ITEM 1. BUSINESS
The disclosures set forth in this item are qualified by Item 1A.
ITEM 1A. RISK FACTORS
An investment in the Company’s common stock involves risks. The following is a description of the material risks and uncertainties that the Company believes affect it business and an investment in the common stock. Additional risks and uncertainties that the Company is unaware of, or that it currently deems immaterial, also may become important factors that affect the Company and its business. If any of the risks described in this Annual Report on Form 10-K were to occur, the Company’s financial condition, results of operations and cash flows could be materially and adversely affected. In such an event, the value of the Company’s common stock could decline and you could lose all or part of your investment.
Risks Related to the Company’s Business
The Company’s business concentration in Texas, specifically in the Houston metropolitan area, imposes risks and may magnify the consequences of any regional or local economic downturn affecting Houston, including any downturn in the energy or real estate sectors.
The Company conducts its operations almost exclusively in the Houston metropolitan area. As of December 31, 2016, the substantial majority of the loans in the Company’s loan portfolio were made to borrowers who live and/or conduct business in Texas, and
specifically, in the Houston metropolitan area, and the substantial majority of the Company’s secured loans were secured by collateral located in the Houston metropolitan area. Accordingly, the Company is significantly exposed to risks associated with a lack of geographic diversification. The economic conditions in the Houston metropolitan area are dependent on the energy sector generally and the price of oil and gas specifically. Any downturn or adverse development in the energy sector or continued low oil or gas prices could have a material adverse impact on the Company’s business, financial condition, results of operations and future prospects. Adverse economic developments, among other things, could negatively affect the volume of loan originations, increase the level of nonperforming assets and charge-offs, increase the rate of foreclosure losses on loans and reduce the value of the Company’s loans and loan servicing portfolio. Any regional or local economic downturn that affects the Houston metropolitan area or Texas more generally, or the Company’s existing borrowers, prospective borrowers or property values in the Company’s market area may affect the Company and its profitability more significantly and more adversely than those of the Company’s competitors with operations that are less geographically concentrated in the same area.
The Company may not be able to implement aspects of its growth strategy, which may affect the Company’s ability to maintain its historical earnings trends.
The Company’s growth strategy focuses on organic growth, supplemented by strategic acquisitions. The Company may not be able to execute on aspects of its growth strategy to sustain its historical rate of growth or may not be able to grow at all. More specifically, the Company may not be able to generate sufficient new loans and deposits within acceptable risk and expense tolerances, obtain the personnel or funding necessary for additional growth or find suitable acquisition candidates. Various factors, such as economic conditions, in particular, the volatility of oil and gas prices and competition, may impede or prohibit the growth of the Company’s operations, the opening of new branches and the consummation of additional acquisitions. Further, the Company may be unable to attract and retain experienced bankers, which could adversely affect its growth. The success of the Company’s growth strategy also depends on its ability to effectively manage growth, which is dependent upon a number of factors, including the Company’s ability to adapt its existing credit, operational, technology and governance infrastructure to accommodate expanded operations. If the Company fails to implement one or more aspects of its growth strategy, the Company may be unable to maintain its historical earnings trends, which could adversely affect its business, financial condition and results of operations.
The Company is dependent on its executive officers and other key individuals to continue the implementation of the Company’s long-term business strategy and the loss of one or more of these key individuals could curtail the Company’s growth and adversely affect its business, financial condition, results of operations and prospects.
The Company’s continued success is dependent upon the skills, experience and continued service of its executive management team and Board of Directors. The Company’s goals, strategies and continued growth are closely tied to the strengths and banking philosophy of its executive management team, including the Company’s Chairman and Chief Executive Officer, George Martinez, and its President, Steven F. Retzloff. Successful implementation of the Company’s business strategy is also dependent in part on the continued service of its branch presidents. The community involvement and diverse and extensive local business relationships and experience in the Houston market of the Company’s officers in the Houston metropolitan area are important to its success. The loss of services of any of these key personnel in the future could have a negative impact on the Company’s business because of their skills, years of industry experience and the difficulty of promptly finding qualified replacement personnel who are experienced in the specialized aspects of the Company’s business or who have ties to the communities within its market area. Currently, it is generally the Company’s policy not to have employment agreements with its officers. While the Company does not anticipate any changes in its executive management team, the unexpected loss of any of these members of management could have a material adverse effect on the Company and its ability to implement the Company’s business strategy.
