $20.0 million, secured by our stock in Equity Bank. At December 31, 2016, there was no outstanding balance on this loan. The borrowing facility matured on January 26, 2017, and was subsequently extended, at which time we entered into a new agreement with the same lender that provides for a maximum borrowing facility of $30.0 million, secured by our stock in Equity Bank. At June 30, 2017, there was no outstanding balance on this loan. The borrowing facility will mature on March 12, 2018. Each draw of funds on the facility will create a separate note that is repayable over a term of five years. Each note will bear interest at a variable interest rate equal to the prime rate published in the “Money Rates” section of The Wall Street Journal (or any generally recognized successor), floating daily. Accrued interest and principal payments will be due quarterly with one final payment of unpaid principal and interest due at the end of the five year term of each separate note. We are also required to pay an unused commitment fee in an amount equal to 20 basis points per annum on the unused portion of the maximum borrowing facility. We can use the proceeds from the borrowing facility to fund future acquisitions and for general corporate purposes approved by the lender.
The terms of the borrowing facility require the Company and Equity Bank to maintain minimum capital ratios and other covenants. We believe we are in compliance with the terms of the borrowing facility and have not been otherwise notified of noncompliance.
Subordinated debentures: In conjunction with the 2012 acquisition of First Community Bancshares, Inc., we assumed certain subordinated debentures owed to special purpose unconsolidated subsidiaries that are controlled by us, FCB Capital Trust II (“CTII”) and FCB Capital Trust III (“CTIII”). The trust preferred securities issued by CTII accrue and pay distributions quarterly at three-month LIBOR plus 2.00% on the stated liquidation amount of the trust preferred securities. These trust preferred securities are mandatorily redeemable upon maturity on April 15, 2035 or upon earlier redemption. The trust preferred securities issued by CTIII accrue and pay distributions quarterly at three-month LIBOR plus 1.89% on the stated liquidation amount of the trust preferred securities. These trust preferred securities are mandatorily redeemable upon maturity on June 15, 2037 or upon earlier redemption.
In conjunction with the 2016 acquisition of Community First Bancshares, Inc., we assumed certain subordinated debentures owed to a special purpose unconsolidated subsidiary that is controlled by us, Community First (AR) Statutory Trust I, (“CFSTI”). The trust preferred securities issued by CFSTI accrue and pay distributions quarterly at three-month LIBOR plus 3.25% on the stated liquidation amount of the trust preferred securities. These trust preferred securities are mandatorily redeemable upon maturity on December 26, 2032, or upon earlier redemption.
The subordinated debentures balance, including CTII, CTIII and CFSTI, was $13.8 million at June 30, 2017 and $13.7 million at December 31, 2016.
Liquidity
Market and public confidence in our financial strength and financial institutions in general will largely determine access to appropriate levels of liquidity. This confidence is significantly dependent on our ability to maintain sound asset quality and appropriate levels of capital reserves.
Liquidity is defined as the ability to meet anticipated customer demands for future funds under credit commitments and deposit withdrawals at a reasonable cost and on a timely basis. We measure our liquidity position by giving consideration to both on- and off-balance sheet sources of and demands for funds on a daily, weekly, and monthly basis.
Liquidity risk involves the risk of being unable to fund assets with the appropriate duration and rate-based liabilities, as well as the risk of not being able to meet unexpected cash needs. Liquidity planning and management are necessary to ensure the ability to fund operations in a cost-effective manner and to meet current and future potential obligations such as loan commitments, lease obligations, and unexpected deposit outflows. In this process, we focus on both assets and liabilities and on the manner in which they combine to provide adequate liquidity to meet our needs.
During the six-month periods ended June 30, 2017 and 2016 our liquidity needs have primarily been met by core deposits, security and loan maturities and amortizing investment and loan portfolios. Other funding sources include federal funds purchased, brokered certificates of deposit, and borrowings from the FHLB.
Our largest sources of funds are deposits and FHLB borrowings and largest uses of funds are loans and securities. Average loans were $1.46 billion for the six months ended June 30, 2017, an increase of 44.7% over December 31, 2016 average balance. Excess deposits are primarily invested in our interest-bearing deposit account with the Federal Reserve Bank of Kansas City, investment securities, federal funds sold or other short-term liquid investments until the funds are needed to fund loan growth. Our securities portfolio has a weighted average life of 5.2 years and a modified duration of 4.6 years at June 30, 2017.
