ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
In addition to the results of operations and financial condition presented in accordance with GAAP, this management's discussion and analysis includes non-GAAP financial measures and should be read along with the accompanying tables which provide a reconciliation of non-GAAP financial measures to GAAP financial measures. The Company's management uses these non-GAAP financial measures, including tangible common equity, in its analysis of the Company's performance. The tangible common equity non-GAAP reconciliation, which includes tangible book value per share, is presented within the “Summary of Recent Performance and Other Activities” section below.
Management believes that non-GAAP financial measures provide additional useful information that allows readers to evaluate the ongoing performance of the Company without regard to transactional activities. Non-GAAP financial measures should not be considered as an alternative to any measure of performance or financial condition as promulgated under GAAP, and investors should consider the Company's performance and financial condition as reported under GAAP and all other relevant information when assessing the performance or financial condition of the Company. Non-GAAP financial measures have limitations as analytical tools, and investors should not consider them in isolation or as a substitute for analysis of the Company's results or financial condition as reported under GAAP.
Safe Harbor Statement for Forward-Looking Statements
This report may contain forward-looking statements within the meaning of the federal securities laws. These statements are not historical facts; rather they are statements based on the Company’s current expectations regarding its business strategies and their intended results and its future performance. Forward-looking statements are preceded by terms such as “expects”, “believes”, “anticipates”, “intends”, and similar expressions.
Forward-looking statements are not guarantees of future performance. Numerous risks and uncertainties could cause or contribute to the Company’s actual results, performance, and achievements being materially different from those expressed or implied by the forward-looking statements. Factors that may cause or contribute to these differences include, without limitation, general economic conditions, including changes in market interest rates and changes in monetary and fiscal policies of the federal government, legislative and regulatory changes, the quality and composition of the loan and investment securities portfolio, loan demand, deposit flows, competition, changes in accounting principles and guidelines, and change or other circumstances related to the Company’s recently announced merger with Orrstown Financial Services, Inc. (“Orrstown”) that negatively affects the Company’s financial condition or results of operations, including delays in closing the merger, the diversion of management's time from existing business operations due to time spent related to the merger or integration efforts, potential litigation in connection with the merger, higher than expected transaction or other costs and expenses, or higher than expected attrition of the customers or key employees of the Company. Additional factors that may affect our results are discussed in Part II, Item 1A of this form 10-Q and Item 1A of Hamilton Bancorp, Inc.’s Annual Report on Form 10-K filed June 29, 2018 with the Securities and Exchange Commission under the sections titled
“Risk Factors”
. These factors should be considered in evaluating the forward-looking statements, and undue reliance should not be placed on such statements. Except as required by applicable law or regulation, the Company assumes no obligation and disclaims any obligation to update any forward-looking statements.
General
Hamilton Bancorp, Inc. (the “Company”) is a Maryland corporation incorporated on June 7, 2012 by Hamilton Bank (the “Bank”) to be its holding company following the Bank’s conversion from the mutual to the stock form of organization (the “Conversion”). The Conversion was completed on October 10, 2012. On that same date, the Company completed its public stock offering and issued 3,703,000 shares of its common stock for aggregate proceeds of $37,030,000, and net proceeds of $35,580,000. The Company’s business is the ownership of the outstanding capital stock of the Bank. On December 21, 2017, the Bank converted its charter from a federal savings bank to a Maryland state-chartered commercial bank and now operates under the laws of the State of Maryland and applicable Federal laws. In conjunction with the Bank’s charter conversion, Hamilton Bancorp converted from a savings and loan holding company to a bank holding company. The charter conversion was part of the bank’s strategic plan to allow it to continue to focus on growth opportunities in commercial, consumer and mortgage lending as well as small business and retail banking. The Maryland Office of the Commissioner of Financial Regulation serves as the Bank's primary regulator with federal oversight provided by the Federal Deposit Insurance Corporation. Hamilton Bancorp will continue to be regulated by the Federal Reserve Board.
Founded in 1915 and celebrating over 103 years of service, the Bank is a community-oriented financial institution, dedicated to serving the financial service needs of consumers and businesses within its market area, which is considered greater Maryland, southern Pennsylvania, Washington D.C., and northern Virginia. We offer a variety of deposit products and provide loans secured by real estate located in our market area. Our real estate loans consist primarily of one-to four-family mortgage loans, as well as commercial real estate loans, and home equity loans and lines of credit. We also offer commercial term and line of credit loans and, to a limited extent, consumer loans. We currently operate out of our corporate headquarters in Towson, Maryland and our seven full-service branch offices located in Baltimore City, Cockeysville, Towson, Rosedale, Ellicott City and Pasadena, Maryland. The Company does not own or lease any property but instead uses the premises, equipment and other property of the Bank.
On May 13, 2016, the Company acquired Fraternity Community Bancorp, Inc. (“Fraternity”), the parent company of Fraternity Federal Savings and Loan in an all cash transaction for $25.7 million. In addition, the Company acquired Fairmount Bancorp, Inc. (“Fairmount”), the parent company of Fairmount Bank on September 11, 2015 in an all cash transaction for $14.2 million. Both acquisitions combined added three branches to our branch structure in the Baltimore area.
On October 23, 2018, the Company and Orrstown, the parent company of Orrstown Bank, signed a definitive agreement and plan of merger under which the Company will merge with and into Orrstown, with Orrstown as the surviving company. Immediately, thereafter, Hamilton Bank will merge with and into Orrstown Bank, with Orrstown Bank as the surviving institution. Hamilton shareholders will receive a combination of cash and stock. Upon completion of the transaction, the combined company is expected to have approximately $2.5 billion in assets, $1.7 billion in loans, and $2.1 billion in deposits. The transaction is expected to close in the second quarter of calendar 2019.
The Company and the Bank maintain an Internet website at
http://www.hamilton-bank.com
. Information on our website should not be considered a part of this Quarterly Report on Form 10-Q.
Summary of Recent Performance and Other Activities
The Company and its wholly owned subsidiary, Hamilton Bank, continued to show improvement in overall earnings, as well as revenue and lower loan loss provisions during the three months ended December 31, 2018 compared to the same period a year ago. Earnings improved from a net loss of $1.9 million to a net loss of $125,000 for the comparable periods, an improvement of $1.8 million. The net loss for the current quarter resulted from $503,000 in merger related expenses pertaining to the pending merger with Orrstown, while the net loss in the prior year quarter was impacted by the recording of a one-time adjustment equal to $2.2 million to our deferred tax asset through tax expense. The adjustment was due to the reduction in the corporate income tax rate that was enacted through the passage of the
Tax Cuts and Jobs Act
(the “Jobs Act”). Over these same comparable periods, interest revenue grew from $4.6 million to $4.8 million, an increase of $196,000. This increase is reflective of the overall growth of the loan portfolio during the prior year due to both organic and purchased loans. The increase in interest revenue is offset by a $425,000 increase in interest expense over this same period resulting from the rise in interest rates on deposits and borrowings.
Non-interest revenue of $281,000 for the three months ended December 31, 2018 represented a $182,000 decrease compared to $463,000 for the three months ended December 31, 2017. Noninterest revenue is lower compared to a year ago due to $213,000 in revenue generated during the prior year period relating to the sale and re-location of our Pigtown branch within the same community of Baltimore City. We went from owning our old location to leasing our new smaller, space. Excluding the prior year period gain on sale of the branch, noninterest revenue increased $31,000 quarter-over-quarter. On a comparative basis, there were increases relating to gain on sale of loans, service charges, and other noninterest revenue, partially offset by a reduction in earnings on bank-owned life insurance (BOLI). In the prior fiscal year, the Company made a decision to hold in portfolio the majority of our residential loan originations versus selling them in the secondary market to partially offset the increased run-off associated with this loan type. Beginning in fiscal 2019, however, we again started to sell qualified residential loan originations into the secondary market as a means to generate noninterest revenue and diversify our income stream. For the three and nine months ended December 31, 2018 we recorded gains of $9,000 and $34,000 on the sale of these loans, respectively.
Non-interest expense for the quarter ended December 31, 2018 increased $434,000 to $3.8 million compared to the quarter ended December 31, 2017. The increase is attributable to $503,000 in merger related expenses that have been incurred relating to the pending merger with Orrstown. Excluding the merger expenses, our non-interest expenses have actually decreased compared to the prior year period, indicating we have been able to manage a larger loan portfolio from an operational cost basis and increase our interest revenue as noted earlier. However, the recent rise in interest rates and the impact to our cost of funds has resulted in a higher efficiency ratio of 87.7%, excluding merger expenses, for the three months ended December 31, 2018 compared to 81.2% for the three months ended December 31, 2017. We have experienced significant declines in both legal and other professional services expense quarter-over-quarter related to costs incurred in the prior year, including costs associated with our charter conversion and payments under non-compete agreements that were a part of the Fraternity Community Bancorp, Inc. acquisition. Both these declines were more than offset by increases in salaries and data processing expense. Salaries increased due to respective annual salary increases, along with bonus accruals that were not present in the prior year period due to our net loss position, while data processing increased because of new technology we incorporated to create a better banking experience for our customers. Management remains committed to managing our operational expenses.
For the three and nine months ended December 31, 2018, the Company did not report any income tax expense due to the release of a portion of the valuation allowance on our net deferred tax assets established in the prior fiscal year. Management concluded, based upon analysis and substantive evidence, particularly negative evidence associated with being in a three-year cumulative loss position, that it is more likely than not that the Company will be unable to generate sufficient taxable income in the foreseeable future to fully utilize the net deferred tax assets. If, in the future, the Company generates taxable income on a sustained basis sufficient to support the deferred tax assets, the need for a deferred tax valuation allowance could change, resulting in the reversal of all or a portion of the deferred tax asset valuation at that time. The establishment of a valuation allowance on our net deferred tax assets for financial reporting purposes does not affect how the net operating loss carryforwards may be utilized on our subsequent income tax returns. Income tax expense for the periods reported is based upon year-to-date results and may not be reflective of annual earnings.
The following highlights contain additional financial data and events relating to the three and nine months ended December 31, 2018 compared to the same periods ended December 31, 2017:
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●
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The Company reported a net loss of $125,000, or $0.04 per common share, and net income of $1.9 million, or $0.60 per common share for the three and nine months ended December 31, 2018, respectively, compared to a net loss of $1.9 million, or $0.60 per common share, and a net loss of $1.1 million, or $0.35 per common share for the comparable periods ended December 31, 2017. This represents an increase of $3.0 million in earnings for the nine-month comparable periods.
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●
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Net interest income for the three months ended December 31, 2018 was $3.4 million, or $199,000 lower than the same period a year ago. For the nine months ended December 31, 2018, net interest income increased $153,000, or 1.4%, to $11.0 million compared to $10.8 million for the same nine-month period a year ago.
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●
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The net interest margin decreased 13 basis points from 3.07% to 2.94% for the three months ended December 31, 2017 and 2018, respectively, due to the decrease in net interest income. The net interest margin for the nine months ended December 31, 2018 declined slightly from 3.07% to 3.06% due to an increase in average interest-earning assets.
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●
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Return on average assets and equity for the first nine months of fiscal 2019 improved to 0.37% and 3.41%, compared to negative return of 0.29% and 2.45% for the first nine months of fiscal 2018.
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●
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Efficiency ratio was higher for the nine months ended December 31, 2018 at 84.8% compared to 81.8% for the nine months ended December 31, 2017 primarily as a result of the merger costs related to Orrstown. Excluding the merger costs, the efficiency ratio improved to 80.1% for the comparable periods from 81.8%, respectively; an improvement of 2.1%. The improvement is attributable to increased interest revenue and the reduction of non-interest expenses (exclusive of merger expenses), including legal and other professional services.
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●
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Total assets declined $29.3 million from $525.5 million at March 31, 2018 to $496.3 million at December 31, 2018. The decline in overall assets is attributable to declines in investments and gross loans.
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Cash and cash equivalents increased $3.2 million, or 13.6%, to $26.5 million at December 31, 2018, compared to $23.4 million at March 31, 2018, while investments declined $9.8 million from $75.4 million to $65.6 million over the same period. The decline in the investment portfolio is related to normal principal paydowns on mortgage-backed securities.
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●
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Gross loans decreased $21.0 million, or 5.4%, from $389.2 million at March 31, 2018 to $368.2 million at December 31, 2018. The decrease is due to principal paydowns and pay-offs within the loan portfolio, including $9.6 million in pay-offs composed of one commercial relationship that totaled $6.3 million and a $3.3 million commercial real estate loan that was on nonaccrual.
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●
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The allowance for loan losses to nonperforming loans improved to 54.8% at December 31, 2018 from 39.4% at March 31, 2018. This improvement resulted from the pay-off on a $3.3 million nonaccrual loan during the second quarter and a $209,000 increase in the allowance for loan losses over that period.
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Annualized net charge-offs to average loans improved to 0.06% for the nine-month period ended December 31, 2018 compared to 0.26% for the fiscal year ended March 31, 2018, while the allowance for loan losses as a percentage of gross loans increased from 0.73% to 0.82% over this same period.
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Total deposits decreased $21.0 million to $384.2 million at December 31, 2018, while borrowings decreased $9.6 million to $51.1 million. The decline in deposits was related to higher costing time deposits which declined by $8.5 million; while lower costing core deposits declined by $12.2 million. Core deposits at December 31, 2018 made up 37.9% of total deposits compared to 38.9% and 37.5% at March 31, 2018 and December 31, 2017, respectively.