The Company’s ability to retain bankers and recruit additional successful bankers is critical to the success of its business strategy and any failure to do so could impair its customer relationships and adversely affect its business and results of operations.
The Company’s ability to retain and grow its loans, deposits and fee income depends upon the business generation capabilities, reputation and the relationship management skills of the Company’s lenders. If the Company were to lose the services of any of its bankers, including successful bankers employed by an acquired bank, to a competitor or otherwise, the Company may not be able to retain valuable relationships and some of its customers could choose to use the services of a competitor instead of the Company’s services.
The Company’s success and growth strategy also depends on its continued ability to attract and retain experienced loan officers and support staff, as well as other management personnel. The Company may face difficulties in recruiting and retaining lenders and other personnel of the Company’s desired caliber, including as a result of competition from other financial institutions. Competition for loan officers and other personnel is strong and the Company may not be successful in attracting or retaining the personnel it requires. In particular, many of the Company’s competitors are significantly larger with greater financial resources, and may be able to offer more
attractive compensation packages and broader career opportunities. Additionally, the Company may incur significant expenses and expend significant time and resources on training, integration and business development before it is able to determine whether a new loan officer will be profitable or effective. If the Company is unable to attract and retain successful loan officers and other personnel, or if its loan officers and other personnel fail to meet the Company’s expectations in terms of customer relationships and profitability, the Company may be unable to execute its business strategy and the Company’s business, financial condition, results of operations and growth prospects may be negatively affected.
A key piece of the Company’s strategic growth plan involves decision-making authority at the branch level, and the Company’s business, financial condition, results of operations and prospects could be negatively affected if the Company’s local teams do not follow the Company’s internal policies or are negligent in their decision-making.
The Company attracts and retains its management talent by empowering them to make certain business decisions on a local level. Lending authorities are assigned to branch presidents and their banking teams based on their level of experience. Additionally, all loan relationships in excess of internal specified maximums are reviewed by the Bank’s Executive Loan Committee, comprised of senior management of the Bank, or the Bank’s Board of Directors, as the case may be. The Company’s local lenders may not follow its internal procedures or otherwise act in the Company’s best interests with respect to its decision-making. A failure of the Company’s employees to follow the Company’s internal policies, or actions taken by its employees that are negligent, could have a material adverse effect on the Company’s business, financial condition, results of operations and prospects.
The Company’s strategic growth plan, which includes pursuing acquisitions, could expose the Company to financial, execution and operational risks that could have a material adverse effect on its business, financial condition, results of operations and growth prospects.
The Company has acquired two financial institutions and intends to continue to pursue a strategy that includes future acquisitions. An acquisition strategy involves significant risks, including the following:
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discovering proper candidates for acquisition;
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incurring time and expense associated with identifying and evaluating potential acquisitions and negotiating potential transactions, resulting in management’s attention being diverted from the operation of its existing business;
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using inaccurate estimates and judgments to evaluate credit, operations, management, compliance and market risks with respect to the target institution or assets;
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conducting adequate due diligence and managing known and unknown risks and uncertainties;
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obtaining necessary regulatory approvals;
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integrating the operations and personnel of the combined businesses, thereby creating an adverse short-term effect on results of operations;
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attracting and retaining qualified management and key personnel, including lenders;
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maintaining asset quality;
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attracting and retaining customers;
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attracting funding to support additional growth within acceptable risk tolerances; and
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maintaining adequate regulatory capital.
