Isabella Bank Corp: Form 10-Q for the period ended Jun 30, 2024

Executive Summary

(Dollars in thousands except per share amounts)

The following is management's discussion and analysis of our financial condition and results of operations for the unaudited three months ended June 30, 2024 and 2023. This analysis should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2023 and with the unaudited interim condensed consolidated financial statements and notes, beginning on page 4 of this report.

Comparison of Operating Results for the three and six months ended June 30, 2024, and 2023, unless otherwise noted

For the three months ended June 30, 2024, we reported net income of $3,481 and earnings per share of $0.47. Net income and earnings per share for the same period of 2023 were $4,630 and $0.62, respectively. For the six months ended June 30, 2024, net income was $6,612 and earnings per share was $0.88. Net income and earnings per share for the same period of 2023 were $9,951 and $1.32, respectively. The decrease in net income in both comparative periods is principally due to a lower NIM as our interest earning assets have not repriced as quickly as our interest bearing liabilities in the current interest rate cycle.

During the second quarter of 2024, net interest income was $13,550, as compared with $14,679 in the same quarter of 2023. Our yield on interest earning assets (FTE) was 2.83% for the three months ended June 30, 2024, as compared to 3.11% for the three months ended June 30, 2023. The book yield from securities was 2.23% and 2.26% during the second quarter of 2024 and 2023, respectively. The yield includes the effect of the investment of excess cash in shorter term U.S. Treasury securities following the COVID pandemic in 2021 and 2022. The weighted average maturity of our U.S. Treasury portfolio is approximately 2 years. Our yield on loans expanded to 5.49% in the second quarter 2024, up from 4.90% in the same quarter of 2023. Loan yields continued to expand due to higher rates on new loans and the repricing of fixed rate commercial loans to variable rates. At the end of the second quarter 2024, approximately 44% of commercial loans are fixed at rates that are lower than current market rates but will contractually reprice to variable rates over the next 3 to 5 years. Our cost of interest bearing liabilities increased to 2.37% from 1.41% in the second quarter 2023 due to several interest rate hikes throughout 2023 and the associated remix from noninterest bearing deposits into higher tier money market and certificate of deposit accounts. While we have experienced a downward trend in our NIM for the past several quarters, the second quarter 2024 marks a reversal as NIM expanded five basis points over the first quarter 2024.

For the first six months of 2024, net interest income was $26,792 compared with $30,030 in the same period of 2023. The comparison of NIM and yield on interest earning assets for the respective six month periods of 2024 and 2023 were 2.80% and 3.17%, and 4.52% and 4.00%. The yield on loans expanded to 5.42%, up from 4.80%, and our cost of interest bearing liabilities increased to 2.32% from 1.18% for the six months of 2024 and 2023, respectively. The explanations for the improvement in NIM are consistent with those provided in the year-over-year three month comparison above.

The provision for credit losses was $170 in the second quarter of 2024 and $196 for the same period in 2023. The provision for the current year quarter reflects growth in residential loans and a $72,000 increase due to higher unfunded commitments. For the first half of 2024, provision for credit losses was $562 and $237 in the same period of 2023. The increase is primarily driven by loan growth. The ratio of net charge-offs to total loans was near zero for the second quarter of 2024 and year-to-date June 30, 2024 as well in the same comparative periods of 2023. Net charge-offs have been at historic lows for the past five years, which we believe is due to our disciplined underwriting standards.

Noninterest income for the three months ended June 30, 2024 and 2023 was $3,608 and $3,604, respectively. Wealth management fees grew $67, or 6.8%, due to an increase in new accounts and higher market valuations. Customer service fees increased $81 compared to the same quarter of 2023 based on a higher number of transaction accounts. A decline in other income of $182, related to a few one-time items recorded in 2023, offset this growth. For the first half of 2024, noninterest income was $7,076, compared to $6,897 in the same period of 2023. The reasons for the increase in income for the six month comparison are the same as the three month comparison.