Cash and cash equivalents were $24.2 million at June 30, 2017, a decrease of $10.9 million from the $35.1 million cash and cash equivalents at December 31, 2016. The net cash provided by operating activities of $14.0 million and net cash provided by financing activities of $62.5 million were offset by net cash used in investing activities of $87.5 million, resulting in a net use of cash and cash equivalents of $10.9 million. Cash and cash equivalents at January 1, 2017 plus liquidity provided by operating activities, pay downs, sales and maturities of investment securities and FHLB borrowings during the first six months of 2017 were used to originate or purchase loans and to purchase investment securities. We believe that our daily funding needs can be met through cash provided by operating activities, payments and maturities on loans and investment securities, our core deposit base and FHLB advances and other borrowing relationships.
Off-Balance Sheet Items
In the normal course of business, we enter into various transactions, which, in accordance with GAAP, are not included in our consolidated balance sheets. We enter into these transactions to meet the financing needs of our customers. These transactions include commitments to extend credit and standby and commercial letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in the consolidated balance sheets. Our exposure to credit loss is represented by the contractual amounts of these commitments. The same credit policies and procedures are used in making these commitments as for on-balance sheet instruments.
Our commitments associated with outstanding standby and performance letters of credit and commitments to extend credit expiring by period as of June 30, 2017 are summarized below. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements:
Credit Extensions Commitments
1 Year
or Less
More Than
1 Year but
Less Than
3 Years
3 Years or
More but
5 Years
or More
Standby and performance letters of credit
6,478
695
7,198
Commitments to extend credit
155,232
19,308
23,234
34,892
232,666
161,710
20,003
23,259
239,864
Standby and Performance Letters of Credit: Standby letters of credit are irrevocable commitments issued by us to guarantee the performance of a customer to a third party once specified pre-conditions are met. Financial standby letters of credit are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. Performance standby letters of credit are issued to guarantee performance of certain customers under non-financial contractual
obligations. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loans to customers.
Commitments to Extend Credit: Commitments to originate loans and available lines of credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments and lines of credit generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since a portion of the commitments and lines of credit may expire without being drawn upon, the total commitment and lines of credit amounts do not necessarily represent future cash requirements. Each customer’s creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if deemed necessary, is based on management’s credit evaluation of the counterparty. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, commercial real estate, and residential real estate. Mortgage loans in the process of origination represent amounts that we plan to fund within a normal period of 60 to 90 days, and which are intended for sale to investors in the secondary market.
Capital Resources
Capital management consists of providing equity to support our current and future operations. The federal bank regulators view capital levels as important indicators of an institution’s financial soundness. As a general matter, FDIC-insured depository institutions and their holding companies are required to maintain minimum capital relative to the amount and types of assets they hold. As a bank holding company and a state-chartered-Fed-member bank, the Company and Equity Bank are subject to regulatory capital requirements.
Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action. Management believes as of June 30, 2017 and December 31, 2016, the Company and Equity Bank meet all capital adequacy requirements to which they are subject.
Failure to meet capital guidelines could subject the institution to a variety of enforcement remedies by federal bank regulatory agencies, including termination of deposit insurance by the FDIC, restrictions on certain business activities and appointment of the FDIC as conservator or receiver. As of June 30, 2017, the most recent notifications from the federal regulatory agencies categorized Equity Bank as “well capitalized” under the regulatory framework for prompt corrective action. To be categorized as well capitalized, Equity Bank must maintain minimum total capital, Tier 1 capital, Common Equity Tier 1 capital, and Tier 1 leverage ratios as set forth in the table below. There are no conditions or events since that notification that management believes have changed Equity Bank’s category.
Total stockholders’ equity was $286.1 million at June 30, 2017, an increase of $28.1 million, or 10.9%, compared with December 31, 2016. The increase was attributable to common stock of $14.9 million, net of issuance expenses, issued as part of the merger with Prairie State Bancshares, Inc., retained earnings of $11.2 million for the six months ended June 30, 2017, common stock issued upon the exercise of stock options of $726 thousand, stock based compensation of $732 thousand, a change in accumulated other comprehensive income of $433 thousand, and repayments on employee stock loans of $72 thousand.