The market for acquisition targets is highly competitive, which may adversely affect the Company’s ability to find acquisition candidates that fit its strategy and standards. To the extent that the Company is unable to find suitable acquisition targets, an important component of its growth strategy may not be realized. Acquisitions of financial institutions involve operational risks and uncertainties, such as unknown or contingent liabilities with no available manner of recourse, exposure to unexpected problems such as asset quality, the retention of key employees and customers and other issues that could negatively affect the Company’s business. Acquisitions of financial institutions are also subject to regulatory approvals that can result in delays, in some cases, for a lengthy period of time. The Company may not be able to complete future acquisitions or, if completed, the Company may not be able to successfully integrate the operations, technology platforms, management, products and services of the entities that it acquires or effectively eliminate redundancies. The integration process may also require significant time and attention from the Company’s management that would otherwise be directed toward servicing existing business and developing new business. Further, acquisitions
typically involve the payment of a premium over book and market values and, therefore, some dilution of the Company’s tangible book value and net income per common share may occur in connection with any future acquisition, and the goodwill that the Company currently maintains or may recognize in connection with future transactions may be subject to impairment in future periods.
Challenging market conditions and economic trends have adversely affected the banking industry and could adversely affect the Company’s business, financial condition and results of operations.
The Company is a business operating in the challenging and uncertain financial services environment. The success of the Company’s business and operations is sensitive to general business and economic conditions in the U.S. and locally in the Company’s industry and market. If the U.S. economy weakens and a lack of growth in population, income levels, deposits and business investment in the Company’s local market occurs, its growth and profitability from the Company’s lending, deposit and asset management services could be constrained. Although economic conditions have improved in recent years, financial institutions continue to be affected by volatility in the real estate market in some parts of the country and uncertain regulatory and interest rate conditions. The Company has direct exposure to the residential and commercial real estate market in Texas, particularly in the Houston metropolitan area, and could be affected by these events.
Uncertain market and economic conditions can make the Company’s ability to assess the creditworthiness of customers and estimate the losses in its loan portfolio more complex. Another national economic recession or continued deterioration of conditions in the Company’s market could drive losses beyond that which is provided for in its allowance for loan losses and result in the following consequences, any of which could have a material adverse effect on the Company’s business:
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loan delinquencies may rise:
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nonperforming assets and foreclosures may increase;
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demand for the Company’s products and services may decline; and
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collateral securing the Company’s loans, especially real estate, may decline in value, which could reduce customers’ borrowing power and repayment ability.
Low or volatile oil and gas prices could have an adverse impact on economic conditions in the U.S. generally and in the Houston metropolitan area specifically. Declines in real estate values, declines in the volume of home sales and financial stress on borrowers as a result of low oil and gas prices, including job losses, could have an adverse effect on the Company’s borrowers or their customers, which could adversely affect the Company’s business, financial condition and results of operations.
If the goodwill that the Company has recorded in connection with a business acquisition becomes impaired, it could require charges to earnings, which would have a negative impact on the Company’s financial condition and results of operations.
Goodwill represents the amount by which the cost of an acquisition exceeded the fair value of net assets the Company acquired in connection with the purchase of another financial institution. The Company reviews goodwill for impairment at least annually, or more frequently if a triggering event occurs which indicates that the carrying value of the asset might be impaired.
The Company determines impairment by comparing the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. Any such adjustments are reflected in the Company’s results of operations in the periods in which they become known. As of December 31, 2016, the Company’s goodwill totaled $39.4 million. While the Company has not recorded any impairment charges since it initially recorded the goodwill, the Company’s future evaluations of goodwill may result in findings of impairment and related write-downs, which may have a material adverse effect on the Company’s financial condition and results of operations.
The small to medium-sized businesses that the Company lends to may have fewer resources to weather adverse business developments, which may impair a borrower’s ability to repay a loan, and such impairment could adversely affect the Company’s results of operations and financial condition.
The Company focuses its business development and marketing strategy primarily on small to medium-sized businesses, which the Company categorizes as commercial borrowing relationships of less than $5 million of exposure. The Company had loans totaling approximately $1.34 billion to small to medium-sized businesses, or 70.6%, of its total loans, as of December 31, 2016 and $1.21 billion, or 72.0%, of the Company’s total loans as of December 31, 2015. Small to medium-sized businesses frequently have a smaller market share than their competition, may be more vulnerable to economic downturns, often need substantial additional capital to
expand or compete and may experience substantial volatility in operating results, any of which may impair a borrower’s ability to repay a loan. In addition, the success of a small and medium-sized business often depends on the management skills, talents and efforts of one or two people or a small group of people, and the death, disability or resignation of one or more of these people could have a material adverse impact on the business and its ability to repay its loan. If general economic conditions negatively impact the Houston metropolitan area or Texas and small to medium-sized businesses are adversely affected, or the Company’s borrowers are otherwise affected by adverse business developments, the Company’s business, financial condition and results of operations may be negatively affected.