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●
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At December 31, 2018 the Company had a book value of $16.53 per common share and a tangible book value of $13.88 per common share compared to $15.87 and $13.18, respectively, at March 31, 2018. Book value and tangible book value increased as a result of the net income reported for the fiscal year. Tangible book value, a non-GAAP measure, was determined as follows:
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December 31,
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March 31,
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2018
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2018
|
|
Tangible book value per common share:
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Total shareholders' equity
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$
|
56,489,940
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|
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$
|
54,076,132
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|
Less: Goodwill and other intangible assets
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|
|
(9,082,215
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)
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|
|
(9,176,764
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)
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Tangible common equity (Non-GAAP)
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|
$
|
47,407,725
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|
|
$
|
44,899,368
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|
|
|
|
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Outstanding common shares
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3,416,414
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|
|
|
3,407,613
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Book value per common share (GAAP)
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|
$
|
16.53
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|
|
$
|
15.87
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Tangible book value per common share (Non-GAAP)
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|
$
|
13.88
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|
$
|
13.18
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●
|
The Company maintained strong liquidity based upon cash equivalents held and the amount and make-up of its investment portfolio. At December 31, 2018 the Bank was deemed “well capitalized” under federal regulations.
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Strategic Plan
We have based our 2019-2021 strategic plan on the objective of improving shareholder value and growth through creating sustainable and profitable growth given the current and expected economic and competitive environment in the financial services industry. Our short-term goals include continuing the growth of operating revenue, changing the mix of our deposits base to be more concentrated in lower costing core deposits, collecting payments on non-accrual and past due loans, enhancing and improving credit quality, expanding fee income, maintaining a branch network that is economical and efficient, and using technology to improve efficiencies and enhance the customer experience.
We identified several strategic priorities in our three-year Strategic Plan that focused on the following core areas:
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Efficient Operating Revenue Growth
– Generating sustainable, profitable operating revenue through smart growth of earning assets that are funded by low-cost core deposits and growth of noninterest income. In addition, we will focus on efficient utilization of the Bank’s assets and other resources. This strategic priority includes prudent loan growth, sales strategies to attract and grow small business deposit and other fee income services, strategic marketing campaigns, studying and benchmarking efficiency and productivity, and focusing on ways to utilize technology to drive earnings.
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●
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Low-Cost Funding Strategies
– Focusing on utilizing and growing low-cost core deposits as the primary funding source for loans. Given the current environment for higher-returns on investments, the retention of deposit customers along with targeted sales strategies will be important to growing deposits. Comprehensive marketing plans for increasing brand awareness in our market and promotion of products and services will be required, along with a seamless, fully integrated delivery experience for our customers that leverages technology and optimizes efficiencies. These strategies will apply to not just consumers, but to all commercial and small business customers.
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●
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Capital to Support Growth
– Increasing the capital and value of the holding company’s stock through sustainable, consistent earnings, prudent capital management and enhancement of overall “franchise value”. We will continually evaluate the Bank’s capital needs and, if additional capital is needed, evaluate the most suitable type of capital, whether it be subordinated-debt or common or preferred stock.
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Although the current economic climate continues to present significant challenges for the financial industry, management feels that based on our strategic initiatives we have positioned the Company to capitalize on the opportunities that may become available in the current economy, as well as a healthier economy going forward.
Critical Accounting Policies
The discussion and analysis of the financial condition and results of operations are based on our consolidated financial statements, which are prepared in conformity with generally accepted accounting principles used in the United States of America. The preparation of these consolidated financial statements requires management to make estimates and assumptions affecting the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities, and the reported amounts of income and expenses. We consider the accounting policies discussed below to be critical accounting policies. The estimates and assumptions that we use are based on historical experience and various other factors and are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions, resulting in a change that could have a material impact on the carrying value of our assets and liabilities and our results of operations.
For a discussion of significant accounting policies,
see Note 1—
Nature of Operations and
Summary of Significant Accounting Policies
in the Notes to our Consolidated Financial Statements. The following are the accounting policies that we believe require the most subjective or complex judgments, and as such could be most subject to revision as new information becomes available:
Allowance for Loan Losses.
The allowance for loan losses is the estimated amount considered necessary to cover inherent credit losses in the loan portfolio at the balance sheet date. The allowance is established through the provision for losses on loans which is charged against income. In determining the allowance for loan losses, management makes significant estimates and has identified this policy as one of our most critical accounting policies.
Management, at a minimum, performs a quarterly evaluation of the allowance for loan losses. Consideration is given to historical losses in conjunction with a variety of other factors including, but not limited to, current economic conditions, delinquency statistics, geographic and industry concentrations, the adequacy of the underlying collateral, the financial strength of the borrower, results of internal loan reviews and other relevant factors. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant change.
The analysis has two components, specific and general allocations. Specific allocations can be made for estimated losses related to loans that are determined to be impaired. Impairment is measured by determining the present value of expected future cash flows or, for collateral-dependent loans, the fair value of the collateral adjusted for market conditions and selling expenses. If the fair value of the loan is less than the loan’s carrying value, a charge is recorded for the difference. The general allocation is determined by segregating the remaining loans by type of loan, risk weighting (if applicable) and payment history. We also analyze historical loss experience, delinquency trends, general economic conditions and geographic and industry concentrations. This analysis establishes factors that are applied to the loan groups to determine the amount of the general reserve.
We cannot predict with certainty the amount of loan charge-offs that we will incur. Our regulatory agencies, as an integral part of their examination processes, periodically review our allowance for credit losses. Such agencies may require that we recognize additions to the allowance for credit losses based on their judgments about information available to them at the time of their examination. To the extent that actual outcomes differ from management’s estimates, additional provisions to the allowance for credit losses may be required that would adversely impact earnings in future periods.
Securities Valuation and Impairment
.
We classify our investments in debt and equity securities as either held to maturity or available for sale. Securities classified as held to maturity are recorded at cost or amortized cost. Available-for-sale securities are carried at fair value. We obtain our fair values from a third-party service. This service’s fair value calculations are based on quoted market prices when such prices are available. If quoted market prices are not available, estimates of fair value are computed using a variety of techniques, including extrapolation from the quoted prices of similar instruments or recent trades for thinly traded securities, fundamental analysis, or through obtaining purchase quotes. Due to the subjective nature of the valuation process, it is possible that the actual fair values of these investments could differ from the estimated amounts, thereby affecting our financial position, results of operations and cash flows.
If the estimated value of investments is less than the cost or amortized cost, we evaluate whether an event or change in circumstances has occurred that may have a significant adverse effect on the fair value of the investment. If such an event or change has occurred and we determine that the impairment is other-than-temporary, we record the impairment of the investment in the period in which the event or change occurred. We also consider how long a security has been in a loss position in determining if it is other than temporarily impaired. Management also assesses the nature of the unrealized losses taking into consideration factors such as changes in risk-free interest rates, general credit spread widening, market supply and demand, creditworthiness of the issuer, and quality of the underlying collateral. At December 31, 2018, all of our securities were either issued by U.S. government agencies, U.S. government-sponsored enterprises, municipalities, or corporations.
Goodwill Impairment.
Goodwill represents the excess purchase price paid over the fair value of the net assets acquired. Goodwill is not amortized but is tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. The Company is considered the Reporting Unit for purposes of impairment testing. Impairment testing requires that the fair value of the Company be compared to the carrying amount of the Company’s net assets, including goodwill. If the fair value of the Company exceeds the book value, no write-down of recorded goodwill is required. If the fair value of the Company is less than book value, an expense may be required to write-down the related goodwill to the proper carrying value. We perform the goodwill impairment analysis during the fourth quarter of each fiscal year utilizing December financial information and current projections. We estimate the fair value of the Company utilizing four valuation methods including the Comparable Transactions Approach, the Control Premium Approach, the Public Market Peers Approach, and the Discounted Cash Flow Approach.
Based on our annual analysis of impairment testing performed in the fourth quarter of fiscal 2018, there was no evidence of impairment with respect to the Company’s goodwill or intangible assets. Subsequent to this testing, there was a triggering event at March 31, 2018 associated with the establishment of a valuation allowance on our deferred tax asset. Due to this event, we re-evaluated the impairment testing on our goodwill and intangible assets and concluded that there was still no impairment.
Business Combinations.
Business combinations are accounted for using the acquisition method of accounting. Under the acquisition method of accounting, acquired assets and assumed liabilities are included with the acquirer's accounts as of the date of acquisition at estimated fair value, with any excess of purchase price over the fair value of the net assets acquired (including identifiable core deposit intangibles) capitalized as goodwill. In the event that the fair value of the net assets acquired exceeds the purchase price, an acquisition gain is recorded for the difference in the consolidated statements of operations for the period in which the acquisition occurred. The core deposit intangible asset is recognized as an asset apart from goodwill when it arises from contractual or other legal rights or if it is capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented or exchanged. In addition, acquisition-related costs and restructuring costs are recognized as period expenses as incurred.
Income Taxes.
Income taxes are accounted for under the asset/liability method. Deferred tax assets are recognized for the future consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as operating loss and tax credit carry-forwards. We measure deferred tax assets and liabilities using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period indicated by the enactment date. We establish a valuation allowance for deferred tax assets when, in the judgment of management, it is more likely than not that such deferred tax assets will not become realizable. The judgment about the level of future taxable income is dependent to a great extent on matters that may, at least in part, be beyond our control.
Analysis
of Financial
Condition at
December
3
1
, 201
8
and March 31, 201
8
Assets.
Total assets decreased $29.3 million to $496.3 million at December 31, 2018 from $525.5 million at March 31, 2018. The decrease is primarily attributable to a $21.0 million reduction in gross loans and a $9.8 million decrease in the investment portfolio, partially offset by a $3.2 million increase in cash and cash equivalents.
Cash and Cash Equivalents.
Cash and cash equivalents at December 31, 2018 totaled $26.5 million compared to $22.0 million and $23.4 million at September 30, 2018 and March 31, 2018, respectively. The 20.5% increase since September 30, 2018 was due to principal paydowns and/or pay-offs within the loan portfolio and a declining investment portfolio from normal principal payments associated with the mortgage-backed security portfolio. Excluding funds needed for liquidity and operational needs, management intends to utilize any excess cash for future loan growth and/or purchase of investment securities.
Investment Securities.
Our investment portfolio consists primarily of investment grade securities including U.S. government agency and government-sponsored entity (“GSEs”) securities, securities issued by states, counties and municipalities, corporate bonds, and mortgage-backed securities. At December 31, 2018, all securities are classified as available for sale. While we usually intend to hold investment securities until maturity, this classification provides us the opportunity to divest of securities that may no longer meet our liquidity objectives. During the nine months ended December 31, 2018, we did not sell any securities.
Investment securities decreased $9.8 million, or 13.0%, to $65.6 million at December 31, 2018, from $75.4 million at March 31, 2018. The decrease is attributable to $9.1 million in cash flows resulting from normal principal payments associated with our collateralized mortgage obligation and mortgage-backed security portfolios, partially offset by the purchase of one security during the first quarter of fiscal 2019 with a book value of $2.0 million. The fair value of the investment portfolio increased $505,000 from an unrealized net loss position of $2.9 million at March 31, 2018 to an unrealized net loss position of $2.4 million at December 31, 2018. The improvement in fair value of the investment portfolio is a result of the decrease in longer-term interest rates over the past nine months.
We have evaluated securities with unrealized losses for an extended period of time and determined that these losses are temporary because, at this point in time, we have the ability to hold them until maturity. Currently, we have no intent to sell these securities; however, if market conditions or funding needs change, we may sell securities if needed. As the maturity date moves closer and/or interest rates decline, we expect that any unrealized losses for individual securities in the portfolio will decline or dissipate. In addition, we perform an annual impairment analysis with respect to securities issued by states, counties, municipalities, and corporations that are in a loss position for an extended period of time, typically twelve months. As a result, we have not identified any portion of the unrecorded loss as being attributed to credit deterioration in the issuer of the security.
Loans.