In July 2013, the federal banking agencies published final rules establishing a new comprehensive capital framework for U.S. banking organizations. These rules became effective as applied to the Company and Equity Bank on January 1, 2015, with a phase in period from January 1, 2015 through January 1, 2019. Beginning in January 2016, the implementation of the capital conservation buffer was effective for the Company starting at the 0.625% level and increasing 0.625% each year thereafter, until it reaches 2.5% on January 1, 2019. The capital conservation buffer is designed to absorb losses during periods of economic stress and requires increased capital levels for the purpose of capital distributions and other payments. Failure to meet the full amount of the buffer will result in restrictions on the Company's ability to make capital distributions, including dividend payments and stock repurchases, and to pay discretionary bonuses to executive officers. The following table provides a comparison of the Company’s and Equity Bank’s leverage and risk-weighted capital ratios as of June 30, 2017 to the minimum and well-capitalized regulatory standards.
Capital Adequacy Analysis
Capital Adequacy Under Basel III
Phase-In
To be Categorized as
Well Capitalized
Under Prompt
Corrective Action
The Company(1)
Total capital (to risk weighted assets)
Tier 1 capital (to risk weighted assets)
Common equity tier 1 capital (to risk weighted
assets)
Tier 1 leverage capital (to average assets)
The Bank(2)
The Federal Reserve may require the Company to maintain capital ratios above the required minimums.
The FDIC may require the Equity Bank to maintain capital ratios above the required minimums
We identify certain financial measures discussed in this Quarterly Report as being “non-GAAP financial measures.” In accordance with the SEC’s rules, we classify a financial measure as being a non-GAAP financial measure if that financial measure excludes or includes amounts, or is subject to adjustments that have the effect of excluding or including amounts, that are included or excluded, as the case may be, in the most directly comparable measure calculated and presented in accordance with GAAP as in effect from time to time in the United States in our statements of income, balance sheet or statements of cash flows. Non-GAAP financial measures do not include operating and other statistical measures or ratios or statistical measures calculated using exclusively either financial measures calculated in accordance with GAAP, operating measures or other measures that are not non-GAAP financial measures or both.
The non-GAAP financial measures that we discuss in this Quarterly Report should not be considered in isolation or as a substitute for the most directly comparable or other financial measures calculated in accordance with GAAP. Moreover, the manner in which we calculate the non-GAAP financial measures that we discuss in this Quarterly Report may differ from that of other companies reporting measures with similar names. You should understand how such other banking organizations calculate their financial measures similar or with names similar to the non-GAAP financial measures we have discussed in this Quarterly Report when comparing such non-GAAP financial measures.
Tangible Book Value Per Common Share and Tangible Book Value Per Diluted Common Share: Tangible book value is a non-GAAP measure generally used by financial analysts and investment bankers to evaluate financial institutions. We calculate: (a) tangible common equity as total stockholders’ equity less preferred stock, goodwill, core deposit intangibles, net of accumulated amortization and mortgage servicing asset; (b) tangible book value per common share as tangible common equity (as described in clause (a)) divided by shares of common stock outstanding; and tangible book value per diluted common share as tangible common equity (as described in clause (a)) divided by diluted shares of common stock outstanding. For tangible book value, the most directly comparable financial measure calculated in accordance with GAAP is book value.
Management believes that these measures are important to many investors who are interested in changes from period to period in book value per common share exclusive of changes in intangible assets. Goodwill and other intangible assets have the effect of increasing total book value while not increasing our tangible book value.
