Consumers Bancorp Inc: Form 10-Q for the period ended Sep 30, 2022

(Dollars in thousands, except per share data)

General

The following is management’s analysis of the Corporation’s results of operations for the three-month period ended September 30, 2022, compared to the same period in 2021, and the consolidated balance sheet at September 30, 2022, compared to June 30, 2022. This discussion is designed to provide a more comprehensive review of the operating results and financial condition than could be obtained from an examination of the financial statements alone. This analysis should be read in conjunction with the consolidated financial statements and related footnotes and the selected financial data included elsewhere in this report.

Overview

Consumers Bancorp, Inc., a bank holding company incorporated under the laws of the State of Ohio (the Corporation), owns all the issued and outstanding common shares of Consumers National Bank, a bank chartered under the laws of the United States of America (the Bank). The Corporation’s activities have been limited primarily to holding the common shares of the Bank. The Bank’s business involves attracting deposits from businesses and individual customers and using such deposits to originate commercial, mortgage and consumer loans in its market area, consisting primarily of Carroll, Columbiana, Jefferson, Stark, Summit, Wayne and contiguous counties in Ohio, Pennsylvania, and West Virginia. The Bank also invests in securities consisting primarily of U.S. government sponsored entities, municipal obligations, mortgage-backed and collateralized mortgage obligations issued by Fannie Mae, Freddie Mac and Ginnie Mae.

Results of Operations

Three-Month Periods Ended September 30, 2022 and 2021

Net income for the first quarter of fiscal year 2023 was $2,535, or $0.83 per common share, compared to $2,665, or $0.88 per common share for the three months ended September 30, 2021. The following are key highlights of our results of operations for the three months ended September 30, 2022, compared to the prior fiscal year comparable period:

• net interest income increased by $423, or 5.3%, to $8,396 in the first quarter of fiscal year 2023 from the same prior year period primarily as a result of the growth in average interest-earning assets;
• a $410 provision for loans loss expense was recorded for the three-month period ended September 30, 2022 compared with $190 for the same prior year period primarily as a result of the organic growth within the loan portfolio in the first quarter of fiscal year 2023;
• noninterest income decreased by $142, or 11.2%, in the first quarter of fiscal year 2023 from the same prior year period primarily as a result of a $176, or 68.2%, decline in mortgage banking activity which was partially offset by a $39, or 10.9%, increase in service charges on deposit accounts and a $32, or 6.3%, increase in debit card interchange income; and
• noninterest expenses increased by $246, or 4.2%, in the first quarter of fiscal year 2023 from the same prior year period primarily due to increases in salaries and employee benefits; occupancy and equipment expenses; and Federal Deposit Insurance Corporation (FDIC) assessments that was primarily driven by the growth in the organization.

Return on average equity and return on average assets were 18.03% and 1.02%, respectively, for the three months ended September 30, 2022 compared to 14.75% and 1.14%, respectively, for the same prior year period.

Net Interest Income

Net interest income, the difference between interest income earned on interest-earning assets and interest expense incurred on interest-bearing liabilities, is the largest component of the Corporation’s earnings. Net interest income is affected by changes in the volumes, rates and composition of interest-earning assets and interest-bearing liabilities. In addition, prevailing economic conditions, fiscal and monetary policies and the policies of various regulatory agencies all affect market rates of interest and the availability and cost of credit, which, in turn, can significantly affect net interest income. Net interest margin is calculated by dividing net interest income on a fully tax equivalent basis (FTE) by total average interest-earning assets. FTE income includes tax-exempt income, restated to a pre-tax equivalent, based on the statutory federal income tax rate. The federal income tax rate in effect for the 2023 and 2022 fiscal years was 21.0%. All average balances are daily average balances. Non-accruing loans are included in average loan balances and average securities include unrealized gains and losses on securities available for sale, while yields are based on average amortized cost.

The Corporation’s net interest margin was 3.48% for the three months ended September 30, 2022, compared with 3.62% for the same period in 2021. FTE net interest income for the three months ended September 30, 2022 increased by $425, or 5.3%, to $8,517 from $8,092 for the same prior year period.