Excluding loan premiums and loan origination fees and costs, gross loans decreased by $21.0 million, or 5.4%, to $368.2 million at December 31, 2018 from $389.2 million at March 31, 2018. The decrease is primarily attributable to normal principal pay-downs and pay-offs within the loan portfolio. Pay-offs over this period included $6.3 million in loans associated with one commercial relationship and a $3.3 million nonaccrual loan in which we collected all of our principal and past due interest, plus all legal and other expenses incurred. Included in gross loans at December 31, 2018 are acquired loans with a book balance of $100.4 million associated with the prior acquisitions of Fraternity and Fairmount institutions (these loans are reflected in the “acquired” loan column of the table below). At December 31 and March 31, 2018 gross loans receivable represented 74.1% of total assets. The following table details the composition of loans and the related percentage mix and growth of total loans:
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December 31, 2018
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March 31, 2018
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Year-To-Date Growth
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Percent
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Percent
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Growth
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Legacy
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Acquired
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Total
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|
of Total
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Legacy
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Acquired
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Total
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of Total
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Amount
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Percent
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Real estate loans:
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One-to four-family:
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Residential
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$
|
83,117,881
|
|
|
$
|
66,255,260
|
|
|
$
|
149,373,141
|
|
|
|
40.6
|
%
|
|
$
|
85,248,184
|
|
|
$
|
72,749,066
|
|
|
$
|
157,997,250
|
|
|
|
40.6
|
%
|
|
$
|
(8,624,109
|
)
|
|
|
-5.5
|
%
|
Residential construction
|
|
|
3,430,203
|
|
|
|
-
|
|
|
|
3,430,203
|
|
|
|
0.9
|
%
|
|
|
5,450,827
|
|
|
|
-
|
|
|
|
5,450,827
|
|
|
|
1.4
|
%
|
|
|
(2,020,624
|
)
|
|
|
-37.1
|
%
|
Investor
|
|
|
7,337,281
|
|
|
|
16,407,266
|
|
|
|
23,744,547
|
|
|
|
6.5
|
%
|
|
|
9,275,031
|
|
|
|
17,460,809
|
|
|
|
26,735,840
|
|
|
|
6.9
|
%
|
|
|
(2,991,293
|
)
|
|
|
-11.2
|
%
|
Commercial
|
|
|
105,755,786
|
|
|
|
9,289,784
|
|
|
|
115,045,570
|
|
|
|
31.2
|
%
|
|
|
100,403,769
|
|
|
|
11,762,485
|
|
|
|
112,166,254
|
|
|
|
28.8
|
%
|
|
|
2,879,316
|
|
|
|
2.6
|
%
|
Commercial construction
|
|
|
1,543,313
|
|
|
|
1,059,217
|
|
|
|
2,602,530
|
|
|
|
0.7
|
%
|
|
|
5,763,784
|
|
|
|
1,352,019
|
|
|
|
7,115,803
|
|
|
|
1.8
|
%
|
|
|
(4,513,273
|
)
|
|
|
-63.4
|
%
|
Total real estate loans
|
|
|
201,184,464
|
|
|
|
93,011,527
|
|
|
|
294,195,991
|
|
|
|
79.9
|
%
|
|
|
206,141,595
|
|
|
|
103,324,379
|
|
|
|
309,465,974
|
|
|
|
79.5
|
%
|
|
|
(15,269,983
|
)
|
|
|
-4.9
|
%
|
Commercial business
|
|
|
35,276,493
|
|
|
|
1,706,509
|
|
|
|
36,983,002
|
|
|
|
10.0
|
%
|
|
|
38,302,739
|
|
|
|
1,841,226
|
|
|
|
40,143,965
|
|
|
|
10.4
|
%
|
|
|
(3,160,963
|
)
|
|
|
-7.9
|
%
|
Home equity loans
|
|
|
15,077,068
|
|
|
|
4,941,051
|
|
|
|
20,018,119
|
|
|
|
5.5
|
%
|
|
|
13,956,327
|
|
|
|
6,039,462
|
|
|
|
19,995,789
|
|
|
|
5.1
|
%
|
|
|
22,330
|
|
|
|
0.1
|
%
|
Consumer
|
|
|
16,329,237
|
|
|
|
699,371
|
|
|
|
17,028,608
|
|
|
|
4.6
|
%
|
|
|
18,849,448
|
|
|
|
766,063
|
|
|
|
19,615,511
|
|
|
|
5.0
|
%
|
|
|
(2,586,903
|
)
|
|
|
-13.2
|
%
|
Gross loans
|
|
$
|
267,867,262
|
|
|
$
|
100,358,458
|
|
|
$
|
368,225,720
|
|
|
|
100.0
|
%
|
|
$
|
277,250,109
|
|
|
$
|
111,971,130
|
|
|
$
|
389,221,239
|
|
|
|
100.0
|
%
|
|
$
|
(20,995,519
|
)
|
|
|
-5.4
|
%
|
The Company’s largest category of loans continues to be residential one-to four-family loans as a result of the loans acquired in the Fraternity and Fairmount acquisitions. This segment of our loan portfolio comprises 40.6% of the entire loan portfolio at December 31, 2018, the same percentage as of March 31, 2018 despite a decrease of $8.6 million. During the last half of fiscal 2017 and into fiscal 2018 we retained in portfolio many of the traditional residential mortgage loans we originated, versus selling them in the secondary market, due to the increase in normal attrition within this loan segment resulting from our acquisitions. Prior to that time, we generally sold these loans in the secondary market at a premium to assist with managing interest rate risk and to enhance non-interest revenue. At the beginning of this year, we began to once again sell most newly originated residential loans that qualify into the secondary market versus putting them in portfolio for those same reasons. To date we have originated and sold $1.7 million in loans into the secondary market. Because of this, we expect the one-to four-family residential loan portfolio to continue to decline as we focus more on the growth within the commercial portfolio to replace the residential run-off and assist with managing interest rate risk.
As a means to supplement our residential loan portfolio, the Company began to promote its one-to-four family residential construction lending program several years ago. Over the first three quarters of fiscal 2019, the Bank has originated $8.9 million of commitments in residential construction loans. At December 31, 2018 there were $8.7 million in residential construction commitments, of which $3.4 million in funds have been advanced; compared to $8.7 million in residential construction commitments at March 31, 2018, of which $5.4 million in funds had been advanced. The construction period on residential homes is typically nine to twelve months.
Real estate investor loans represent funds advanced to borrowers for the purchase or refinance of non-owner occupied one-to-four family properties. These loans made up $23.7 million, or 6.5%, of gross loans at December 31, 2018, including a remaining balance of $16.4 million of such loans acquired from Fraternity and Fairmount. This type of lending typically involves more risk than originating owner-occupied one-to-four family residential mortgages. The Bank typically refrains from originating this type of loan.
The Bank continues to focus on growth through origination and/or purchase of both commercial real estate and commercial business loans as these loans offer higher rates of return and shorter maturity periods than typical retail lending. Over the nine months ended December 31, 2018, we saw strong organic growth within our commercial real estate loan portfolio. We organically originated $14.8 million in commercial real estate loans and transferred or reclassed nearly $2.0 million more from commercial construction loans over this period. This resulted in an overall increase, after several loan pay-offs and normal principal payments, of nearly $2.9 million within this loan segment. Commercial business loans declined from $40.1 million to $37.0 million, a decrease of 7.9% or $3.2 million. Commercial business loans, although relatively stable, can fluctuate based upon demands or pay-downs on respective lines of credit. Overall commercial loans, including commercial construction loans, have declined since March 31, 2018 due to $6.3 million in pay-offs associated with one commercial relationship that had several commercial loans with the Bank, the pay-off of a nonaccrual commercial real estate loan with a book balance of $3.3 million, and a $1.2 million take out of an SBA 504 commercial construction loan that occurred during the quarter ended December 31, 2018.
Bank-Owned Life Insurance.
We invest in bank-owned life insurance (“BOLI”) to provide us with a funding source for our benefit plan obligations. BOLI also provides us noninterest income that is tax-exempt. Our investment in BOLI increased by $344,000 to $17.8 million at December 31, 2018. The increase is attributable to the increase in cash surrender value of the underlying insurance policies. Federal regulations generally limit our investment in BOLI to 25% of our Tier 1 capital plus our allowance for loan losses. Our amount of BOLI at December 31, 2018 exceeded these limits because of the BOLI we acquired in the Fraternity acquisition in May 2016 and the increase in cash surrender value of the policies over the years. Due to the amount of BOLI currently held, the Company has no plans to purchase additional BOLI at this time.
Deposits.
Total deposits (excluding premiums on acquired deposits) decreased $20.8 million, or 5.1%, to $384.0 million at December 31, 2018 from $404.7 million at March 31, 2018. The Company continues to focus on generating lower cost, core deposits (which includes all deposits other than certificates of deposit) to support continued loan growth. Core deposits accounted for 37.9% of total deposits at December 31, 2018, compared to 39.0% at March 31, 2018.
The following table details the composition of deposits and the related percentage mix and growth of total deposits.
|
|
December 31, 2018
|
|
|
March 31, 2018
|
|
|
Year-To-Date Growth
|
|
|
|
|
|
|
|
Percent
|
|
|
|
|
|
|
Percent
|
|
|
|
|
|
|
Growth
|
|
|
|
Total
|
|
|
of Total
|
|
|
Total
|
|
|
of Total
|
|
|
Amount
|
|
|
Percent
|
|
Savings
|
|
$
|
41,548,268
|
|
|
|
10.8
|
%
|
|
$
|
42,499,381
|
|
|
|
10.6
|
%
|
|
$
|
(951,113
|
)
|
|
|
-2.2
|
%
|
Noninterest-bearing checking
|
|
|
27,365,942
|
|
|
|
7.1
|
%
|
|
|
29,557,943
|
|
|
|
7.3
|
%
|
|
|
(2,192,001
|
)
|
|
|
-7.4
|
%
|
Interest-bearing checking
|
|
|
28,478,231
|
|
|
|
7.4
|
%
|
|
|
27,219,286
|
|
|
|
6.7
|
%
|
|
|
1,258,945
|
|
|
|
4.6
|
%
|
Money market accounts
|
|
|
48,128,831
|
|
|
|
12.6
|
%
|
|
|
58,466,228
|
|
|
|
14.4
|
%
|
|
|
(10,337,397
|
)
|
|
|
-17.7
|
%
|
Time deposits
|
|
|
238,448,636
|
|
|
|
62.1
|
%
|
|
|
246,988,613
|
|
|
|
61.0
|
%
|
|
|
(8,539,977
|
)
|
|
|
-3.5
|
%
|
|
|
$
|
383,969,908
|
|
|
|
100.0
|
%
|
|
$
|
404,731,451
|
|
|
|
100.0
|
%
|
|
$
|
(20,761,543
|
)
|
|
|
-5.1
|
%
|
Premium on deposits asssumed
|
|
|
201,034
|
|
|
|
|
|
|
|
411,524
|
|
|
|
|
|
|
|
(210,490
|
)
|
|
|
|
|
Total deposits
|
|
$
|
384,170,942
|
|
|
|
|
|
|
$
|
405,142,975
|
|
|
|
|
|
|
$
|
(20,972,033
|
)
|
|
|
|
|
Our strategy with respect to deposits has been to maintain our current certificate of deposit base as needed to support loan demand by pricing more competitively in the marketplace or through short-term certificate of deposit promotions, as we focus on growing our core deposits at a faster pace to reduce our overall cost of funds. During the first nine months of fiscal 2019, however, we have not been as aggressive in maintaining our certificates of deposits based upon funding and liquidity needs. Over this period, time deposits have decreased $8.5 million, or 3.5%, to $238.4 million at December 31, 2018. As interest rates have risen in the past nine months, the market for time deposits has become more competitive with respect to pricing. We have strategically decided not to price at the top of the market, unless through a promotional deposit product, or to match competitor pricing in certain circumstances as a means to manage interest expense. Over this period core deposits have also declined by $12.2 million, or 7.7%, from $157.7 million at March 31, 2018 to $145.5 million at September 30, 2018. The largest decline in core deposits has been in our money market accounts, which declined $10.1 million over this period. The decline in money market accounts is due to a prior promotional campaign offered by the Bank that included a money market account with a six-month introductory rate. During the quarter ended December 31, 2018, many of these introductory rates expired and the Bank was unable to retain many of these depositors. Because of the decrease in deposits, the Company began utilizing a certificate of deposit subscription service in the third quarter of fiscal 2018. The cost of these deposits is more expensive than traditional certificates of deposit because of the ability to provide the funding needed in a timely manner; but can be less costly than borrowing from the Federal Home Loan Bank or other sources. During the first nine months of fiscal 2019 we did not need to utilize this service to originate deposits to support any additional funding requirements.
Borrowings.
Borrowings consist of both short and long-term advances from the Federal Home Loan Bank (FHLB). At December 31, 2018, outstanding advances from the FHLB decreased $9.6 million, or 15.9%, to $51.5 million compared to $60.7 million at March 31, 2018. Approximately $6.0 million of this decline occurred during the quarter ended September 30, 2018. During the first nine months of fiscal 2019 there were $30.5 million in borrowings that have either matured or been called. We elected to rollover $21.0 million of those borrowings and pay-off $9.6 million to date. The next date a borrowing is expected to mature or be called is not until August 2019.
At December 31, 2018, $7.5 million of the total advances are considered short-term and mature in less than one year, while the remaining $43.6 million in advances are considered long-term and mature in more than one year (See Note 9 of the Notes to Consolidated Financial Statements). Included in long-term advances is $11.6 million in advances that mature on a quarterly basis; however, they are associated with several cash flow hedge transactions and will be continuously renewed over the expected life of the hedged transactions. The hedge transactions currently have an average life of 5.3 years. Excluding the advances associated with the hedge transactions, the longest outstanding borrowing is for $2.0 million and matures in September 2023.
The FHLB borrowings provide an alternative means to support the cash outflow needed to fund new loan originations in coordination with deposit growth. FHLB borrowings can provide a less expensive means to support cash outflow when compared to selling higher yielding investment securities. These obligations are secured by our residential and home equity loan portfolios. At December 31, 2018, we had the ability to borrow approximately $73.6 million in additional funds from the FHLB, subject to our pledging sufficient assets. These obligations will be repaid as our cash position strengthens.
Equity.
Total equity increased $2.4 million or 4.5%, to $56.5 million at December 31, 2018 from $54.1 million at March 31, 2018. The change in equity is primarily attributable to net income of $1.4 million reported for the first nine months of fiscal 2019, along with a $434,000 increase in additional paid in capital resulting from equity awards granted in prior periods and a $412,000 increase in the accumulated other comprehensive loss associated with the fair value of the investment portfolio and cash flow hedges on FHLB borrowings. The fair value of the investment portfolio increased while the fair value of our cash flow hedge decreased due to rising interest rates that occurred over that same period. The Company’s book value per common share was $16.53 at December 31, 2018 compared to $15.87 at March 31, 2018. At December 31, 2018, the Bank remains “well capitalized” as defined under federal regulations.