The following table reconciles, as of the dates set forth below, total stockholders’ equity to tangible common equity, tangible book value per common share, and tangible book value per diluted common share and compares these values with book value per common share:
(Dollars in thousands, except per share data)
Less: goodwill
64,521
18,130
Less: core deposit intangibles, net
5,954
1,289
1,376
Less: mortgage servicing asset, net
Less: naming rights, net
1,282
1,293
Tangible common equity
Common shares outstanding at period end
12,202,237
Diluted common shares outstanding at period end
12,441,429
12,450,315
11,873,480
8,365,283
8,334,445
Book value per common share
Tangible book value per common share
Tangible book value per diluted common share
Tangible Common Equity to Tangible Assets: Tangible common equity to tangible assets is a non-GAAP measure generally used by financial analysts and investment bankers to evaluate financial institutions. We calculate: (a) tangible common equity as total stockholders’ equity less preferred stock, goodwill, core deposit intangibles, net of accumulated amortization and mortgage servicing asset; (b) tangible assets as total assets less goodwill, core deposit intangibles, net of accumulated amortization and mortgage servicing asset; and (c) tangible common equity to tangible assets as tangible common equity (as described in clause (a)) divided by tangible assets (as described in clause (b)). For tangible common equity to tangible assets, the most directly comparable financial measure calculated in accordance with GAAP is total stockholders’ equity to total assets.
Management believes that this measure is important to many investors in the marketplace who are interested in the relative changes from period to period in common equity and total assets, each exclusive of changes in intangible assets. Goodwill and other intangible assets have the effect of increasing both total stockholders’ equity and total assets while not increasing tangible common equity or tangible assets.
The following table reconciles, as of the dates set forth below, total stockholders’ equity to tangible common equity and total assets to tangible assets:
Tangible assets
2,337,016
2,327,466
2,128,580
1,537,638
1,525,325
Equity to assets
Tangible common equity to tangible assets
Return on Average Tangible Common Equity: Return on average tangible common equity is a non-GAAP measure generally used by financial analysts and investment bankers to evaluate financial institutions. We calculate: (a) average tangible common equity as total average stockholders’ equity less average goodwill, core deposit intangibles, net of accumulated amortization, mortgage servicing asset and preferred stock; (b) adjusted net income allocable to common stockholders as net income allocable to common stockholders plus intangible asset amortization less tax effect on intangible assets amortization; and (c) return on average tangible common equity as annualized adjusted net income allocable to common stockholders (as described in clause (b)) divided by average tangible common equity (as described in clause (a)). For return on average tangible common equity, the most directly comparable financial measure calculated in accordance with GAAP is return on average equity.
Management believes that this measure is important to many investors in the marketplace who are interested in earnings quality on tangible common equity. Goodwill and other intangible assets have the effect of increasing total stockholders’ equity while not increasing tangible common equity.
The following table reconciles, as of the dates set forth below, return on average stockholders equity and return on average tangible common equity:
Total average stockholders’ equity
264,736
204,773
159,887
Less: average intangible assets
65,185
44,144
23,116
21,309
Average tangible common equity
211,467
199,551
160,629
136,771
135,094
Amortization of intangible assets
247
155
88
Less: tax effect of intangible assets amortization
Adjusted net income allocable to common
stockholders
6,515
2,728
2,903
Return on total average stockholders’ equity
(ROAE) annualized
Return on average tangible common equity
(ROATCE) annualized
Efficiency Ratio: The efficiency ratio is a non-GAAP measure generally used by financial analysts and investment bankers to evaluate financial institutions. We calculate the efficiency ratio by dividing non-interest expense, excluding merger expenses and loss on debt extinguishment, by the sum of net interest income and non-interest income, excluding net gain from securities transactions and
net gain on acquisition. The GAAP-based efficiency ratio is non-interest expenses divided by net interest income plus non-interest income.
In management’s judgment, the adjustments made to non-interest expense and non-interest income allow investors and analysts to better assess operating expenses in relation to operating revenue by removing merger expenses, loss on debt extinguishment, net gain from securities transactions and net gain on acquisition.
The following table reconciles, as of the dates set forth below, the efficiency ratio to the GAAP-based efficiency ratio:
15,226
16,711
10,734
Less: Merger expenses
Non-interest expense, excluding merger expenses
3,339
Less: net gain from securities transactions
Non-interest income, excluding net gain from
securities transactions
Net interest income plus non-interest income,
excluding net gain from securities transactions
25,078
23,219
18,452
14,509
14,587
Non-interest expense to net interest income
plus non-interest income
60.14
65.54
90.56
73.98
67.88
Item 3: Quantitative and Qualitative Disclosures About Market Risk
Our asset-liability policy provides guidelines to management for effective funds management, and management has established a measurement system for monitoring net interest rate sensitivity position within established guidelines.