Tax-equivalent interest income increased by $741, or 8.8%, for the three months ended September 30, 2022 from the same prior year period. Interest income was positively impacted by a $51,979, or 5.8%, increase in average interest-earning assets from the same prior year period as well as the increase in current market rates. The interest income earned from the growth in average interest-earning assets for the three-month period ended September 30, 2022 more than offset the decline of $987 on interest and fee income earned from the forgiveness of Paycheck Protection Program (PPP) loans that was recognized in the same prior year period. The yield on average interest-earning assets declined to 3.76% for the three months ended September 30, 2022, compared with 3.78% for the same period last year. The yield on loans and the yield on interest-earning assets was negatively impacted by the decline in interest and fee income from the forgiveness of PPP loans.

Interest expense for the three months ended September 30, 2022 increased by $316, or 87.3%, from the same prior year period primarily due to an increase in deposit and short-term borrowing costs as a result of higher market interest rates. The Corporation’s cost of funds increased to 0.40% for the three months ended September 30, 2022 compared with 0.23% for the same prior year period.

(Dollars in thousands, except per share data

Average Balance Sheets and Analysis of Net Interest Income for the Three Months Ended September 30, (In thousands, except percentages)

(1) calculated on a fully taxable equivalent basis utilizing a statutory federal income tax rate of 21.0%

Provision for Loan Losses

The provision for loan losses represents the charge to income necessary to adjust the allowance for loan losses to an amount that represents management’s assessment of the estimated probable incurred credit losses in the Bank’s loan portfolio that have been incurred at each balance sheet date. For the three-month period ended September 30, 2022, the provision for loan losses was $410 compared with $190 for the same prior year period. Net charge-offs of $24 and net recoveries of $16 were recorded during the three-month periods ended September 30, 2022 and 2021, respectively. The loan loss provision expense recorded in fiscal year 2022 was primarily due to the organic growth within the loan portfolio.

Non-performing loans were $66 as of September 30, 2022, compared with $440 as of June 30, 2022 and $1,719 as of September 30, 2021. Non-performing loans to total loans were 0.01% at September 30, 2022 and 0.07% at June 30, 2022. Non-performing loans declined from June 30, 2022 since two loans were upgraded and returned to accrual status during the first quarter of fiscal year 2023. The allowance for loan losses as a percentage of loans was 1.18% at September 30, 2022 and 1.17% at June 30, 2022. Uncertainty remains regarding future levels of criticized and classified loans, non-performing loans and charge-offs. Management will continue to closely monitor changes in the loan portfolio and adjust the provision accordingly.

Noninterest Income

Noninterest income decreased by $142, or 11.2%, for the first quarter of fiscal year 2023 from the same period last year. The decline was primarily the result of a $176, or 68.2%, decline in mortgage banking activity from the same prior year period. Gains from the sale of mortgage loans to the secondary market declined as refinancing of mortgages slowed because of the increase in mortgage rates from the record lows in the previous year. This decline was partially offset by increases in service charges on deposit accounts of $39, or 10.9%, and debit card interchange income increasing by $32, or 6.3% for the first quarter of fiscal year 2023 from the same period last year. Effective March 1, 2022, the Bank made a small reduction to the non-sufficient funds/overdraft fee and eliminated many internal account transfer fees. The Bank may make future reductions to the non-sufficient funds/overdraft fee in response to the industry wide trend of reducing overdraft fees as large banks have announced a reduction in these types of fees in response to regulatory pressure. As a result, service charges on deposit accounts may be negatively impacted in future periods.

Noninterest Expenses

Total noninterest expenses increased by $246, or 4.2%, for the first quarter of fiscal year 2023 compared with the same period last year. Increases in salaries and employee benefits; FDIC assessments; and occupancy and equipment expenses contributed to the increase in noninterest expenses for the three-month period ended September 30, 2022.

On October 18, 2022, the FDIC issued a final rule that will increase the initial base deposit insurance assessment rate paid by insured depository institutions by two basis points, beginning with the first quarterly assessment period of calendar year 2023. According to the FDIC, the proposal increases the likelihood that its designated reserve ratio will reach the required minimum level of 1.35% by the statutory deadline of September 30, 2028 and will support progress toward achieving the long-term goal of a 2% ratio. The proposed increase would remain in effect until the long-term goal of a 2% FDIC designated reserve ratio is achieved. Progressively lower assessment rates will take effect when the reserve ratio reaches 2% and again when the reserve ratio reaches 2.5%.