Analysis
of Asset Quality
at
December
3
1
, 201
8,
March 31, 201
8, and
December
3
1
, 2017
The Bank’s asset quality remains a primary focus of management and the Board of Directors. Nonperforming assets at December 31, 2018, were $6.0 million, a decrease of $1.6 million from March 31, 2018 and a $1.1 million decrease from December 31, 2017. Nonperforming assets to total assets decreased from 1.45% at March 31, 2018 to 1.21% at December 31, 2018. Nonperforming assets for the respective periods were as follows:
|
|
At or For The Three
|
|
|
At or For The Year
|
|
|
At or For The Three
|
|
|
|
Months Ended
|
|
|
Ended
|
|
|
Months Ended
|
|
|
|
December 31, 2018
|
|
|
March 31, 2018
|
|
|
December 31, 2017
|
|
|
|
(dollars in thousands)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Nonaccruing loans
|
|
$
|
5,196
|
|
|
$
|
5,964
|
|
|
$
|
6,195
|
|
Accruing loans delinquent more than 90 days
|
|
|
335
|
|
|
|
1,206
|
|
|
|
441
|
|
Foreclosed real estate
|
|
|
458
|
|
|
|
458
|
|
|
|
451
|
|
Total nonperforming assets
|
|
$
|
5,989
|
|
|
$
|
7,628
|
|
|
$
|
7,087
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Asset Quality Ratios:
|
|
|
|
|
|
|
|
|
|
|
|
|
Nonperforming loans to gross loans
|
|
|
1.50
|
%
|
|
|
1.84
|
%
|
|
|
1.71
|
%
|
Nonperforming assets to total assets
|
|
|
1.21
|
%
|
|
|
1.45
|
%
|
|
|
1.36
|
%
|
Net charge-offs (annualized) to average loans
|
|
|
0.06
|
%
|
|
|
0.26
|
%
|
|
|
0.08
|
%
|
Nonaccrual loans decreased to $5.2 million at December 31, 2018 compared to $6.0 million at March 31, 2018. At the end of the first quarter of fiscal 2019, nonaccrual loans reached a high of $8.9 million due to the addition of a commercial real estate relationship with a recorded value of $3.1 million. The borrower on this loan continues to make timely payments to date under the original terms of that loan and has never been delinquent; however, review of their financial information indicates they do not have sufficient cash flow to service the debt, thus we have placed it on nonaccrual status. To date there is no impairment associated with this relationship based upon the most recently obtained appraised value. In July 2018, another commercial real estate loan that was already on nonaccrual, with a recorded value of $3.3 million, was resolved and paid-off with no loss to the Bank. Proceeds from the pay-off included payment of principal, past due interest and all legal and other expenses incurred. In addition, several other nonaccrual commercial loans paid-off during the quarter ended December 31, 2018 with minimal additional charge-offs, including a $197,000 commercial real estate loan, $254,000 in investor loans to one borrower, and two commercial lease loans equaling $66,000. The aggregate of the loans just described is primarily responsible for the $768,000 decrease in nonaccrual loans from March 31, 2018 to December 31, 2018.
As of December 31, 2018, there are two commercial real estate relationships totaling $4.1 million that are a part of the $5.2 million in nonaccrual loans, including the one relationship that was added in the first quarter of fiscal 2019 that was previously discussed. Both relationships have been reviewed for impairment and recorded at their fair value based upon recent appraisals, one of which has incurred $1.9 million in write-downs through charge-offs over the past two years. Management continues to actively explore options and work with the borrowers to obtain the best outcome for the Bank, which may or may not result in new or additional write-downs.
There were $143,000 in nonaccrual commercial business loans at December 31, 2018 compared to $165,000 at March 31, 2018. The recorded book balance of $143,000 in loans is primarily comprised of three commercial lease loans to different borrowers with a combined contractual balance of $399,000 and charge-offs totaling $261,000. The purpose of the loans was to provide funding to purchase medical equipment related to cosmetic surgery. Based upon the inability to generate sufficient revenue, the borrowers stopped making payments on the leases or asked for the equipment to be repossessed. All three loans are fully guaranteed by the respective borrowers.
The remaining balance of nonaccrual loans at December 31, 2018 30, 2018 consisted of $797,000 in one-to four-family residential mortgage loans, including two loans with a book balance of $271,000 that were acquired loans, and $96,000 in residential investor loans. The majority of the residential investor loans were acquired in the Fairmount acquisition.
Included in nonperforming assets are accruing loans delinquent more than 90 days. These loans represent loans that are on accrual status and making payments, however, such loans are 90 days past their contractual maturity date, and therefore reported as nonperforming. At March 31, 2018, these loan balances were elevated as they related to several borrowing relationships that are comprised of many smaller investor (residential non-owner occupied) loans that matured at the same time. The decline over fiscal 2019 is a result of the Bank’s credit department working diligently to obtain the necessary financial information from these borrowers so that these loans can either be renewed or extended accordingly.
Loans 30-89 days past due decreased $322,000 to $948,000 at December 31, 2018 from $1.3 million at March 31, 2018. This decrease is attributable to a $540,000 and $123,000 decrease in delinquencies associated with one-to four-family residential mortgage loans and consumer loans, respectively, partially offset by a $311,000 increase in commercial business loans. Delinquencies related to one-to four-family residential loans decreased $540,000 from $823,000 at March 31, 2018 to $283,000 at December 31, 2018 due to the pay-off of one delinquent loan with a book balance of $555,000; while consumer loans decreased $123,000 over this same nine-month period due to a $127,000 decline in delinquent recreational vehicles. These decreases were partially offset by an increase in delinquent commercial business loans from $270,000 at March 31, 2018 to $581,000 at December 31, 2018. At September 30, 2018 there were no delinquent commercial business loans. The increase of $581,000 from September 30, 2018 to December 31, 2018 is related to four commercial medical lease loans. The Bank is monitoring the delinquent loans closely and working with the borrowers to develop a payment plan. If the borrowers are unable to bring these loans current or re-pay or re-finance the respective loans, there could be future charge-offs associated with these loans based upon collateral values.
Foreclosed real estate at December 30, 2018 was $458,000; unchanged from March 31, 2018. At December 31, 2018 there were five properties that comprised the foreclosed real estate balance. One of the five properties consists of semi-developed land with a fair value of $411,000. The property is listed for sale and is participated with another financial institution, with Hamilton being the lead lender. The remaining four properties totaling $70,000 are all participations and comprised of one-to- four family residential mortgage loans in which Hamilton owns less than 15% of and is not the lead lender. During the quarter ended December 31, 2018, one property that was booked to foreclosed real estate earlier in the year for $130,000 was sold at a loss of $4,200.
The Bank recorded a $382,000 provision for loan loss during the first nine months of fiscal 2019 compared to a $625,000 provision for loan loss for the same period a year ago. The provision for loan loss for the nine months ended December 31, 2018 was a result of $173,000 in net charge-offs and roughly $294,000 in additional reserves associated with the revaluation of our environmental factors in the prior quarter (see Note 1 of the Financial Statements under
Summary of Significant Accounting Policies
for further discussion), partially offset by a decline in loan balances; compared to prior year provisions which were primarily related to growth within the loan portfolio due to organic loan originations and loan purchases. The allowance for loan losses at December 31, 2018 totaled $3.0 million, or 0.82% of gross loans, compared to the same $2.8 million, or 0.73% of gross loans, at March 31, 2018. The change in percentage was due to in part to both the decrease in overall loan balances and the increase in the allowance for loan losses itself. This overall percentage remains relatively low compared to peers as a result of our acquired loan portfolios. Loans acquired in an acquisition are recorded at estimated fair value on their purchase date with no carryover of the related allowance for loan and lease losses. We continue to monitor and manage the acquired loan portfolio to determine if additional provisions are necessary in relation to the estimated fair value placed on those loans at acquisition date as determined by management.
The activity in the allowance for loan losses for the nine-month period ended December 31, 2018 includes $297,000 in charge-offs, offset by $124,000 in recoveries and a $382,000 provision for loan losses. We currently review the adequacy of the allowance for loan losses on a quarterly basis and are proactively managing problem assets. Based upon our analysis, we believe this allowance appropriately reflects the inherent risk of loss in our loan portfolio at December 31, 2018. We estimate the allowance for loan losses based upon a four-year charge-off history and certain environmental factors.
Results of Operations for th
e Three Months Ended
December
3
1
, 201
8 and 2017
(unaudited)
General.
Net loss for the quarter ended December 31, 2018 was $125,000, or $0.04 per common share, compared to net loss of $1.9 million, or $0.60 per common share for the quarter ended December 31, 2017; an improvement of $1.8 million quarter-over-quarter. The improvement was largely due to a $2.2 million tax adjustment in the prior year period to the Company’s net deferred tax asset resulting from the reduction in the corporate tax rate associated with the federal government’s passage of the
Jobs Act
; whereas there was no tax expense or benefit for the three month period ended December 31, 2018 because of the valuation allowance established at March 31, 2018 on the deferred tax asset. Also contributing to a lower net loss were the lower provision for loan losses, partially offset by a decrease in net interest income associated with rising rates on deposits and borrowings, a decline in noninterest revenue, and an increase in noninterest expenses related to $503,000 thousand in merger related expenses associated with the pending acquisition by Orrstown. Excluding the merger costs, net income would have been $378,000, or $0.12 per common share, for the three months ended December 31, 2018 compared to a net loss of $1.9 million, or $0.60 per common share for the quarter ended December 31, 2017.
Net Interest Income.
Net interest income decreased $199,000, or 5.5%, to $3.4 million for the three-months ended December 31, 2018 compared to $3.6 million for the three-months ended December 31, 2017. The decrease in net interest income was due to a $425,000 increase in interest expense, partially offset by a $226,000 increase in interest revenue. The net interest margin decreased 13 basis point from 3.07% for the three months ended December 31, 2017 to 2.94% for the three months ended December 31, 2018.
The increase in interest revenue quarter-over-quarter was due to an increase in the average yield on interest-earning assets, partially offset by a decrease in the average balance of those same assets. The average yield on interest-earning assets increased 26 basis points to 4.10% from 3.84%, while the average balance decreased $7.1 million, or 1.5%, for the quarter ended December 31, 2018 compared to the same period in fiscal 2018. The decrease in average balances was primarily due to a declining investment portfolio.
The increase in interest expense for the quarter ended December 31, 2018 compared to the same quarter last year was the result of a 43 basis points increase in the average cost of interest-bearing liabilities. The average cost of interest-bearing liabilities increased from 0.88% for the three months ended December 31, 2017 to 1.31% for the three months ended December 31, 2018. Partially offsetting the rise in the average cost was a decrease of $8.7 million in the average balance of interest-bearing liabilities from $420.4 million to $411.7 million. The decrease resulted from the decline in average interest-bearing deposits.
Interest Revenue
.
Interest revenue increased $226,000, or 4.9% to $4.8 million during the three months ended December 31, 2018 compared to $4.6 million for the three months ended December 31, 2017. The increase resulted from increases in interest and fees on loans and interest on federal funds sold and other bank deposits, partially offset by a decrease in interest revenue from investment securities.
Interest and fees on loans increased $156,000, or 3.8%, to $4.3 million for the three months ended December 31, 2018, compared to $4.1 million for the three months ended December 31, 2017. The increase in interest and fees on loans is due to a 19-basis point increase in the average yield earned on loans from 4.42% to 4.61% for the comparable periods. The increase in average yield is a result of higher interest rates on new loan originations, as well as interest revenue realized through the pay-off of certain purchased credit impaired loans (PCI) associated with our prior acquisitions. Partially offsetting the increase in interest revenue associated with the average yield is a $2.1 million decrease in the average balance of net loans from $371.5 million to $369.3 million quarter-over-quarter. The decrease in average loans was attributable to normal attrition associated with a larger loan portfolio resulting from loan purchases in the prior year, along with several large commercial relationships and loans that paid-off during the year.
Interest revenue on total investment securities decreased $25,000 to $414,000 for the three months ended December 31, 2018 from $439,000 for the three months ended December 31, 2017. The decrease is due to the average balance of investment securities decreasing $19.0 million, or 21.1%, to $71.2 million for the three months ended December 31, 2018 from $90.2 million for the same period last year, while the average yield increased 38 basis points to 2.33% from 1.95%. The largest decrease in investment securities was in mortgage-backed securities, which decreased $16.2 million to $51.7 million for the three months ended December 31, 2018 from $67.9 million for the same period last year. The average balance of investment securities other than mortgage-backed securities also decreased quarter-over-quarter by $2.8 million. The overall decrease in average investments is attributable to normal principal paydowns related to mortgage-backed securities over the past twelve months as no securities were sold during this period. One investment security, with a book value of $2.0 million, was purchased during the first quarter of fiscal 2019.
Interest Expense.
Interest expense increased $425,000, or 45.6%, to $1.3 million for the three months ended December 31, 2018 compared to $924,000 for the same period in fiscal 2018, due to the increase in the average cost of both interest-bearing deposits and borrowings. The average cost of interest-bearing deposits increased 36 basis points from 0.78% for the three months ended December 31, 2017 to 1.14% for the three months ended December 31, 2018. The increase in average cost was partially offset by a decrease in the average balance of interest-bearing deposits. The average balance of interest-bearing deposits decreased $8.1 million, or 2.2%, to $358.7 million for the three months ended December 31, 2018 from $366.8 million for the three months ended December 31, 2017. Due to the increase in costs, the interest expense associated with interest-bearing deposits increased $306,000, or 42.8%, period-over-period.
For the three-month period ended December 31, 2018, average interest-bearing deposit balances decreased for all types of deposits other than checking accounts which increased $4.6 million, when compared to the same period a year ago. As interest rates have risen over the past year, the market competition for deposits, in particular time deposits and money market accounts, has become more competitive with respect to pricing. We have strategically decided not to price our deposits at the top of the market, unless through a promotional deposit product, or to match competitor pricing in certain circumstances as a means to manage interest expense. The Company continues to focus on generating lower cost, core deposits (which includes all deposits other than certificates of deposit) to support continued loan growth. The average balance of core interest-bearing deposits decreased $3.1 million, or 2.6%, to $123.7 million for the three-month period ended December 31, 2018 compared to $126.8 million for the three months ended December 31, 2017. The average balance of time deposits also decreased $5.0 million, or 2.1%, to $235.0 million for the quarter ended December 31, 2018 compared to $239.9 million for the quarter ended December 31, 2017.
Noninterest-bearing deposits allow us to fund growth in interest-earning assets at minimal cost. Average noninterest-bearing deposits decreased $159,000, or less than 1.0%, to $29.5 million for the three months ended December 31, 2018, compared to $29.7 million for the three months ended December 31, 2017. Our cash management personnel and commercial loan officers remain focused in working with commercial clients to move their core deposit relationships to Hamilton Bank and provide lower cost of funds.