As a financial institution, the primary component of market risk is interest rate volatility. Fluctuations in interest rates will ultimately impact both the level of income and expense recorded on most assets and liabilities, and the market value of all interest-earning assets and interest-bearing liabilities, other than those which have a short-term held-to-maturity. Interest rate risk is the potential of economic gains or losses due to future interest rate changes. These changes can be reflected in future net interest income and/or fair market values. The objective is to measure the effect on net interest income (“NII”) and economic value of equity (“EVE”) and to adjust the balance sheet to minimize the inherent risk, while at the same time maximizing income.
We manage exposure to interest rates by structuring the balance sheet in the ordinary course of business. We have the ability to enter into instruments such as leveraged derivatives, interest rate swaps, financial options, financial future contracts or forward delivery contracts for the purpose of reducing interest rate risk; however, currently we do not have a material exposure to these instruments. We also have the ability to enter into interest rate swaps as an accommodation to our customers in connection with an interest rate swap program. Based upon the nature of our operations, we are not subject to foreign exchange or commodity price risk. We do not own any trading assets.
Our exposure to interest rate risk is managed by the Asset Liability Committee (“ALCO”), which is composed of certain members of senior management, in accordance with policies approved by the Board of Directors. The ALCO formulates strategies based on appropriate levels of interest rate risk. In determining the appropriate level of interest rate risk, the ALCO considers the impact on earnings and capital of the current outlook on interest rates, potential changes in interest rates, regional economies, liquidity, business strategies and other factors. The ALCO meets monthly to review, among other things, the sensitivity of assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses, securities purchase and sale activities, commitments to originate loans and the maturities of investment securities and borrowings. Additionally, the ALCO reviews liquidity, projected cash flows, maturities of deposits and consumer and commercial deposit activity.
ALCO uses a simulation analysis to monitor and manage the pricing and maturity of assets and liabilities in order to diminish the potential adverse impact that changes in interest rates could have on net interest income. The simulation tests the sensitivity of NII
and EVE. Contractual maturities and repricing opportunities of loans are incorporated in the simulation model as are prepayment assumptions, maturity data and call options within the investment securities portfolio. Assumptions based on past experience are incorporated into the model for non-maturity deposit accounts. The assumptions used are inherently uncertain and, as a result, the model cannot precisely measure the future NII and EVE. Actual results will differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and the application and timing of various management strategies.
The change in the impact of net interest income from the base case for June 30, 2017 and December 31, 2016, was primarily driven by the rate and mix of variable and fixed rate financial instruments, the underlying duration of the financial instruments, and the level of response to changes in the interest rate environment. The increase in the level of negative impact to net interest income in the up interest rate shock scenarios are due to the assumed migration of non-term deposit liabilities to higher rate term deposits; the level of fixed rate investments and loans receivable that will not reprice to higher rates; the variable rate Federal Home Loan Bank advances; the variable rate subordinated debentures, and the non-term deposits that are assumed not to migrate to term deposits that are variable rate and will reprice to the higher rates; and a portion of our portfolio of variable rate loans contain restrictions on the amount of repricing and frequency of repricing that limit the amount of repricing to the current higher rates. These factors result in the negative impacts to net interest income in the up interest rate shock scenarios that are detailed in the table below. In the down interest rate shock scenario the main drivers of the negative impact on net interest income are the decrease in investment income due to the negative convexity features of the fixed rate mortgage backed securities; assumed prepayment of existing fixed rate loans receivable; the downward pricing of variable rate loans receivable; the constraint of the shock on non-term deposits; and the level of term deposit repricing. Our mortgage backed security portfolio is comprised of fixed rate investments and as rates decrease the level of prepayments are assumed to increase and cause the current higher rate investments to prepay and the assumed reinvestment will be at lower interest rates. Similar to our mortgage backed securities, the model assumes that our fixed rate loans receivable will prepay at a faster rate and reinvestment will occur at lower rates. The level of downward shock on the non-term deposits is constrained to limit the downward shock to a non-zero rate which results in a minimal reduction in the average rate paid. Term deposits repricing will only decrease the average cost paid by a minimal amount due to the assumed repricing occurring at maturity. These factors result in the negative impact to net interest income in the down interest rate shock scenario.