If the Company’s allowance for loan losses is not sufficient to cover actual loan losses, the Company’s earnings may be affected.
The allowance for loan losses is a valuation allowance for probable incurred loan losses. The Company establishes its allowance for loan losses and maintains it at a level management considers adequate to absorb probable incurred loan losses in its loan portfolio. The allowance for loan losses represents the Company’s estimate of probable losses in the portfolio at each balance sheet date and is based upon relevant information available to us, such as past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions and other factors. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited back to the allowance. The Company’s allowance for loan losses consists of a general component based upon probable incurred but unidentified losses in the portfolio and a specific component based on individual loans that are considered impaired. In determining the collectability of certain loans, management also considers the fair value of any underlying collateral. The amount ultimately realized may differ from the carrying value of these assets because of economic, operating or other conditions beyond the Company’s control, and any such differences may be material.
As of December 31, 2016, the Company’s allowance for loan losses was $17.9 million, which represents 0.95% of its total loans and 107.26% of the Company’s total nonperforming loans. As of December 31, 2015, the Company’s allowance for loan losses was $13.1 million, which represented 0.78% of its total loans and 252.66% of the Company’s total nonperforming loans as of the same date. Additional loan losses will likely occur in the future and may occur at a rate greater than the Company has previously experienced. The Company may be required to take additional provisions for loan losses in the future to further supplement the allowance for loan losses, either due to management’s decision to do so or as required by the Company’s banking regulators. In addition, federal and state bank regulatory agencies periodically review the Company’s allowance for loan losses and the value attributed to nonaccrual loans or to real estate acquired through foreclosure. Such regulatory agencies may require the Company to recognize future charge-offs. These adjustments may adversely affect the Company’s business, financial condition and results of operations.
The acquisition method of accounting requires that acquired loans are initially recorded at fair value at the time of acquisition, which includes an estimate of loan losses expected to be realized over the remaining lives of the loans, and therefore no corresponding allowance for loan losses is recorded for these loans at acquisition because credit quality, among other elements, was considered in the determination of fair value. To the extent that the Company’s estimates of fair value are too high, it will incur losses associated with the acquired loans.
As a significant percentage of the Company’s loan portfolio is comprised of real estate loans, an adverse change in the economic conditions of the real estate market where the Company operates could affect real estate values and may result in losses to its business.
As of December 31, 2016, $1.40 billion, or 73.8%, of the Company’s total loans was comprised of loans with real estate as a primary or secondary component of collateral. The real estate collateral provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value over the term of the loan, limiting the Company’s ability to realize the full value of the collateral anticipated at the time of the originating loan. A weakening of the real estate market in the Company’s primary market area could have an adverse effect on the demand for new loans, the ability of borrowers to repay outstanding loans, the value of real estate and other collateral securing the loans and the value of the Company’s business. Collateral may have to be sold for less than the outstanding balance of the loan, which could result in losses on such loans. Such declines and losses in real estate values may cause the Company to experience increases in provisions for loan losses and charge-offs, which could adversely affect its profitability.
The Company’s commercial real estate and construction, land development and other land loan portfolios expose it to credit risks that may be greater than the risks related to other types of loans.
As of December 31, 2016, $892.0 million, or 47.2%, of the Company’s total loans was comprised of commercial real estate loans (including owner-occupied commercial real estate loans) and $159.2 million, or 8.4%, of its total loans was comprised of construction, land development and other land loans. Commercial real estate loans generally involve relatively large balances to single borrowers or related groups of borrowers. Repayment of these loans is typically dependent upon income generated, or expected to be generated, by
the property securing the loan in amounts sufficient to cover operating expenses and debt service. The availability of such income for repayment may be adversely affected by changes in the economy or local market conditions. These loans expose a lender to greater credit risk than loans secured by other types of collateral because the collateral securing these loans is typically more difficult to liquidate due to the fluctuation of real estate values. Unexpected deterioration in the credit quality of the Company’s commercial real estate loan portfolio could require the Company to increase its allowance for loan losses, which would reduce its profitability and may have a material adverse effect on the Company’s business, financial condition and results of operations.