For the three-month period ended December 31, 2018, average borrowings were $53.0 million compared to an average balance of $53.6 million for the same period a year ago. The decrease in borrowings is associated with maturing FHLB advances that were paid-off versus rolled over at higher interest rates, partially offset with new advances entered into at the end of December 2017 that coincided with specific loan purchases and a seasonal decline in deposits. The borrowings at December 31, 2018 consist of only advances from the FHLB and totaled $51.1 million; a decrease of $8.5 million since June 30, 2018. Due to rising interest rates, we have paid-off maturing advances based upon available liquidity at that time versus rolling the advance over at the higher rate. Borrowings carry an average rate of 2.48% for the three months ended December 31, 2018; a 91 basis points increase from 1.57% for the same period a year ago. Borrowing from the FHLB in today’s low interest rate environment can be a more cost-effective means to obtain funds if deposits are not growing compared to selling investment securities that are earning a higher yield.
Average Balances, Interest and Yields.
The following table presents information regarding average balances of assets and liabilities, the total dollar amounts of interest revenue from average interest-earning assets, the dollar amounts of interest expense on average interest-bearing liabilities, and the resulting annualized average yields and costs. The yields and costs for the periods indicated are derived by dividing interest revenue or interest expense by the average balances of assets or liabilities, respectively, for the periods presented and have been annualized. Average balances have been calculated using average daily balances. No tax-equivalent adjustments were made. Nonaccrual loans have been included in the table as loans carrying a zero yield.
|
|
Three Months Ended December 31,
|
|
|
|
(dollars in thousands)
|
|
|
|
2018
|
|
|
2017
|
|
|
|
Average
|
|
|
|
|
|
|
Yield/
|
|
|
Average
|
|
|
|
|
|
|
Yield/
|
|
|
|
Balance
|
|
|
Interest
|
|
|
Cost
|
|
|
Balance
|
|
|
Interest
|
|
|
Cost
|
|
Interest-earning assets:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest bearing deposits with banks
|
|
$
|
26,950
|
|
|
$
|
113
|
|
|
|
1.68
|
%
|
|
$
|
12,850
|
|
|
$
|
19
|
|
|
|
0.59
|
%
|
Investment securities (1)
|
|
|
19,478
|
|
|
|
143
|
|
|
|
2.94
|
%
|
|
|
22,310
|
|
|
|
141
|
|
|
|
2.53
|
%
|
Mortgage-backed securities
|
|
|
51,739
|
|
|
|
271
|
|
|
|
2.10
|
%
|
|
|
67,919
|
|
|
|
298
|
|
|
|
1.76
|
%
|
Loans receivable, net (2)
|
|
|
369,337
|
|
|
|
4,260
|
|
|
|
4.61
|
%
|
|
|
371,486
|
|
|
|
4,103
|
|
|
|
4.42
|
%
|
Total interest-earning assets
|
|
|
467,504
|
|
|
|
4,787
|
|
|
|
4.10
|
%
|
|
|
474,565
|
|
|
|
4,561
|
|
|
|
3.84
|
%
|
Noninterest-earning assets
|
|
|
34,465
|
|
|
|
|
|
|
|
|
|
|
|
43,173
|
|
|
|
|
|
|
|
|
|
Total assets
|
|
$
|
501,969
|
|
|
|
|
|
|
|
|
|
|
$
|
517,738
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest-bearing liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Statement savings
|
|
$
|
39,648
|
|
|
$
|
25
|
|
|
|
0.25
|
%
|
|
$
|
43,080
|
|
|
$
|
13
|
|
|
|
0.12
|
%
|
Checking accounts
|
|
|
29,601
|
|
|
|
3
|
|
|
|
0.04
|
%
|
|
|
24,996
|
|
|
|
2
|
|
|
|
0.03
|
%
|
Money market
|
|
|
54,468
|
|
|
|
90
|
|
|
|
0.66
|
%
|
|
|
58,761
|
|
|
|
74
|
|
|
|
0.50
|
%
|
Certificates of deposit
|
|
|
234,957
|
|
|
|
902
|
|
|
|
1.54
|
%
|
|
|
239,920
|
|
|
|
625
|
|
|
|
1.04
|
%
|
Total interest-bearing deposits
|
|
|
358,674
|
|
|
|
1,020
|
|
|
|
1.14
|
%
|
|
|
366,757
|
|
|
|
714
|
|
|
|
0.78
|
%
|
Borrowings
|
|
|
53,011
|
|
|
|
329
|
|
|
|
2.48
|
%
|
|
|
53,645
|
|
|
|
210
|
|
|
|
1.57
|
%
|
Total interest-bearing liabilities
|
|
|
411,685
|
|
|
|
1,349
|
|
|
|
1.31
|
%
|
|
|
420,402
|
|
|
|
924
|
|
|
|
0.88
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Noninterest-bearing liabilities and equity:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Noninterest-bearing deposits
|
|
|
29,549
|
|
|
|
|
|
|
|
|
|
|
|
29,708
|
|
|
|
|
|
|
|
|
|
Other noninterest-bearing liabilities
|
|
|
5,233
|
|
|
|
|
|
|
|
|
|
|
|
6,026
|
|
|
|
|
|
|
|
|
|
Total liabilities
|
|
|
446,467
|
|
|
|
|
|
|
|
|
|
|
|
456,136
|
|
|
|
|
|
|
|
|
|
Total shareholders’ equity
|
|
|
55,502
|
|
|
|
|
|
|
|
|
|
|
|
61,602
|
|
|
|
|
|
|
|
|
|
Total liabilities and shareholders’ equity
|
|
$
|
501,969
|
|
|
|
|
|
|
|
|
|
|
$
|
517,738
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net interest income
|
|
|
|
|
|
$
|
3,438
|
|
|
|
|
|
|
|
|
|
|
$
|
3,637
|
|
|
|
|
|
Net interest rate spread (3)
|
|
|
|
|
|
|
|
|
|
|
2.79
|
%
|
|
|
|
|
|
|
|
|
|
|
2.98
|
%
|
Net interest-earning assets (4)
|
|
$
|
55,819
|
|
|
|
|
|
|
|
|
|
|
$
|
54,163
|
|
|
|
|
|
|
|
|
|
Net interest margin (5)
|
|
|
|
|
|
|
|
|
|
|
2.94
|
%
|
|
|
|
|
|
|
|
|
|
|
3.07
|
%
|
Average interest-earning assets to average interest-bearing liabilities
|
|
|
113.56
|
%
|
|
|
|
|
|
|
|
|
|
|
112.88
|
%
|
|
|
|
|
|
|
|
|
(1) Includes U.S agency and treasury securities, municipal and corporate bonds and to a much lesser extent, Federal Home Loan Bank equity securities.
|
(2) Loans on non-accrual status are included in average loans carrying a zero yield.
|
(3) Net interest rate spread represents the difference between the yield on average interest-earning assets and the cost of average interest-bearing libilities.
|
(4) Net interest-earning assets represents total interest-earning assets less total interest-bearing liabilities.
|
(5) Net interest margin represents net interest income divided by average total interest-earning assets.
|
Provision for Loan Losses.
We establish provisions for loan losses that are charged to operations in order to maintain the allowance for loan losses at a level believed, to the best of management’s knowledge, to cover all known and inherent losses in the portfolio both probable and reasonable to estimate at each reporting date. There was $80,000 charged to the provision for loan losses for the three months ended December 31, 2018 compared to a provision for loan loss of $345,000 for the three months ended December 31, 2017. In the current quarter, the $80,000 provision for loan loss recorded is primarily attributable to $80,000 in net charge-offs experienced during the quarter; compared to the provision for the prior year quarter, which was related to net charge-offs of $206,000 and growth within the loan portfolio, as reflected in the table below.
The allowance for loan losses was $3.0 million, or 54.8% of non-performing loans at December 31, 2018 compared to $2.6 million, or 39.3% of non-performing loans at December 31, 2017. The increase in the percentage is a result of the $1.1 million decrease in nonperforming loans over this period, partially offset by a $421,000 increase in the allowance for loan losses. The $5.5 million in non-performing loans at December 31, 2018 primarily consisted of two commercial real estate relationships totaling $4.1 million. The first relationship has a recorded value of $2.9 million and was placed on nonaccrual in June 2018, while the second relationship has a book value of $1.2 million and has had $1.9 million in charge-offs over the past two years. Both relationships have been recorded at their net realizable fair value based upon recent appraisals. No additional charge-offs are anticipated with these relationships at this time; however, changes in property values and other circumstances may result in additional charge-offs at a later date.
During the three months ended December 31, 2018, loan charge-offs totaled $167,000 with recoveries of $87,000, compared to $211,000 in charge-offs and $5,000 in recoveries during the three months ended December 31, 2017. During fiscal year 2019, we expect that we will continue our emphasis in growing commercial real estate and commercial business loans, which have higher interest rates than one-to four-family mortgage loans, thus are generally considered to bear higher risk than one-to four-family mortgage loans and could contribute to higher loan loss provisions going forward.
Summary of Allowance for Loan Losses Activity.
The following table sets forth an analysis of the allowance for loan losses for the periods indicated.
|
|
Three Months Ended
|
|
|
|
December 31,
|
|
|
|
2018
|
|
|
2017
|
|
|
|
(dollars in thousands)
|
|
|
|
|
|
|
|
|
|
|
Allowance for loan losses at beginning of period
|
|
$
|
3,031
|
|
|
$
|
2,471
|
|
Charge-offs:
|
|
|
|
|
|
|
|
|
Real estate loans:
|
|
|
|
|
|
|
|
|
Residential
|
|
|
-
|
|
|
|
-
|
|
Investor
|
|
|
33
|
|
|
|
111
|
|
Commercial
|
|
|
-
|
|
|
|
100
|
|
Commercial construction
|
|
|
-
|
|
|
|
-
|
|
Commercial business
|
|
|
134
|
|
|
|
-
|
|
Home equity
|
|
|
-
|
|
|
|
-
|
|
Consumer
|
|
|
-
|
|
|
|
-
|
|
Total charge-offs
|
|
|
167
|
|
|
|
211
|
|
Recoveries
|
|
|
87
|
|
|
|
5
|
|
Net charge-offs
|
|
|
80
|
|
|
|
206
|
|
Provision for loan losses
|
|
|
80
|
|
|
|
345
|
|
Allowance for loan losses at end of period
|
|
$
|
3,031
|
|
|
$
|
2,610
|
|
|
|
|
|
|
|
|
|
|
Allowance for loan losses to non-performing loans
|
|
|
54.80
|
%
|
|
|
39.33
|
%
|
Allowance for loan losses to total loans outstanding at the end of the period
|
|
|
0.82
|
%
|
|
|
0.67
|
%
|
Net charge-offs to average loans outstanding during the period (annualized)
|
|
|
0.09
|
%
|
|
|
0.22
|
%
|
Noninterest
Revenue
.
Noninterest revenue decreased $181,000 to $281,000 for the three months ended December 31, 2018, compared to $463,000 for the three months ended December 31, 2017. The following table outlines the changes in noninterest revenue for the three-month periods.
|
|
Three months ended
|
|
|
|
|
|
|
|
|
|
|
|
December 31,
|
|
|
|
|
|
|
|
|
|
|
|
2018
|
|
|
2017
|
|
|
$ Change
|
|
|
% Change
|
|
Service charges
|
|
$
|
123,885
|
|
|
$
|
109,151
|
|
|
$
|
14,734
|
|
|
|
13.5
|
|
Loss on sale of investment securities
|
|
|
-
|
|
|
|
(12,736
|
)
|
|
|
12,736
|
|
|
|
100.0
|
|
Gain on sale of loans held for sale
|
|
|
8,609
|
|
|
|
-
|
|
|
|
8,609
|
|
|
|
N/A
|
|
Gain on sale of property and equipment
|
|
|
-
|
|
|
|
212,743
|
|
|
|
(212,743
|
)
|
|
|
(100.0
|
)
|
Earnings on bank-owned life insurance
|
|
|
115,419
|
|
|
|
123,597
|
|
|
|
(8,178
|
)
|
|
|
(6.6
|
)
|
Other fees and commissions
|
|
|
33,260
|
|
|
|
29,860
|
|
|
|
3,400
|
|
|
|
11.4
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total noninterest revenue
|
|
$
|
281,173
|
|
|
$
|
462,615
|
|
|
$
|
(181,442
|
)
|
|
|
(39.2
|
)
|
Service charges associated with retail and commercial deposit products increased during the three-months ending December 31, 2018 compared to the same period a year ago. Management remains focused on growing core deposits, particularly checking accounts, which typically generate more service fee income. The average balance relating to overall checking accounts for the three months ended December 31, 2018 was $59.2 million compared to an average balance of $54.7 million at December 31, 2017, an increase of 8.1%, or $4.4 million. We continue to review and evaluate our fee structure to be more aligned with our market. Customers, however, have become more cost conscious of fees and better manage their deposit relationship with the Bank.
During the three months ended December 31, 2018, the Company was able to enhance noninterest revenue by $9,000 relating to gains on loans sold to the secondary market. In the last quarter of fiscal 2017 and into fiscal 2018, the Company purposely held in portfolio the majority of our residential loan originations to partially offset the increased run-off associated with this loan segment. The increased run-off was due to higher balances resulting from our two prior acquisitions. Beginning in fiscal 2019, however, we again started to sell qualified residential loan originations into the secondary market as a means to generate noninterest revenue and diversify our income stream. In the prior year three-month period we also realized losses on the sale of investment securities of $13,000 compared to none for the three months ended December 31, 2018.
The $213,000 gain on sale of property and equipment for the prior year quarter ended December 31, 2017 is related specifically to the sale of our Pigtown branch in Baltimore City, along with various furniture and equipment that was associated with the property. This branch was relocated within the same community, but to a smaller, more efficient space that provided operational cost savings.
The other components that make up noninterest revenue for the three months ended December 31, 2018 include a $3,000 increase in other fees and commissions, along with an $8,000 decline in earnings associated with BOLI due to a reduction in the cash surrender value of the Company’s outstanding BOLI related to the pay-out of death benefits in the fourth quarter of fiscal 2018. Other fees and commissions include the collection of certain loan fees, merchant card services and other miscellaneous items.