The change in the EVE from the base case for June 30, 2017 and December 31, 2016 is due to us being in a liability sensitive position and the level of convexity in our pre-payable assets. Generally, with a liability sensitive position, as interest rates increase the value of your assets decrease faster than the value of liabilities and as interest rates decrease the value of your assets increase at a faster rate than liabilities. However, due to the level of convexity in our fixed rate pre-payable assets we do not experience a similar change in the value of assets in a down interest rate shock scenario. Substantially all investments and approximately 48.0% of loans are pre-payable and fixed rate and as rates decrease the level of modeled prepayments increase. The prepaid principal is assumed to reprice at the assumed current rates, resulting in a smaller positive impact to the EVE.
Management utilizes static balance sheet rate shocks to estimate the potential impact on various rate scenarios. This analysis estimates a percentage of change in the metric from the stable rate base scenario versus alternative scenarios of rising and falling market interest rates by instantaneously shocking a static balance sheet. The following table summarizes the simulated immediate change in net interest income for twelve months as of the dates indicated:
Market Risk
Impact on Net Interest Income
Change in prevailing interest rates
+300 basis points
(9.2
)%
(11.2
+200 basis points
(5.4
(6.9
+100 basis points
(2.3
(3.2
0 basis points
-100 basis points
(1.5
(0.6
71
The following table summarizes the simulated immediate impact on economic value of equity as of the dates indicated:
Impact on Economic Value
of Equity
(13.7
(22.4
(6.4
(12.9
(2.0
(3.8
(2.6
2.7
Item 4: Controls and Procedures
Evaluation of disclosure controls and procedures
An evaluation of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)) under the Exchange Act) as of the end of the period covered by this Quarterly Report on Form 10-Q was performed under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management was required to apply judgement in evaluating its controls and procedures. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure and are effective to provide reasonable assurance that such information is recorded, processed, summarized and reported within the time periods specified by the SEC’s rules and forms.
Changes in internal control over financial reporting
There were no changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the period covered by this Quarterly Report on Form 10-Q that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
PART II—OTHER INFORMATION
Item 1: Legal Proceedings
From time to time we are a party to various litigation matters incidental to the conduct of our business. See “NOTE 11 – LEGAL MATTERS” of the Condensed Notes to Interim Consolidated Financial Statements under Item 1 to this Quarterly report for a complete discussion of litigation matters.
Item 1A: Risk Factors
There have been no material changes in the Company’s risk factors previously disclosed in our Annual Report on Form 10-K filed with the SEC on March 16, 2017.
Item 2: Unregistered Sales of Equity Securities and Use of Proceeds
Recent Sales of Unregistered Equity Securities
None
Use of Proceeds
Item 3: Defaults Upon Senior Securities
Item 4: Mine Safety Disclosures
Not applicable.
Item 5: Other Information
Item 6: Exhibits
The information required by this Item 6 is set forth in the Index to Exhibits following our signature page and is incorporated by reference or attached hereto.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
August 9, 2017
By:
/s/ Brad S. Elliott
Date
Brad S. Elliott
Chairman and Chief Executive Officer
/s/ Gregory H. Kossover
Gregory H. Kossover
Executive Vice President and Chief Financial Officer
INDEX TO EXHIBITS
Exhibit
No.
Description
31.1*
Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2*
Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Exchange Act as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1**
Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2**
Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101.INS*
XBRL Instance Document.
101.SCH*
XBRL Taxonomy Extension Schema Document.
101.CAL*
XBRL Taxonomy Extension Calculation Linkbase Document.
101.DEF*
XBRL Taxonomy Extension Definition Linkbase Document.
101.LAB*
XBRL Taxonomy Extension Label Linkbase Document.
101.PRE*
XBRL Taxonomy Extension Presentation Linkbase Document.
*
Filed herewith.
**
These exhibits are furnished herewith and shall not be deemed “filed” for purposes of Section 18 of the Exchange Act, or otherwise subject to the liability of that section, and shall not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act.