Real estate construction, land development and other similar land loans involve risks attributable to the fact that loan funds are secured by a project under construction, and the project is of uncertain value prior to its completion. These risks include:
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the viability of the contractor:
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the value of the project being subject to successful completion;
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the contractor’s ability to complete the project, to meet deadlines and time schedules and to stay within the Company’s estimates; and
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concentration of such loans with a single contractor and its affiliates.
Real estate construction lending often involves the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project rather than the ability of a borrower or guarantor to repay the loan and also present risks of default in the event of declines in property values or volatility in the real estate market during the construction phase. If the Company is forced to foreclose on a project prior to completion, it may be unable to recover the entire unpaid portion of the loan. In addition, the Company may be required to fund additional amounts to complete a project and may have to hold the property for an indeterminate period of time, any of which could adversely affect the Company’s business, financial condition and results of operations.
A large portion of the Company’s loan portfolio is comprised of commercial and industrial loans secured by receivables, inventory, equipment or other commercial collateral, the deterioration in value of which could increase the potential for future losses.
As of December 31, 2016, $416.8 million, or 22.0%, of the Company’s total loans was comprised of commercial and industrial loans that are typically based on the borrowers’ ability to repay the loans from the cash flow of their businesses. These loans may involve greater risk because the availability of funds to repay each loan depends substantially on the success of the borrower’s business itself and these loans are typically larger in amount, which creates the potential for larger losses on a single loan basis. Commercial and industrial loans are collateralized by general business assets including, among other things, accounts receivable, inventory and equipment and are generally backed by a personal guaranty of the borrower or principal. This collateral may decline in value more rapidly than the Company anticipates, exposing it to increased credit risk. Significant adverse changes in the economy or local market conditions in which the Company’s commercial lending customers operate could cause rapid declines in loan collectability and the values associated with general business assets resulting in inadequate collateral coverage that may expose the Company to credit losses and could adversely affect its business, financial condition and results of operations.
A lack of liquidity could adversely affect the Company’s operations and jeopardize its business, financial condition and results of operations.
Liquidity is essential to the Company’s business. The Company relies on its ability to generate deposits and effectively manage the repayment and maturity schedules of the Company’s loans and investment securities, respectively, to ensure that the Company has adequate liquidity to fund its operations. An inability to raise funds through deposits, borrowings, the sale of the Company’s investment securities, the sale of loans and other sources could have a substantial negative effect on the Company’s liquidity. The Company’s most important source of funds is deposits. Deposit balances can decrease when customers perceive alternative investments as providing a better risk/return tradeoff. If customers move money out of bank deposits and into other investments such as money market funds, the Company would lose a relatively low-cost source of funds, increasing its funding costs and reducing the Company’s net interest income and net income.
Other primary sources of funds consist of cash flows from operations, maturities and sales of investment securities and proceeds from the issuance and sale of the Company’s equity and debt securities to investors. Additional liquidity is provided by the Company’s ability to borrow from the Federal Reserve Bank of Dallas and the Federal Home Loan Bank (the “FHLB”) and the Company’s ability to raise brokered deposits. The Company also may borrow funds from third-party lenders, such as other financial institutions. The Company’s access to funding sources in amounts adequate to finance or capitalize its activities, or on terms that are acceptable to the Company, could be impaired by factors that affect it directly or the financial services industry or economy in general, such as disruptions in the financial markets or negative views and expectations about the prospects for the financial services industry. The
Company’s access to funding sources could also be affected by a decrease in the level of its business activity as a result of a downturn in the economy of the Houston metropolitan area or by one or more adverse regulatory actions against the Company.