Noninterest Expense.
Noninterest expense increased $434,000 to $3.8 million for the three months ended December 31, 2018 compared to $3.3 million for the three months ended December 31, 2017. The increase is attributable to $503,000 in merger expenses related to the pending merger with Orrstown. These expenses include legal fees and services provided by the Company’s investment bankers. The following table outlines the changes within noninterest expense for those periods.
|
|
Three months ended
|
|
|
|
|
|
|
|
|
|
|
|
December 31,
|
|
|
|
|
|
|
|
|
|
|
|
2018
|
|
|
2017
|
|
|
$ Change
|
|
|
% Change
|
|
Salaries and benefits
|
|
$
|
2,027,646
|
|
|
$
|
1,819,035
|
|
|
$
|
208,611
|
|
|
|
11.5
|
|
Occupancy
|
|
|
253,488
|
|
|
|
259,595
|
|
|
|
(6,107
|
)
|
|
|
(2.4
|
)
|
Advertising
|
|
|
21,524
|
|
|
|
22,487
|
|
|
|
(963
|
)
|
|
|
(4.3
|
)
|
Furniture and equipment
|
|
|
103,400
|
|
|
|
92,894
|
|
|
|
10,506
|
|
|
|
11.3
|
|
Data processing
|
|
|
202,915
|
|
|
|
176,114
|
|
|
|
26,801
|
|
|
|
15.2
|
|
Legal services
|
|
|
70,115
|
|
|
|
153,615
|
|
|
|
(83,500
|
)
|
|
|
(54.4
|
)
|
Other professional services
|
|
|
96,510
|
|
|
|
218,879
|
|
|
|
(122,369
|
)
|
|
|
(55.9
|
)
|
Merger related expenses
|
|
|
502,835
|
|
|
|
-
|
|
|
|
502,835
|
|
|
|
N/A
|
|
Deposit insurance premiums
|
|
|
56,760
|
|
|
|
91,470
|
|
|
|
(34,710
|
)
|
|
|
(37.9
|
)
|
Foreclosed real estate expense and losses
|
|
|
4,447
|
|
|
|
43,706
|
|
|
|
(39,259
|
)
|
|
|
89.8
|
|
Other operating
|
|
|
424,505
|
|
|
|
452,423
|
|
|
|
(27,918
|
)
|
|
|
(6.2
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total noninterest expense
|
|
$
|
3,764,145
|
|
|
$
|
3,330,218
|
|
|
$
|
433,927
|
|
|
|
13.0
|
|
Excluding merger costs, overall our operating expenses have remained relatively unchanged, despite decreases in certain operating expenses related to specific expenses incurred in the prior year, offset by increases in other operating expenses, particularly salaries and benefits. We have been able to manage a larger loan portfolio from an operational cost basis and continue to increase our interest revenue. However, the recent rise in interest rates and the impact to our cost of funds has resulted in a higher efficiency ratio of 87.7% for the three months ended December 31, 2018 compared to 81.2% for the three months ended December 31, 2017. The efficiency ratio presented excludes the $503,000 in merger related expenses. Management remains committed to reducing operational expenses.
Salaries and benefit expense remain our highest operational cost and increased by $209,000, or 11.5%, quarter-over-quarter. This increase is due to annual evaluations and respective salary increases, along with bonus accruals that were not present in the prior year period due to our net loss position, partially offset by unfilled positions and a decrease in employee benefits related to lower costs associated with our employee stock ownership plan (ESOP). The decrease in the ESOP is related to the decrease in the Company’s average stock price quarter-over-quarter. Also included in salaries and benefits for the three months ended December 31, 2018 and 2017, is $91,000 and $80,000 in expense, respectively, relating to prior equity awards granted to officers under the Company’s Equity Incentive Plan. The equity awards provide for management to have a vested interest in the performance of the company and share in the benefit of an increase in shareholder value. Similarly, other operating expenses for the same periods include $35,000 in expense associated with equity awards granted to Directors.
The Company realized an increase in operating expenses relating to furniture and equipment and data processing for the three-month periods ended December 31, 2018 compared to the 2017 period. Data processing costs increased $27,000 for the comparable quarters due to annual cost increases, along with the introduction of new technology that has made banking easier for our customers, including products such as mobile banking and our on-line consumer loan application.
The Company has been able to offset the increase in certain noninterest expenses through reduced operating expenses in other operational areas, including legal and other professional services. Legal fees are lower by $84,000 due to fewer problem assets and the exclusion of certain costs incurred in the prior year period, including our charter conversion and branch sale and re-location. Other professional services also declined by $122,000 due to the exclusion of certain costs incurred in the prior year period, including the use of a financial consultant to assist with strategy and non-compete payments made to executives associated with the Fraternity Community Bancorp, Inc. acquisition. The terms and the payments under the consulting and non-compete agreements were fully satisfied in March and April 2018, respectively. FDIC insurance premiums decreased $35,000 to $57,000 for the three months ended December 31, 2018 compared to $91,000 for the three months ended December 31, 2017. The decrease in the premiums is attributable to a reduction in nonaccrual loans quarter-over-quarter and an increase in the Bank’s capital position due to the $2 million of new capital brought down from the Holding Company to the Bank in August 2018. Foreclosed real estate expense also decreased $39,000 due to a write-down of one property in the prior year quarter to its net realizable value determined through a newly obtained appraisal.
Income Tax E
xpense.
For the three months ended December 31, 2018, the Company did not report any income tax benefit on pre-tax loss of $125,000 compared to tax expense of $2.4 million for the three months ended December 31, 2017 after pre-tax income of $425,000. There was no tax expense during the current quarter due to the release of a portion of the valuation allowance on our net deferred tax assets established in the prior fiscal year. In accordance with Accounting Standards Codification (ASC) 740,
Accounting for Income Taxes
, at December 31, 2018, the Company has assessed whether the deferred tax assets are more likely than not to be realized based on an evaluative process that considers all available positive and negative evidence. As part of this evaluative process, management considered the following sources of taxable income: 1.) taxable income in prior carryback years; 2.) the future reversals of taxable temporary differences; 3.) tax planning strategies; and 4.) future taxable income exclusive of reversing temporary differences and carryforwards. In making a conclusion, management evaluated all the available positive and negative evidence impacting these sources of taxable income. The first three options are more quantifiable and verifiable; however, management has concluded they are not viable sources of taxable income. As such, the positive evidence that has been most heavily relied upon, but the most subjective, is future taxable income exclusive of reversing temporary differences and carryforwards. Based upon the Company being in a three-year cumulative loss position, which creates negative evidence, and because this evidence is considered significant, management has concluded that there is more negative evidence than positive evidence and therefore, it is more likely than not that the Company will be unable to generate sufficient taxable income in the foreseeable future to fully utilize the net deferred tax assets.
If, in the future, the Company generates taxable income on a sustained basis sufficient to support the deferred tax assets, the need for a deferred tax valuation allowance could change, resulting in the reversal of all or a portion of the deferred tax asset valuation at that time. The establishment of a valuation allowance on our deferred tax assets for financial reporting purposes does not affect how the net operating loss carryforwards may be utilized on our subsequent income tax returns. The valuation allowance on the Company’s net deferred tax assets decreased $94,000 to $5.3 million at December 31, 2018, from $5.4 million at September 30, 2018 due to $503,000 in non-deductible merger expenses, partially offset by the net loss of $125,000 and adjustments for permanent and temporary differences between book and tax expenses. Income tax expense for the periods reported is based upon year-to-date results and may not be reflective of annual earnings.
The large tax expense for the prior year quarter ended December 31, 2017 is directly related to the passage of the
Jobs Act
that was signed into law on December 22, 2017. The Act amended the Internal Revenue Code to reduce income tax rates and modify policies, credits, and deductions for individuals and businesses. For businesses, the Act reduces the federal corporate income tax rate from a maximum 35 percent to a flat 21 percent tax rate. As a result, our net deferred tax assets at that time, which were based upon a 34 percent corporate tax rate, had to be re-evaluated to reflect the new tax rate of 21 percent. This one-time non-cash adjustment was estimated to be $2.2 million and was recorded through income tax expense.
Results of Operations for the
Nine
Months Ended
December
3
1
, 2018 and 2017 (unaudited)
General.
Net income was $1.4 million, or $0.44 per common share for the nine-month period ended December 31, 2018 compared to a net loss of $1.1 million, or $0.35 per common share for the same period in fiscal 2018, a period-over-period increase of $2.5 million. The increase in net income is largely due to a $2.2 million tax adjustment in the prior year period to the Company’s net deferred tax asset resulting from the reduction in the corporate tax rate associated with the federal government’s passage of the
Jobs Act
; whereas there was no tax expense or benefit for the nine month period ended December 31, 2018 because of the valuation allowance established at March 31, 2018 on our deferred tax asset. Also contributing to a higher net income was an increase in net interest income associated with higher average loan balances and a lower provision for loan losses, partially offset by a decline in noninterest revenue and an increase in operating expenses realized in the nine-month period ended December 31, 2018. The increase in operating expenses is related to $559,000 in merger related expenses associated with the pending merger with Orrstown. Excluding the merger expenses, net income would have been $2.0 million, or $0.62 per common share, for the nine months ended December 31, 2018.
Net Interest Income.
Net interest income increased $153,000, or 1.4%, to $11.0 million for the nine months ended December 31, 2018 compared to $10.8 million for the nine months ended December 31, 2017. The increase in net interest income was due to a $1.3 million increase in interest revenue, partially offset by a $1.1 million increase in interest expense. The increase in interest revenue was due to an increase in the average balance of interest-earning assets, particularly higher yielding loans, as well as an increase in average yield on interest-earning assets. The average balance in interest-earning assets increased $7.8 million, or 1.6%, over the first three quarters of fiscal year 2019 compared to the same period in fiscal 2018, while the average yield increased 30 basis points to 4.09% from 3.79%, respectively. The average balances increased period-over-period due to organic loan growth and the purchase of several pools of loans in the second half of fiscal 2018, including residential mortgage loan pools totaling $19.2 million and several guaranteed SBA loans equal to $3.2 million.
The increase in interest expense for the nine-month period ended December 31, 2018 compared to the same period last year was the result of a 35 basis points increase in the average cost of interest-bearing liabilities. The average cost of interest-bearing liabilities increased from 0.81% for the nine months ended December 31, 2017 to 1.16% for the nine months ended December 31, 2018. In addition, the average balance of interest-bearing liabilities also increased $6.0 million from $417.2 million to $423.3 million. The increase resulted from the growth in average borrowings, partially offset by a decrease in average interest-bearing deposits. The net interest margin decreased 1 basis point from 3.07% for the nine months ended December 31, 2017 to 3.06% for the nine months ended December 31, 2018.
Interest Revenue
.
Interest revenue increased $1.3 million, or 9.6% to $14.7 million during the nine months ended December 31, 2018 compared to $13.4 million for the nine months ended December 31, 2017. The increase resulted from increases in interest and fees on loans and interest on federal funds sold and other bank deposits, partially offset by a decrease in interest on investment securities.
Interest and fees on loans increased $1.2 million, or 9.9%, to $13.1 million for the nine months ended December 31, 2018, compared to $11.9 million for the nine months ended December 31, 2017. The increase in interest and fees on loans is due to a $20.5 million increase in the average balance of net loans from $354.1 million to $374.6 million period-over-period. The increase in average loans is attributable to organic growth generated by our commercial lending area and strategic loan purchases that occurred in the second half of fiscal 2018. In addition, the average yield earned on loans increased 17 basis points from 4.48% for the nine months ended December 31, 2017 to 4.65% for the nine months ended December 31, 2018. The increase in yield is a result of interest revenue recognized over the first nine months of the fiscal year relating to early pay-offs on acquired loans and the associated purchase accounting marks, pay-off on a $3.3 million nonaccrual commercial loan in which all past due interest was collected, as well as overall higher rates on new loan originations due to rising interest rates.
Interest revenue on total investment securities decreased $137,000 to $1.3 million for the nine months ended December 31, 2018 from $1.4 million for the nine months ended December 31, 2017. The decrease is due to the average balance of investment securities decreasing $22.5 million, or 23.1%, to $74.8 million for the nine months ended December 31, 2018 from $97.3 million for the same period last year, while the average yield increased 33 basis points to 2.25% from 1.92%. The largest decrease in investment securities was in mortgage-backed securities, which decreased $18.8 million to $54.9 million for the nine months ended December 31, 2018 from $73.6 million for the same period last year. The average balance of investment securities other than mortgage-backed securities also decreased period-over-period by $3.7 million. The decrease in average investments is attributable to both normal principal paydowns related to mortgage-backed securities over the past twelve months, along with $11.6 million in securities that were sold between August and December 2017. There were no securities sold and only one investment security, with a book value of $2.0 million, purchased during the first quarter of fiscal 2019.
Interest Expense.
Interest expense increased $1.1 million, or 44.3%, to $3.7 million for the nine months ended December 31, 2018 compared to $2.5 million for the same period in fiscal 2018, due to the increase in the average cost of both interest-bearing deposits and borrowings. The average cost of interest-bearing deposits increased 29 basis points from 0.73% for the nine months ended December 31, 2017 to 1.02% for the nine months ended December 31, 2018. The increase in the average cost of interest-bearing deposits was partially offset by a decrease in the average balance of interest-bearing deposits. The average balance of interest-bearing deposits decreased $5.9 million, or 1.6%, to $367.3 million for the nine months ended December 31, 2018 from $373.2 million for the nine months ended December 31, 2017. Due to the increase in average costs, the interest expense associated with interest-bearing deposits increased $771,000, or 37.7%, period-over-period.