Noninterest expenses for the three-month period ended June 30, 2024 increased $356, or 2.8%, in comparison to the same period in 2023. Annual merit increases and medical claim adjustments totaling $190 led to a $409 increase in compensation and benefits expenses. Higher card usage drove a $78 increase in ATM and debit card expenses. For the first half of 2024, noninterest expense was $25,571, compared to $24,737 in the period of 2023. The reasons for the increase in expense for the six month comparison are the same as the three month comparison. Our year-to-date efficiency ratio is 74.37% in 2024 compared to 66.12% in 2023, which primarily reflects lower NIM and a relatively stable base of noninterest expense.

Financial Condition (June 30, 2024 to December 31, 2023 comparison)

Total assets remained steady at $2,060,139 as of June 30, 2024. Loan growth during the year was offset by lower cash and security balances and was primarily funded by security amortization and FHLB advances.

Our AFS securities portfolio totaled $505,646 at June 30, 2024, declining $22,502 due to municipal maturities and principal paydowns on mortgage-related securities. Net unrealized losses at June 30, 2024 totaled $34,049, or 6.31%, of the portfolio. The unrealized loss position on our AFS securities portfolio resulted from increases in short-term and intermediate-term benchmark interest rates. Our bond portfolio has a very short remaining life with $220,000 of the U.S. Treasury portfolio maturing by the end of 2026. The $178,424 Collateral Mortgage Obligation portfolio has a projected weighted-average life of 3.4 years and most bonds are bulleted in structure. Over half of the tax-exempt municipal portfolio will mature over the next five years.

Loans outstanding as of June 30, 2024 totaled $1,381,636. Since December 31, 2023, gross loans have increased $32,173 as a result of growth in the residential real estate portfolio due to the slowing of prepayments on steady new volume. Additional loan growth came from increased participation in advances to mortgage brokers.

The ACL was $13,095 at June 30, 2024, relatively unchanged from $13,108 at December 31, 2023. A decline in commercial real estate loans and changes in reserves related to loans individually evaluated led to fluctuations in the allocation of the reserve. Nonaccrual loans remained flat when compared to December 31, 2023 at $994. Past due accounts between 30 to 89 days as a percentage of total loans was 0.12% at June 30, 2024, compared to 0.31% at year-end 2023. Overall, credit quality remains strong, and there are no negative trends.

Total deposits decreased $1,396 since December 31, 2023, to $1,722,299 at the end of the second quarter 2024. Consumer demand for retail CDs continues based on the rate environment, resulting in a $22,075 increase in the balance during the first half of 2024. Interest bearing demand deposits increased $17,592, while demand deposits declined $16,312.

Total equity was $202,249 at June 30, 2024 compared to $202,402 at year-end 2023. Our tangible book value per share was $20.60 as of June 30, 2024, compared to $20.59 on December 31, 2023. Net unrealized losses on AFS securities reduced tangible book value per share by $3.60 and $3.37 for the respective periods.

We continue to have robust liquidity levels and capital. As of June 30, 2024, we had $754,110 of unencumbered sources of liquidity and strong capital ratios; the Tier 1 Leverage Ratio was 8.83%, Tier 1 risk-based capital was 12.37%, and Total risk-based capital was 15.29%.

Reclassifications

Certain amounts reported in the interim 2023 consolidated financial statements have been reclassified to conform to the 2024 presentation.

Subsequent Events

We evaluated subsequent events after June 30, 2024 through the date our interim condensed consolidated financial statements were issued for potential recognition and disclosure. No subsequent events require financial statement recognition or disclosure between June 30, 2024 and the date our interim condensed consolidated financial statements were issued.