As of December 31, 2016, $598.0 million, or 32.0%, of the Company’s deposits consisted of interest-bearing demand deposits and money market and savings accounts. Based on its experience, the Company believes that its deposit accounts are relatively stable sources of funds. If the Company increases interest rates paid to retain deposits, its earnings may be adversely affected, which could have an adverse effect on the Company’s business, financial condition and results of operations.
Any decline in available funding could adversely impact the Company’s ability to originate loans, invest in securities, meet its expenses or to fulfill obligations such as repaying its borrowings or meeting deposit withdrawal demands, any of which could have a material adverse impact on the Company’s liquidity, business, financial condition and results of operations.
If the Company fails to maintain sufficient capital, whether due to losses, an inability to raise additional capital or otherwise, the Company’s financial condition, liquidity and results of operations, as well as its ability to maintain regulatory compliance, could be adversely affected.
The Company, on a consolidated basis, and the Bank, on a stand-alone basis, must meet certain regulatory capital requirements and maintain sufficient liquidity. Importantly, regulatory capital requirements could increase from current levels, which could require the Company to raise additional capital or reduce our operations. The Company’s ability to raise additional capital depends on conditions in the capital markets, economic conditions and a number of other factors, including investor perceptions regarding the banking industry, market conditions and governmental activities, and on the Company’s financial condition and performance. Accordingly, the Company cannot guarantee that it will be able to raise additional capital if needed or on terms acceptable to the Company. If the Company fails to maintain capital to meet regulatory requirements, its liquidity, business, financial condition and results of operations could be materially and adversely affected.
Fluctuations in interest rates may adversely impact the Company’s earnings and capital levels and overall results of operations.
Like most financial institutions, the Company’s earnings and cash flows depend to a great extent upon the level of its net interest income, or the difference between the interest income the Company earns on loans, investments and other interest-earning assets, and the interest expense the Company pays on deposits, borrowings and other interest-bearing liabilities. Therefore, any change in general market interest rates, such as a change in the monetary policy of the Federal Reserve or otherwise, can have a significant effect on the Company’s net interest income. The majority of the Company’s banking assets are monetary in nature and subject to risk from changes in interest rates. Changes in interest rates can increase or decrease the Company’s net interest income, because different types of assets and liabilities may react differently, and at different times, to market interest rate changes. When interest-bearing liabilities mature or reprice more quickly, or to a greater degree than interest-earning assets in a period, an increase in interest rates could reduce net interest income. Similarly, when interest-earning assets mature or reprice more quickly, or to a greater degree than interest-bearing liabilities, falling interest rates could reduce net interest income.
Additionally, an increase in interest rates may, among other things, adversely affect the demand for loans and the Company’s ability to originate loans and decrease loan repayment rates. Conversely, a decrease in the general level of interest rates may affect the Company through, among other things, increased prepayments on its loan and mortgage backed securities portfolio and increased competition for deposits. Accordingly, changes in the general level of market interest rates may adversely affect the Company’s net yield on interest-earning assets, loan origination volume, loan portfolio and the Company’s overall results.
Although the Company’s asset-liability management strategy is designed to control and mitigate exposure to the risks related to changes in market interest rates, those rates are affected by many factors outside of the Company’s control, including various governmental and regulatory monetary policies, inflation, recession, changes in unemployment, the money supply, international disorder and instability in domestic and foreign financial markets. Adverse changes in the Federal Reserve interest rate policies or other changes in monetary policies and economic conditions could materially and adversely affect the Company. The Company may not be able to accurately predict the likelihood, nature and magnitude of those changes or how and to what extent they may affect the Company’s business. The Company also may not be able to adequately prepare for or compensate for the consequences of such changes. Any failure to predict and prepare for changes in interest rates or adjust for the consequences of these changes may adversely affect the Company’s earnings, capital levels and overall results.
The Company could recognize losses on securities held in its securities portfolio, particularly if interest rates increase or economic and market conditions deteriorate.