For the nine-month period ended December 31, 2018, average interest-bearing deposit balances decreased for all types of deposits other than checking accounts which increased $4.1 million, when compared to the same period a year ago. As interest rates have risen over the past year, the market for deposits, in particular time deposits and money market accounts, has become more competitive with respect to pricing. We have strategically decided not to price our deposits at the top of the market, unless through a promotional deposit product, or match competitor pricing in certain circumstances as a means to manage interest expense. The Company continues to focus on generating lower cost, core deposits (which includes all deposits other than certificates of deposit) to support continued loan growth. The average balance of core interest-bearing deposits decreased $3.0 million, or 2.3%, to $129.1 million for the nine-month period ended December 31, 2018 compared to $132.0 million for the nine months ended December 31, 2017. The average balance of time deposits also decreased $2.9 million, or 1.2%, to $238.3 million compared to $241.2 for the same periods, respectively.
Noninterest-bearing deposits allow us to fund growth in interest-earning assets at minimal cost. Average noninterest-bearing deposits decreased $428,000, or 1.4%, to $29.2 million for the nine months ended December 31, 2018, compared to $29.6 million for the nine months ended December 31, 2017. Our cash management personnel and commercial loan officers remain focused in working with commercial clients to move their core deposit relationships to Hamilton Bank and provide lower cost of funds.
For the nine-month period ended December 31, 2018, average borrowings were $56.0 million compared to an average balance of $44.0 million for the same period a year ago. The increase in average borrowings is associated with funds needed to purchase several loan portfolios over the last half of fiscal 2018 and a declining deposit base. The borrowings at December 31, 2018 consist of only advances from the FHLB and totaled $51.1 million; a decrease of $8.5 million since June 30, 2018. Due to rising interest rates, we have paid-off maturing advances based upon available liquidity at that time versus rolling the advance over at the higher rate. The borrowings carry an average rate of 2.48% for the nine months ended December 31, 2018; a 91 basis points increase from 1.57% for the same period a year ago. Borrowing from the FHLB in today’s low interest rate environment can be a more cost-effective means to obtain funds if deposits are not growing compared to selling investment securities that are earning a higher yield.
Average Balances, Interest and Yields.
The following table presents information regarding average balances of assets and liabilities, the total dollar amounts of interest revenue from average interest-earning assets, the dollar amounts of interest expense on average interest-bearing liabilities, and the resulting annualized average yields and costs. The yields and costs for the periods indicated are derived by dividing interest revenue or interest expense by the average balances of assets or liabilities, respectively, for the periods presented and have been annualized. Average balances have been calculated using average daily balances. No tax-equivalent adjustments were made. Nonaccrual loans have been included in the table as loans carrying a zero yield.
|
|
Nine Months Ended December 31,
|
|
|
|
(dollars in thousands)
|
|
|
|
2018
|
|
|
2017
|
|
|
|
Average
|
|
|
|
|
|
|
Yield/
|
|
|
Average
|
|
|
|
|
|
|
Yield/
|
|
|
|
Balance
|
|
|
Interest
|
|
|
Cost
|
|
|
Balance
|
|
|
Interest
|
|
|
Cost
|
|
Interest-earning assets:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cash and cash equivalents
|
|
$
|
29,413
|
|
|
$
|
338
|
|
|
|
1.53
|
%
|
|
$
|
19,636
|
|
|
$
|
100
|
|
|
|
0.68
|
%
|
Investment securities (1)
|
|
|
19,915
|
|
|
|
449
|
|
|
|
3.01
|
%
|
|
|
23,635
|
|
|
|
446
|
|
|
|
2.52
|
%
|
Mortgage-backed securities
|
|
|
54,890
|
|
|
|
811
|
|
|
|
1.97
|
%
|
|
|
73,637
|
|
|
|
951
|
|
|
|
1.72
|
%
|
Loans receivable, net (2)
|
|
|
374,593
|
|
|
|
13,072
|
|
|
|
4.65
|
%
|
|
|
354,132
|
|
|
|
11,891
|
|
|
|
4.48
|
%
|
Total interest-earning assets
|
|
|
478,811
|
|
|
|
14,670
|
|
|
|
4.09
|
%
|
|
|
471,040
|
|
|
|
13,388
|
|
|
|
3.79
|
%
|
Noninterest-earning assets
|
|
|
34,546
|
|
|
|
|
|
|
|
|
|
|
|
43,526
|
|
|
|
|
|
|
|
|
|
Total assets
|
|
$
|
513,357
|
|
|
|
|
|
|
|
|
|
|
$
|
514,566
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest-bearing liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Statement savings
|
|
$
|
40,449
|
|
|
$
|
50
|
|
|
|
0.16
|
%
|
|
$
|
43,771
|
|
|
$
|
41
|
|
|
|
0.12
|
%
|
Checking accounts
|
|
|
30,018
|
|
|
|
8
|
|
|
|
0.04
|
%
|
|
|
25,966
|
|
|
|
7
|
|
|
|
0.04
|
%
|
Money market
|
|
|
58,583
|
|
|
|
292
|
|
|
|
0.66
|
%
|
|
|
62,308
|
|
|
|
243
|
|
|
|
0.52
|
%
|
Certificates of deposit
|
|
|
238,262
|
|
|
|
2,465
|
|
|
|
1.38
|
%
|
|
|
241,176
|
|
|
|
1,753
|
|
|
|
0.97
|
%
|
Total interest-bearing deposits
|
|
|
367,312
|
|
|
|
2,815
|
|
|
|
1.02
|
%
|
|
|
373,221
|
|
|
|
2,044
|
|
|
|
0.73
|
%
|
Borrowings
|
|
|
55,952
|
|
|
|
860
|
|
|
|
2.05
|
%
|
|
|
44,022
|
|
|
|
503
|
|
|
|
1.52
|
%
|
Total interest-bearing liabilities
|
|
|
423,264
|
|
|
|
3,675
|
|
|
|
1.16
|
%
|
|
|
417,243
|
|
|
|
2,547
|
|
|
|
0.81
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Noninterest-bearing liabilities and equity:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Noninterest-bearing deposits
|
|
|
29,157
|
|
|
|
|
|
|
|
|
|
|
|
29,585
|
|
|
|
|
|
|
|
|
|
Other noninterest-bearing liabilities
|
|
|
5,475
|
|
|
|
|
|
|
|
|
|
|
|
6,604
|
|
|
|
|
|
|
|
|
|
Total liabilities
|
|
|
457,896
|
|
|
|
|
|
|
|
|
|
|
|
453,432
|
|
|
|
|
|
|
|
|
|
Total shareholders’ equity
|
|
|
55,461
|
|
|
|
|
|
|
|
|
|
|
|
61,134
|
|
|
|
|
|
|
|
|
|
Total liabilities and shareholders’ equity
|
|
$
|
513,357
|
|
|
|
|
|
|
|
|
|
|
$
|
514,566
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net interest income
|
|
|
|
|
|
$
|
10,995
|
|
|
|
|
|
|
|
|
|
|
$
|
10,841
|
|
|
|
|
|
Net interest rate spread (3)
|
|
|
|
|
|
|
|
|
|
|
2.93
|
%
|
|
|
|
|
|
|
|
|
|
|
2.98
|
%
|
Net interest-earning assets (4)
|
|
$
|
55,547
|
|
|
|
|
|
|
|
|
|
|
$
|
53,797
|
|
|
|
|
|
|
|
|
|
Net interest margin (5)
|
|
|
|
|
|
|
|
|
|
|
3.06
|
%
|
|
|
|
|
|
|
|
|
|
|
3.07
|
%
|
Average interest-earning assets to average interest-bearing liabilities
|
|
|
113.12
|
%
|
|
|
|
|
|
|
|
|
|
|
112.89
|
%
|
|
|
|
|
|
|
|
|
(1) Includes U.S agency and treasury securities, municipal and corporate bonds and to a much lesser extent, Federal Home Loan Bank equity securities.
|
(2) Loans on non-accrual status are included in average loans carrying a zero yield.
|
(3) Net interest rate spread represents the difference between the yield on average interest-earning assets and the cost of average interest-bearing libilities.
|
(4) Net interest-earning assets represents total interest-earning assets less total interest-bearing liabilities.
|
(5) Net interest margin represents net interest income divided by average total interest-earning assets.
|
Provision for Loan Losses.
We establish provisions for loan losses that are charged to operations in order to maintain the allowance for loan losses at a level believed, to the best of management’s knowledge, to cover all known and inherent losses in the portfolio both probable and reasonable to estimate at each reporting date. There was $382,000 charged to the provision for loan losses for the nine months ended December 31, 2018 compared to a provision for loan loss of $625,000 for the nine months ended December 31, 2017. In the first three quarters of fiscal 2019, the $382,000 provision for loan loss recorded is primarily attributable to $173,000 in net charge-offs experienced over this period and roughly $294,000 in additional reserves associated with the revaluation of our environmental factors (see Note 1 of the Financial Statements under
Summary of Significant Accounting Policies
for further discussion), partially offset by a decline in loan balances; compared to the provision for the prior year comparable period, which was related to net charge-offs of $210,000 and growth within the loan portfolio, as reflected in the table below.
The allowance for loan losses was $3.0 million, or 54.8% of non-performing loans at December 31, 2018 compared to $2.6 million, or 39.3% of non-performing loans at December 31, 2017. The increase in the percentage is a result of the $1.1 million decrease in nonperforming loans over this period, partially offset by a $421,000 increase in the allowance for loan losses. The $5.5 million in non-performing loans at December 31, 2018 primarily consisted of two commercial real estate relationships totaling $4.1 million. The first relationship has a recorded value of $2.9 million and was placed on nonaccrual in June 2018, while the second relationship has a book value of $1.2 million and has had $1.9 million in charge-offs over the past two years. Both relationships have been recorded at their net realizable fair value based upon appraisals performed within the last year. No additional charge-offs are anticipated with these relationships at this time; however, changes in property values and other circumstances may result in additional charge-offs at a later date.
During the nine months ended December 31, 2018, loan charge-offs totaled $297,000 with recoveries of $124,000, compared to $236,000 in charge-offs and $26,000 in recoveries during the nine months ended December 31, 2017. During fiscal year 2019, we expect that we will continue our emphasis in growing commercial real estate and commercial business loans, which have higher interest rates than one-to four-family mortgage loans, thus are generally considered to bear higher risk than one-to four-family mortgage loans and could contribute to higher loan loss provisions going forward.
Summary of Allowance for Loan Losses Activity.
The following table sets forth an analysis of the allowance for loan losses for the periods indicated.
|
|
Nine Months Ended
|
|
|
|
December 31,
|
|
|
|
2018
|
|
|
2017
|
|
|
|
(dollars in thousands)
|
|
|
|
|
|
|
|
|
|
|
Allowance for loan losses at beginning of period
|
|
$
|
2,822
|
|
|
$
|
2,195
|
|
Charge-offs:
|
|
|
|
|
|
|
|
|
Real estate loans:
|
|
|
|
|
|
|
|
|
Residential
|
|
|
14
|
|
|
|
9
|
|
Investor
|
|
|
41
|
|
|
|
126
|
|
Commercial
|
|
|
31
|
|
|
|
100
|
|
Construction
|
|
|
-
|
|
|
|
-
|
|
Commercial business
|
|
|
209
|
|
|
|
-
|
|
Home equity
|
|
|
-
|
|
|
|
-
|
|
Consumer
|
|
|
2
|
|
|
|
1
|
|
Total charge-offs
|
|
|
297
|
|
|
|
236
|
|
Recoveries
|
|
|
124
|
|
|
|
26
|
|
Net charge-offs
|
|
|
173
|
|
|
|
210
|
|
Provision for loan losses
|
|
|
382
|
|
|
|
625
|
|
Allowance for loan losses at end of period
|
|
$
|
3,031
|
|
|
$
|
2,610
|
|
|
|
|
|
|
|
|
|
|
Allowance for loan losses to non-performing loans
|
|
|
54.80
|
%
|
|
|
39.33
|
%
|
Allowance for loan losses to total loans outstanding at the end of the period
|
|
|
0.82
|
%
|
|
|
0.67
|
%
|
Net charge-offs to average loans outstanding during the period (annualized)
|
|
|
0.06
|
%
|
|
|
0.08
|
%
|
Noninterest
Revenue
.
Noninterest revenue decreased $155,000, or 15.2%, to $868,000 for the nine months ended December 31, 2018, compared to $1.0 million for the nine months ended December 31, 2017. The following table outlines the changes in noninterest revenue for the nine-month periods.
|
|
Nine months ended
|
|
|
|
|
|
|
|
|
|
|
|
December 31,
|
|
|
|
|
|
|
|
|
|
|
|
2018
|
|
|
2017
|
|
|
$ Change
|
|
|
% Change
|
|
Service charges
|
|
$
|
365,434
|
|
|
$
|
347,201
|
|
|
$
|
18,233
|
|
|
|
5.3
|
|
Loss on sale of investment securities
|
|
|
-
|
|
|
|
(2,356
|
)
|
|
|
2,356
|
|
|
|
100.0
|
|
Gain on sale of loans held for sale
|
|
|
34,482
|
|
|
|
-
|
|
|
|
34,482
|
|
|
|
N/A
|
|
Gain on sale of property and equipment
|
|
|
-
|
|
|
|
212,743
|
|
|
|
(212,743
|
)
|
|
|
(100.0
|
)
|
Earnings on bank-owned life insurance
|
|
|
344,070
|
|
|
|
369,991
|
|
|
|
(25,921
|
)
|
|
|
(7.0
|
)
|
Other fees and commissions
|
|
|
124,177
|
|
|
|
95,972
|
|
|
|
28,205
|
|
|
|
29.4
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total noninterest revenue
|
|
$
|
868,163
|
|
|
$
|
1,023,551
|
|
|
$
|
(155,388
|
)
|
|
|
(15.2
|
)
|
Service charges associated with retail and commercial deposit products increased during the nine months ended December 31, 2018 compared to the same period a year ago. Management remains focused on growing core deposits, particularly checking accounts, which typically generate more service fee income. The average balance relating to overall checking accounts for the nine months ended December 31, 2018 was $59.2 million compared to an average balance of $55.6 million at December 31, 2017, an increase of 6.5%, or $3.6 million. We continue to review and evaluate our fee structure to be more aligned with our market. Customers, however, have become more cost conscious of fees and better manage their deposit relationship with the Bank.