Selected Financial Data (Unaudited)

The following table outlines our results of operations and provides certain performance measures as of, and for the:

(1) At end of period

(2) Non-GAAP financial measure; refer to the "Non-GAAP Financial Measures" section

Average Balances, Interest Rates, and Net Interest Income

The following schedules present the daily average amount outstanding for each major category of interest earning assets, non-earning assets, interest bearing liabilities, and noninterest bearing liabilities. These schedules also present an analysis of interest income and interest expense for the periods indicated. All interest income is reported on a FTE basis using a federal income tax rate of 21%. Loans in nonaccrual status, for the purpose of the following computations, are included in the average loan balances. FRB restricted equity holdings are included in other interest earning assets.

Three Months Ended

(1) Includes loans HFS and nonaccrual loans

(2) Average balances for AFS securities are based on amortized cost

(3) Includes average interest-bearing deposits with other banks, net of Federal Reserve daily cash letter

(4) Non-GAAP financial measure; refer to the "Non-GAAP Financial Measures" section

(1) Includes loans HFS and nonaccrual loans

(2) Average balances for AFS securities are based on amortized cost

(3) Includes average interest-bearing deposits with other banks, net of Federal Reserve daily cash letter

(4) Non-GAAP financial measure; refer to the "Non-GAAP Financial Measures" section

Loans

The following table displays loan balances as of:

Deposits

The following table displays deposit balances as of:

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Asset Quality Analysis

The following table outlines our quarter-to-date asset quality analysis as of, and for the three-month periods ended:

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Capital

Capital consists solely of common stock, retained earnings, and accumulated other comprehensive income (loss). We are authorized to raise capital through dividend reinvestment, employee and director stock purchases, and shareholder stock purchases. Pursuant to these authorizations, we issued 43,980 shares or $840 of common stock during the first six months of 2024, as compared to 37,983 shares or $846 of common stock during the same period in 2023. We offer the Directors Plan in which participants purchase stock units through deferred fees, in lieu of cash payments. Pursuant to this plan, we increased shareholders’ equity by $279 and $428 during the six-month periods ended June 30, 2024 and 2023, respectively. We also grant restricted stock awards pursuant to the RSP. Pursuant to this plan, we increased shareholders’ equity by $45 during the first six months of 2024, as compared to $128 during the same period in 2023.

We have publicly announced a common stock repurchase plan. Pursuant to this plan, we repurchased 72,093 shares or $1,402 of common stock during the first six months of 2024 and 100,578 shares or $2,409 during the first six months of 2023. As of June 30, 2024, we were authorized to repurchase up to an additional 198,713 shares of common stock.

The FRB has established minimum risk-based capital guidelines. Pursuant to these guidelines, a framework has been established that assigns risk weights to each category of on and off-balance-sheet items to arrive at risk adjusted total assets. Regulatory capital is divided by the risk adjusted assets with the resulting ratio compared to the minimum standard to determine whether a corporation has adequate capital.

The following table sets forth our ratios as of:

Liquidity

Liquidity is monitored regularly by our ALCO, which consists of members of senior management. The committee reviews projected cash flows, key ratios, and liquidity available from both primary and secondary sources.

Our primary sources of liquidity are cash and cash equivalents and unencumbered AFS securities. These categories totaled $339,911, or 16.50% of assets, as of June 30, 2024, compared to $381,417, or 18.52%, as of December 31, 2023. The decrease in the amount and percentage of primary liquidity is a direct result of an increase in loans and a decrease in unencumbered AFS securities collateralizing non-market funding. Liquidity is important for financial institutions because of their need to meet loan funding commitments, depositor withdrawal requests, and various other commitments including expansion of operations, investment opportunities, and payment of cash dividends. Based on these same factors, daily liquidity could vary significantly.

Deposit accounts are our primary source of funds. Our secondary sources include the ability to borrow from the FHLB, from the FRB, and through various correspondent banks in the form of federal funds purchased and a line of credit. These funding methods typically carry a higher interest rate than traditional market deposit accounts. Some borrowed funds, including FHLB advances, FRB Discount Window advances, and repurchase agreements, require us to pledge assets, typically in the form of AFS securities or loans, as collateral. As of June 30, 2024, we had available lines of credit of $320,551.