On September 2, 2022, the OCC announced reduced assessment rates for OCC-chartered community banks. Effective with the March 2023 assessment, the OCC will make a 40% reduction in assessments based on the first $200 million in bank assets and a 20% reduction for assets between $200 million and $20 billion.

Income Taxes

Income tax expense was $504 for the three- month period ended September 30, 2022, compared to $559 for the three-month period ended September 30, 2021. The effective tax rates were 16.6% and 17.3% for the three-month periods ended September 30, 2022 and 2021, respectively. The effective tax rates differed from the federal statutory rate because of tax-exempt income from obligations of state and political subdivisions, loans, and bank owned life insurance income.

Financial Condition

Total assets as of September 30, 2022 were $991,423 compared to $977,313 at June 30, 2022, an increase of $14,110, or an annualized 5.8%. From June 30, 2022, total loans increased by $25,758, or an annualized 16.8% and total deposits increased by $25,521, or an annualized 11.5%.

Available-for-sale securities decreased from $296,347 as of June 30, 2022, to $278,418 as of September 30, 2022. The portfolio had an unrealized loss of $44,135 as of September 30, 2022 as a result of recent increases in market interest rates compared with the yields within the portfolio that were available at the time the underlying securities were purchased. The fair value is expected to recover as the securities approach their maturity date or repricing date or if market yields for such securities decline. As of September 30, 2022, the projected cash flow from the portfolio over the next 12 months was approximately $23,250 that will be available to reinvest into loans or securities at the then current market rates.

Total loans increased by $25,758, or an annualized 16.8%, from June 30, 2022. The growth in loans was primarily within the consumer and commercial real estate loan portfolios. Consumer loan growth was primarily from indirect loans due to the expansion of consumer loan sales staff and an expanded dealer network.

Non-Performing Assets

The following table presents the aggregate amounts of non-performing assets and select ratios as of the dates indicated.

As of September 30, 2022, impaired loans totaled $383, of which $47 are included in non-accrual loans. As of June 30, 2022, impaired loans totaled $473, of which $431 are included in non-accrual loans. Commercial and commercial real estate loans are classified as impaired if management determines that full collection of principal and interest, in accordance with the terms of the loan documents, is not probable. Impaired loans and non-performing loans have been considered in management’s analysis of the appropriateness of the allowance for loan losses. Management and the Board of Directors are closely monitoring these loans and believe that the prospects for recovery of principal and interest, less identified specific reserves, are favorable.

Contractual Obligations, Commitments, Contingent Liabilities and Off-Balance Sheet Arrangements

Liquidity

The objective of liquidity management is to ensure adequate cash flows to accommodate the demands of our customers and provide adequate flexibility for the Corporation to take advantage of market opportunities under both normal operating conditions and under unpredictable circumstances of industry or market stress. Cash is used to fund loans, purchase investments, fund the maturity of liabilities, and, at times, to fund deposit outflows and operating activities. The Corporation’s principal sources of funds are deposits; amortization and prepayments of loans; maturities, sales and principal receipts from securities; borrowings; and operations. Management considers the asset position of the Corporation to be sufficiently liquid to meet normal operating needs and conditions. The Corporation’s earning assets are mainly comprised of loans and investment securities. Management continually strives to obtain the best mix of loans and investments to both maximize yield and ensure the soundness of the portfolio, as well as to provide funding for loan demand as needed.

For the three months ended September 30, 2022, net cash inflow from operating activities was $3,957, net cash outflows from investing activities was $24,071 and net cash inflows from financing activities was $24,677. A major source of cash was a $25,521 increase in deposits and $8,047 from maturity, calls, principal pay downs and sales of available-for-sale securities. A major use of cash included $6,509 purchases of available-for-sale securities and a $25,793 increase in loans. Total cash and cash equivalents were $25,515 as of September 30, 2022, compared to $20,952 at June 30, 2022 and $87,092 at September 30, 2021.

The Bank offers several types of deposit products to its customers. We believe the rates offered by the Bank and the fees charged for them are competitive with the rates and fees charged by other banks for similar deposit products currently available in the market area. Deposits totaled $912,083 at September 30, 2022 compared with $886,562 at June 30, 2022.