During the nine months ended December 31, 2018, the Company was able to enhance noninterest revenue by $34,000 relating to gains on loans sold to the secondary market. In the last quarter of fiscal 2017 and into fiscal 2018, the Company purposely held in portfolio the majority of our residential loan originations to partially offset the increased run-off associated with this loan segment due to higher balances resulting from our two prior acquisitions. Beginning in fiscal 2019, however, we again started to sell qualified residential loan originations into the secondary market as a means to generate noninterest revenue and diversify our income stream. In the prior year nine-month period we also realized losses on the sale of investment securities of $2,000 compared to none for the nine months ended December 31, 2018.
The $213,000 gain on sale of property and equipment for the prior year period ended December 31, 2017 is related specifically to the sale of our Pigtown branch in Baltimore City, along with various furniture and equipment that was associated with the property. This branch was relocated within the same community, but to a smaller, more efficient space that provided operational cost savings.
In addition to these noninterest revenue items, the Company also experienced a $28,000 increase in other fees and commissions, offset by a $26,000 decline in earnings associated with BOLI. The decline in BOLI is due to a reduction in the cash surrender value of the company’s outstanding BOLI related to the pay-out of death benefits in the fourth quarter of fiscal 2018. Other fees and commissions include the collection of certain loan fees, merchant card services and other miscellaneous items. Merchant card services increased $6,000 period-over-period.
Noninterest Expense.
Noninterest expense increased $361,000 to $10.1 million for the nine months ended December 31, 2018 compared to $9.7 million the same period a year ago. The increase is attributable to $559,000 in merger related expenses incurred pertaining to the pending merger with Orrstown. The merger expenses to date include legal fees and services provided by the Company’s investment bankers. The following table outlines the changes within noninterest expense for those periods.
|
|
Nine months ended
|
|
|
|
|
|
|
|
|
|
|
|
December 31,
|
|
|
|
|
|
|
|
|
|
|
|
2018
|
|
|
2017
|
|
|
$ Change
|
|
|
% Change
|
|
Salaries and benefits
|
|
$
|
5,768,826
|
|
|
$
|
5,531,033
|
|
|
$
|
237,793
|
|
|
|
4.3
|
|
Occupancy
|
|
|
768,502
|
|
|
|
759,848
|
|
|
|
8,654
|
|
|
|
1.1
|
|
Advertising
|
|
|
53,506
|
|
|
|
63,685
|
|
|
|
(10,179
|
)
|
|
|
(16.0
|
)
|
Furniture and equipment
|
|
|
272,671
|
|
|
|
262,632
|
|
|
|
10,039
|
|
|
|
3.8
|
|
Data processing
|
|
|
604,456
|
|
|
|
522,469
|
|
|
|
81,987
|
|
|
|
15.7
|
|
Legal services
|
|
|
138,314
|
|
|
|
374,610
|
|
|
|
(236,296
|
)
|
|
|
(63.1
|
)
|
Other professional services
|
|
|
298,045
|
|
|
|
611,699
|
|
|
|
(313,654
|
)
|
|
|
(51.3
|
)
|
Merger related expenses
|
|
|
558,598
|
|
|
|
-
|
|
|
|
558,598
|
|
|
|
N/A
|
|
Deposit insurance premiums
|
|
|
270,690
|
|
|
|
222,359
|
|
|
|
48,331
|
|
|
|
21.7
|
|
Foreclosed real estate expense and losses
|
|
|
13,749
|
|
|
|
45,005
|
|
|
|
(31,256
|
)
|
|
|
(69.5
|
)
|
Other operating
|
|
|
1,313,712
|
|
|
|
1,306,791
|
|
|
|
6,921
|
|
|
|
0.5
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total noninterest expense
|
|
$
|
10,061,069
|
|
|
$
|
9,700,131
|
|
|
$
|
360,938
|
|
|
|
3.7
|
|
Excluding merger related expenses, overall operating expenses have remained relatively unchanged, despite decreases in certain operating expenses related to specific expenses incurred in the prior year period, offset by increases in other operating expenses, particularly salaries and benefits and data processing. We have been able to manage a larger loan portfolio from an operational cost basis and continue to increase our interest revenue; however, this has been partially offset by the recent rise in interest rates and the impact to our cost of funds. This is reflected in the modest improvement of the Company’s efficiency ratio which has decreased from 81.8% for the nine months ended December 31, 2017 to 80.1% for the nine months ended December 31, 2018. The efficiency ratio presented excludes the $559,000 in merger related expenses. Management remains committed to reducing operational expenses.
Salaries and benefit expense remain our highest operational cost and increased by $238,000, or 4.3%, period-over-period. This increase is due to annual evaluations and respective salary increases, along with bonus accruals that were not present in the prior year period due to our net loss position, partially offset by unfilled positions. Included in salaries and benefits for the nine months ended December 31, 2018 and 2017, is $273,000 and $241,000 in expense, respectively, relating to prior equity awards granted to officers under the Company’s Equity Incentive Plan. The equity awards provide for management to have a vested interest in the performance of the company and share in the benefit of an increase in shareholder value. Similarly, other operating expenses for the same periods include $104,000 associated with equity awards granted to Directors.
The Company realized an increase in operating expenses relating to data processing and deposit insurance premiums for the nine-month periods ended December 31, 2018 and 2017. Data processing costs increased $82,000 for the comparable periods due to annual cost increases, along with the introduction of new technology that has made banking easier for our customers, including products such as mobile banking and our on-line consumer loan application. FDIC insurance premiums have also increased $48,000 to $271,000 for the nine months ended December 31, 2018 compared to $222,000 for the nine months ended December 31, 2017. This increase is attributable to the Company’s lower capital position that resulted from the establishment of a valuation allowance on our deferred tax asset at the end of March 2018. A financial institution’s FDIC insurance base is determined based upon an institution’s average consolidated assets less tangible equity.
The Company has been able to offset the increase in certain noninterest expenses through reduced operating expenses in other operational areas, including legal and other professional services. Legal fees are lower by $181,000 due to fewer problem assets and the exclusion of certain costs incurred in the prior year period, including our charter conversion and consultation with counsel to advise on agreements associated with loan purchases and certain branch issues and transactions. Other professional services also declined by $314,000 because of certain costs incurred in the prior year period, including the use of a financial consultant to assist with strategy and non-compete payments made to executives associated with the Fraternity Community Bancorp, Inc. acquisition. The terms and the payments under the consulting and non-compete agreements were fully satisfied in March and April 2018, respectively. Foreclosed real estate expense also decreased $31,000 due to a write-down of one property in the prior year period to its net realizable value determined through a newly obtained appraisal.
Income Tax E
xpense.
For the nine months ended December 31, 2018, the Company did not report any income tax expense on pre-tax income of $1.4 million compared to tax expense of $2.7 for the nine months ended December 31, 2017 on pre-tax income of $1.5 million. There was no tax expense during the first nine months of fiscal 2019 due to the release of a portion of the valuation allowance on our net deferred tax assets established in the prior fiscal year. In accordance with Accounting Standards Codification (ASC) 740,
Accounting for Income Taxes
, at December 31, 2018, the Company has assessed whether the deferred tax assets are more likely than not to be realized based on an evaluative process that considers all available positive and negative evidence. As part of this evaluative process, management considered the following sources of taxable income: 1.) taxable income in prior carryback years; 2.) the future reversals of taxable temporary differences; 3.) tax planning strategies; and 4.) future taxable income exclusive of reversing temporary differences and carryforwards. In making a conclusion, management evaluated all the available positive and negative evidence impacting these sources of taxable income. The first three options are more quantifiable and verifiable; however, management has concluded they are not viable sources of taxable income. As such, the positive evidence that has been most heavily relied upon, but the most subjective, is future taxable income exclusive of reversing temporary differences and carryforwards. Based upon the Company being in a three-year cumulative loss position, which creates negative evidence, and because this evidence is considered significant, management has concluded that there is more negative evidence than positive evidence and therefore, it is more likely than not that the Company will be unable to generate sufficient taxable income in the foreseeable future to fully utilize the net deferred tax assets.
If, in the future, the Company generates taxable income on a sustained basis sufficient to support the deferred tax assets, the need for a deferred tax valuation allowance could change, resulting in the reversal of all or a portion of the deferred tax asset valuation at that time. The establishment of a valuation allowance on our deferred tax assets for financial reporting purposes does not affect how the net operating loss carryforwards may be utilized on our subsequent income tax returns. The valuation allowance on the Company’s net deferred tax assets decreased $455,000 to $5.3 million at December 31, 2018, from $5.8 million at March 30, 2018 due to $559,000 in non-deductible merger expenses, book income of $1.4 million and adjustments for permanent and temporary differences between book and tax expenses. Income tax expense for the periods reported is based upon year-to-date results and is not reflective of annual earnings.
The large tax expense for the prior year period ended December 31, 2017 is directly related to the passage of the
Jobs Act
. The Act amended the Internal Revenue Code to reduce income tax rates and modify policies, credits, and deductions for individuals and businesses. For businesses, the Act reduces the federal corporate income tax rate from a maximum 35 percent to a flat 21 percent tax rate. As a result, our net deferred tax assets at that time, which were based upon a 34 percent corporate tax rate, had to be re-evaluated to reflect the new tax rate of 21 percent. This one-time non-cash adjustment was estimated to be $2.2 million and was recorded through income tax expense.
Liquidity and Capital Resources
Liquidity describes our ability to meet current and future financial obligations that arise in the ordinary course of business. Liquidity is primarily needed to meet the borrowing and deposit withdrawal requirements of our customers and to fund current and planned expenditures. Our primary sources of funds are deposits, scheduled amortization and prepayments of loan principal and mortgage-backed securities, maturities and calls of investment securities and funds provided by our operations. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions, and competition. We regularly adjust our investments in liquid assets available to meet short-term liquidity needs based upon our assessment of (i) expected loan demand, (ii) expected deposit flows, (iii) yields available on interest-earning deposits and securities, and (iv) the objectives of our asset/liability management policy.
We also have the ability to borrow from the FHLB to meet our funding and liquidity needs. At December 31, 2018, we had $51.1 million in borrowings from the FHLB and the capacity to borrow approximately $73.6 million more, subject to our pledging sufficient assets.
Hamilton Bank may also borrow up to $5.0 million from a correspondent bank under a secured federal funds line of credit, and $1.0 million under an unsecured line of credit. We would be required to pledge investment securities to draw upon the secured line of credit.
We normally carry balances with correspondent banks that exceed the federally insured limit. We currently conduct a quarterly review of each correspondent bank’s financial information, including the banks’ capital ratios, balance sheet, income statement, allowance for loans losses, and other performance ratios, to determine if the bank is financially stable.
Our most liquid assets are cash and cash equivalents and interest-earning deposits. The level of these assets depends on our operating, financing, lending, and investing activities during any given period. At December 31, 2018, cash and cash equivalents totaled $26.5 million and securities classified as available-for-sale amounted to $65.6 million.
Total deposits decreased $21.0 million over the nine months ended December 31, 2018, while total deposits decreased $20.2 million over the same period a year ago; however, then increasing $12.5 million from December 31, 2017 to March 31, 2018. Deposit flows are affected by the level of interest rates, the interest rates and products offered by competitors and other factors. In the first three quarters of fiscal 2019, we continued our focus in growing our lower costing core deposits (considered to be all deposits other than certificates of deposit) to assist in funding organic loan growth. However, as interest rates have risen over this same period, the market competition for deposits, in particular time deposits and money market accounts, has become more competitive with respect to pricing. We have strategically decided not to price at the top of the market, unless through a promotional deposit product, or match competitor pricing in certain circumstances as a means to manage interest expense. Certificates of deposit due allow us to lock in those funds for an extended period of time based upon current interest rates. At December 31, 2018, certificates of deposit scheduled to mature within one year totaled $118.3 million, or 49.6% of certificates of deposit. We believe the large percentage of certificates of deposit that mature within one year reflects customers’ hesitancy to invest their funds for longer periods due to the current rising interest rate environment and local competitive pressures. Whether we retain these deposits will be determined in part by the interest rates we are willing to pay on such deposits. If these maturing deposits do not remain with us, we will be required to seek other sources of funds, including other certificates of deposit and borrowings. Depending on market conditions, we may be required to pay higher rates on such deposits or other borrowings than we currently pay on certificates of deposit due on or before December 31, 2019.
In the normal course of operations, we engage in a variety of financial transactions that, in accordance with generally accepted accounting principles, are not recorded in our financial statements. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. Such transactions are used primarily to manage customers’ requests for funding and take the form of loan commitments, unused lines of credit and letters of credit. At December 31, 2018, we had $50.5 million in unused lines of credit and commitments to extend credit outstanding.
We are committed to maintaining a strong liquidity position. We monitor our liquidity position on a daily basis. We anticipate that we will have sufficient funds to meet our current funding commitments. Based on our deposit retention experience and current pricing strategy, we anticipate that a significant portion of maturing time deposits will be retained. However, our retention experience could be impacted by the merger with Orrstown and our depositor’s decision to place their funds elsewhere (see Part II – Other Information; Item 1A. Risk Factors for further discussion).
At December 31, 2018, we exceeded all of the applicable regulatory capital requirements for the Bank (See capital tables in Note 10 of the Notes to Consolidated Financial Statements). Our regulatory risk weighted capital ratios increased during the first three quarters of fiscal 2019 as a result of an increase in our capital levels due to the net income recorded over this period.