The frequency and complexity of our liquidity stress testing has increased due to economic uncertainty and changes within the interest rate and economic environment. Our liquidity position remained strong at June 30, 2024, which is illustrated in the following table:

(1) Includes estimated unencumbered lendable value of FHLB collateral of $210,000 as of June 30, 2024.

Fair Value

We utilize fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. AFS securities, cash flow hedge derivative instruments and certain liabilities are recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record at fair value other assets on a nonrecurring basis, such as mortgage loans AFS, collateral dependent loans, goodwill, foreclosed assets, OMSR, and certain other assets and liabilities. These nonrecurring fair value adjustments typically involve the application of lower of cost or market accounting or write downs of individual assets.

For further information regarding fair value measurements see “Note 7 – Fair Value” of our interim condensed consolidated financial statements.

Market Risk

Our primary market risks are interest rate risk and liquidity risk. IRR is the exposure of our net interest income to changes in interest rates. IRR results from the difference in the maturity or repricing frequency of a financial institution's interest earning assets and its interest bearing liabilities. Managing IRR is the fundamental method by which financial institutions earn income and create shareholder value. Excessive exposure to IRR could pose a significant risk to our earnings and capital.

The FRB has adopted a policy requiring banks to effectively manage the various risks that can have a material impact on safety and soundness. The risks include credit, interest rate, liquidity, operational, and reputational. We have policies, procedures, and internal controls for measuring and managing these risks. Specifically, our ALCO policy and procedures include defining acceptable types and terms of investments and funding sources, liquidity requirements, limits on investments in long-term assets, limiting the mismatch in repricing opportunities of assets and liabilities, and the frequency of measuring and reporting to our Board of Directors.

The primary technique to measure IRR is simulation analysis. Simulation analysis forecasts the effects on the balance sheet structure and net interest income under a variety of scenarios that incorporate changes in interest rates, the shape of yield curves, interest rate relationships, loan prepayments, and funding sources. These forecasts are compared against net interest income projected in a stable interest rate environment. While many assets and liabilities reprice either at maturity or in accordance with their contractual terms, several balance sheet components demonstrate characteristics that require an evaluation to more accurately reflect their repricing behavior. Key assumptions in the simulation analysis include prepayments on loans, probable calls of investment securities, changes in market conditions, loan volumes and loan pricing, deposit sensitivity, and customer preferences. These assumptions are inherently uncertain as they are subject to fluctuation and revision in a dynamic rate environment. As a result, the simulation analysis cannot precisely forecast the impact of rising and falling interest rates on net interest income. Actual results will differ from simulated results due to many other factors, including changes in balance sheet components, interest rate changes, changes in market conditions, and management strategies. We regularly monitor our projected net interest income sensitivity to ensure that it remains within established limits.

The following table summarizes our interest rate sensitivity for 12 and 24 months as of June 30, 2024. The results displayed in the table reflect the modeling of immediate shifts in the yield curve and a flat balance sheet and may not reflect actual or expected changes.

Gap analysis, the secondary method to measure IRR, measures the cash flows and/or the earliest repricing of our interest bearing assets and liabilities. This analysis is useful for measuring trends in the repricing characteristics of the balance sheet. Significant assumptions are required in this process because of the embedded repricing options contained in assets and liabilities. Residential real estate and consumer loans allow the borrower to repay the balance prior to maturity without penalty, while commercial and agricultural loans may have prepayment penalties. The amount of prepayments is dependent upon many factors, including the interest rate of a given loan in comparison to the current offering rates, the level of home sales, and the overall availability of credit in the marketplace. Generally, a decrease in interest rates will result in an increase in cash flows from these assets. Savings and demand accounts may generally be withdrawn on request without prior notice. The timing of cash flows from these deposits is estimated based on historical experience. Certificates of deposit have penalties that discourage early withdrawals.