To provide an additional source of liquidity, the Corporation has entered into an agreement with the Federal Home Loan Bank (FHLB) of Cincinnati. At September 30, 2022, advances from the FHLB of Cincinnati totaled $8,217 compared with $8,256 at June 30, 2022. As of September 30, 2022, the Bank had the ability to borrow an additional $101,775 from the FHLB of Cincinnati based on a blanket pledge of qualifying first mortgage and multi-family loans. The Corporation considers the FHLB of Cincinnati to be a reliable source of liquidity funding, secondary to its deposit base.

Short-term borrowings consisted of repurchase agreements, which are financing arrangements that mature daily, and a line of credit for the Corporation. The Bank pledges securities as collateral for the repurchase agreements. Short-term borrowings totaled $20,946 at September 30, 2022 and $21,295 at June 30, 2022.

Jumbo time deposits (those with balances of $250 and over) totaled $23,311 as of September 30, 2022 and $18,164 as of June 30, 2022. These deposits are monitored closely by the Corporation and are mainly priced on an individual basis. The Corporation has the option to use a fee-paid broker to obtain deposits from outside its normal service area as an additional source of funding. The Corporation, however, does not rely upon these deposits as a primary source of funding. Although management monitors interest rates on an ongoing basis, a quarterly rate sensitivity report is used to determine the effect of interest rate changes on the financial statements. In the opinion of management, enough assets or liabilities could be repriced over the near term (up to three years) to compensate for such changes. The spread on interest rates, or the difference between the average earning assets and the average interest-bearing liabilities, is monitored quarterly.

To meet the financial needs of our customers, commitments to originate mortgage, commercial, construction, and consumer loans and commitments for commercial, home equity, and consumer lines of credit have been issued. Since commitments to extend credit have a fixed expiration date or other termination clause, some commitments will expire without being drawn upon and the total commitment amounts do not necessarily represent future cash requirements. Financial standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. The same credit policies are used in making commitments and financial standby letters of credit as are used for on-balance sheet instruments. Total unused commitments were $162,315 as of September 30, 2022 and $149,500 as of June 30, 2022.

Capital Resources

Total shareholders’ equity declined to $43,458 as of September 30, 2022, from $53,970 as of June 30, 2022. The primary reason for the decline in shareholders’ equity was an increase of $12,742 in the accumulated other comprehensive loss from the mark-to-market of available-for-sale securities and from cash dividends paid of $519. As market interest rates rise, the fair value of fixed-rate available-for-sale securities decline with a corresponding net of tax decline recorded in the accumulated other comprehensive loss portion of equity. The fair value is expected to recover as the securities approach their maturity date or repricing date or if market yields for such securities decline. These declines were partially offset by net income of $2,535 for the three-month period ended September 30, 2022.

The Bank is subject to various regulatory capital requirements administered by federal regulatory agencies. Capital adequacy guidelines and prompt corrective-action regulations involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Failure to meet various capital requirements can initiate regulatory action that could have a direct material effect on the Corporation’s financial statements.

As of September 30, 2022, the Bank’s common equity tier 1 capital and tier 1 capital ratios were 11.14% and the leverage and total risk-based capital ratios were 7.55% and 12.24%, respectively. This compares with common equity tier 1 capital and tier 1 capital ratios of 11.39% and leverage and total risk-based capital ratios of 7.39% and 12.49%, respectively, as of June 30, 2022. The Bank exceeded minimum regulatory capital requirements to be considered well-capitalized for both periods. Management is not aware of any matters occurring subsequent to September 30, 2022 that would cause the Bank’s capital category to change.

Critical Accounting Policies

The Corporation’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and follow general practices within the industry in which it operates. Application of these principles requires management to make estimates or judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates or judgments. Certain policies inherently have a greater reliance on the use of estimates, and as such have a greater possibility of producing results that could be materially different than originally reported.

Critical accounting policies are those policies that are highly dependent on subjective or complex judgments, estimates and assumptions and where changes in those estimates and assumptions could have a significant impact on the financial statements. The Corporation has identified the appropriateness of the allowance for loan losses and the evaluation of goodwill for impairment as critical accounting policies and an understanding of these policies is necessary to understand the financial statements. Note one (Summary of Significant Accounting Policies - Allowance for Loan Losses and Goodwill and Other Intangible Assets), Note four (Loans), Note six (Goodwill and Intangible Assets) and Management’s Discussion and Analysis of Financial Condition and Results of Operation (Critical Accounting Policies and Use of Significant Estimates) of the 2022 Form 10-K provide detail regarding the Corporation’s accounting for the critical accounting policies. There have been no significant changes in the application of accounting policies since June 30, 2022.