We do not believe there has been a material change in the nature or categories of our primary market risk exposure, or the particular markets that present the primary risk of loss. We do not know of or expect there to be any material change in the general nature of our primary market risk exposure in the near term, and we do not expect to make material changes to our market risk methods in the near term. We may change those methods in the future to adapt to changes in circumstances or to implement new techniques.

Gap analysis is also utilized as a method to measure interest rate sensitivity. Interest rate sensitivity is determined by the amount of earning assets and interest bearing liabilities repricing within a specific time period, and their relative sensitivity to a change in interest rates. We strive to achieve reasonable stability in the net interest margin through periods of changing interest rates.

Contractual Obligations and Loan Commitments

We have various financial obligations, including contractual obligations and commitments related to deposits and borrowings, which may require future cash payments. We also have loan related commitments that may impact liquidity. The commitments include unused lines of credit, commercial and standby letters of credit, and commitments to grant loans. These commitments to grant loans include residential mortgage loans with the majority committed to be sold to the secondary market. Many of these commitments historically have expired without being drawn upon and do not necessarily represent our future cash requirements.

We are party to credit related financial instruments with off-balance-sheet risk. These financial instruments are entered into in the normal course of business to meet the financing needs of our customers. These financial instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the consolidated balance sheets. The contractual or notional amounts of these instruments reflect the extent of involvement we have in a particular class of financial instrument.

Our exposure to credit-related loss in the event of nonperformance by the counterparties to the financial instruments for commitments to extend credit and standby letters of credit could be up to the contractual notional amount of those instruments. We use the same credit policies when analyzing the creditworthiness of counterparties as we do for extending loans to customers. No significant losses are anticipated as a result of these commitments.

Non-GAAP Financial Measures

Our accounting and reporting policies conform to GAAP and the prevailing practices in the financial services industry. However, we also evaluate our performance by reference to certain additional financial measures discussed in this Quarterly Report on Form 10-Q that we identify as being “non-GAAP financial measures.” In accordance with SEC rules, we classify a financial measure as being a non-GAAP financial measure if that financial measure excludes or includes amounts, or is subject to adjustments that have the effect of excluding or including amounts, as the case may be, in the most directly comparable measure calculated and presented in accordance with GAAP as in effect from time to time in the United States in our statements of income, balance sheets or statements of cash flows. Non-GAAP financial measures do not include operating and other statistical measures or ratios, or statistical measures calculated using exclusively either financial measures calculated in accordance with GAAP, operating measures or other measures that are not non-GAAP financial measures or both.

The non-GAAP financial measures that we discuss in this Quarterly Report on Form 10-Q should not be considered in isolation or as a substitute for the most directly comparable or other financial measures calculated in accordance with GAAP. Moreover, the manner in which we calculate the non-GAAP financial measures that we discuss in this report may differ from that of other companies reporting measures with similar names.

The following table provides more detailed analysis, and reconciliation for, our non-GAAP financial measures.

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The information presented in the section captioned “Market Risk” in Management's Discussion and Analysis of Financial Condition and Results of Operations is incorporated herein by reference.

DISCLOSURE CONTROLS AND PROCEDURES

We carried out an evaluation, under the supervision and with the participation of the Principal Executive Officer and Principal Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15(d)-15(e) under the Exchange Act) as of June 30, 2024, pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Principal Executive Officer and Principal Financial Officer concluded that our disclosure controls and procedures as of June 30, 2024, were effective to ensure that information required to be disclosed in reports that we file or submit under the Exchange Act are recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.

CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING

During the most recent fiscal quarter, no change occurred in our internal control over financial reporting that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

There have been no material changes to the risk factors disclosed in Item 1A in our Annual Report on Form 10-K for the year ended December 31, 2023.