Allowance for Loan Losses. The determination of the allowance for loan losses involves considerable subjective judgment and estimation by management. The allowance for loan losses is a reserve established through a provision for loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The balance in the allowance for loan losses is determined based on management’s review and evaluation of the loan portfolio in relation to past loss experience, the size and composition of the portfolio, current economic events and conditions and other pertinent factors, including management’s assumptions as to future delinquencies, recoveries, and losses. All these factors may be susceptible to significant change. Among the many factors affecting the allowance for loan losses, some are quantitative while others require qualitative judgment. Although management believes its process for determining the allowance adequately considers all the potential factors that could potentially result in credit losses, the process includes subjective elements and may be susceptible to significant change. To the extent actual outcomes differ from management’s estimates, additional provisions for loan losses may be required that would adversely impact the Corporation’s financial condition or earnings in future periods.

Goodwill. The Company accounts for business combinations using the acquisition method of accounting. Accordingly, the identifiable assets acquired and the liabilities assumed are recorded at their estimated fair values as of the date of acquisition with any excess of the cost of the acquisition over the fair value recorded as goodwill. The Company performs an evaluation of goodwill for impairment on an annual basis, or more frequently if events or changes in circumstances indicate that the asset might be impaired. The evaluation for impairment involves comparing the current estimated fair value of the Company to its carrying value. If the current estimated fair value exceeds the carrying value, no additional testing is required, and an impairment loss is not recorded. If the estimated fair value is less than the carrying value, further valuation procedures are performed that could result in impairment of goodwill being recorded. As of April 30, 2022, the measurement date, a qualitative assessment was performed to determine whether there is a more likely than not (greater than 50% likelihood) that the fair value of the Corporation was less than its carrying amount. The qualitative impairment test of goodwill indicated no impairment existed as of the measurement date. However, it is impossible to know the future impact of the evolving economic conditions. If for any future period it is determined that there has been impairment in the carrying value of our goodwill balances, the Corporation will record a charge to earnings, which could have a material adverse effect on net income, but not risk-based capital ratios.

Forward-Looking Statements

Certain statements contained in this Quarterly Report on Form 10-Q, which are not statements of historical fact, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The words “may,” “continue,” “estimate,” “intend,” “plan,” “seek,” “will,” “believe,” “project,” “expect,” “anticipate” and similar expressions are intended to identify forward-looking statements. These forward-looking statements may involve risks and uncertainties that are difficult to predict, may be beyond our control, and could cause actual results to differ materially from those described in such statements. Any such forward-looking statements are made only as of the date of this report or the respective dates of the relevant incorporated documents, as the case may be, and, except as required by law, we undertake no obligation to update these forward-looking statements to reflect subsequent events or circumstances. Risks and uncertainties that could cause actual results for future periods to differ materially from those anticipated or projected include, but are not limited to:

• changes in local, regional and national economic conditions becoming less favorable than we expect, resulting in a deterioration in asset credit quality or debtors being unable to meet their obligations because of high unemployment rates and inflationary pressures;
• rapid fluctuations in market interest rates could result in changes in fair market valuations and a decline in net interest income;
• changes in the level of non-performing assets and charge-offs;
• unanticipated changes in our liquidity position, including, but not limited to, changes in the cost of liquidity and our ability to find alternative funding sources;
• the effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities, and insurance) with which we must comply;
• the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Federal Reserve Board;
• breaches of security or failures of our technology systems due to technological or other factors and cybersecurity threats;
• changes in consumer spending, borrowing and savings habits;
• declining asset values impacting the underlying value of collateral;
• changes in accounting policies, rules and interpretations that may come as a result of COVID-19 or otherwise;
• our ability to attract and retain qualified employees;
• competitive pressures on product pricing and services; and
• changes in the reliability of our vendors, internal control systems or information systems.

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Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by the report, an evaluation was performed under the supervision and with the participation of the Corporation’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Corporation’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15e. Based on the evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Corporation’s disclosure controls and procedures were effective as of September 30, 2022.

Changes in Internal Controls Over Financial Reporting

There have not been any changes in the Corporation’s internal control over financial reporting that occurred during the Corporation’s last quarter that have materially affected, or are reasonably likely to materially affect, the Corporation’s internal control over financial reporting.