The Company invests in available for sale securities with the primary objectives of providing a source of liquidity, providing an appropriate return on funds invested, managing interest rate risk, meeting pledging requirements and meeting regulatory capital requirements. As of December 31, 2016, the amortized cost of the Company’s securities portfolio was $321.2 million, which represented 13.1% of total assets. Factors beyond the Company’s control can significantly influence the fair value of securities in its portfolio and can cause potential adverse changes to the fair value of these securities. For example, fixed-rate securities are generally subject to decreases in market value when interest rates rise. Additional factors include, but are not limited to, rating agency downgrades of the securities, defaults by the issuer or individual borrowers with respect to the underlying securities and continued instability in the credit markets. Any of the foregoing factors could cause other-than-temporary impairment in future periods and result in realized losses. The process for determining whether impairment is other-than-temporary usually requires difficult, subjective judgments about the future financial performance of the issuer and any collateral underlying the security in order to assess the probability of receiving all contractual principal and interest payments on the security. Because of changing economic and market conditions affecting interest rates, the financial condition of issuers of the securities and the performance of the underlying collateral, the Company may recognize realized and/or unrealized losses in future periods, which could have an adverse effect on its business, financial condition and results of operations.
The Company faces strong competition to attract and retain customers from other companies that offer banking services, which could impact the Company’s business by preventing it from obtaining customers and adversely affecting the Company’s future growth and profitability.
The Company conducts its operations almost exclusively in the Houston metropolitan area. Many of the Company’s competitors offer the same, or a wider variety of, banking services within this market area. These competitors include banks with nationwide operations, regional banks and other community banks. The Company also faces competition from many other types of financial institutions, including savings banks, credit unions, finance companies, mutual funds, insurance companies, brokerage and investment banking firms, asset-based non-bank lenders and certain other non-financial entities, such as retail stores that may maintain their own credit programs and certain governmental organizations that may offer more favorable financing or deposit terms than the Company can. In addition, a number of out-of-state financial intermediaries have opened production offices, or otherwise solicit deposits, in the Company’s market area. The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Also, technology and other changes have lowered barriers to entry and made it possible for non-banks to offer products and services functionally equivalent to those provided by banks. Increased competition in the Company’s market may result in reduced loans and deposits, as well as reduced net interest margin, fee income and profitability. Ultimately, the Company may not be able to compete successfully against current and future competitors. If the Company is unable to attract and retain banking customers, it may be unable to continue to grow its loan and deposit portfolios, and the Company’s business, financial condition and results of operations could be adversely affected.
The Company’s ability to compete successfully depends on a number of factors, including, among other things:
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the ability to develop, maintain and build long-term customer relationships based on top quality service, high ethical standards and safe, sound assets;
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the scope, relevance and pricing of products and services offered to meet customer needs and demands;
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the rate at which the Company introduces new products and services relative to its competitors;
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customer satisfaction with the Company’s level of service;
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the ability to expand the Company’s market position; and
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industry and general economic trends.
Failure to perform in any of these areas could significantly weaken the Company’s competitive position, which could adversely affect its growth and profitability, which, in turn, could adversely affect the Company’s business, financial condition and results of operations.
Negative public opinion regarding the Company or failure to maintain its reputation in the community that the Company serves could adversely affect the Company’s business and prevent it from growing the Company’s business.
As a community bank, the Company’s reputation within the community it serves is critical to the Company’s success. The Company has set itself apart from its competitors by building strong personal and professional relationships with its customers and by its management and employees being active members of the communities the Company serves. As such, the Company strives to enhance its reputation by recruiting, hiring and retaining employees who share the Company’s core values of being an integral part of the communities it serves and delivering superior service to its customers. If the Company’s reputation is negatively affected by the actions of its employees or otherwise, the Company may be less successful in attracting new customers, and the Company’s business, financial condition, results of operations and prospects could be materially and adversely affected. Further, negative public opinion can expose the Company to litigation and regulatory action as the Company seeks to implement its growth strategy. While the Company actively works to minimize reputation risk in dealing with its customers, this risk will always be present given the nature of the Company’s business.
If the Company fails to maintain an effective system of disclosure controls and procedures and internal controls over financial reporting, the Company may not be able to accurately report its financial results or prevent fraud.
Ensuring that the Company has adequate disclosure controls and procedures, including internal controls over financial reporting, in place so that the Company can produce accurate financial statements on a timely basis is costly and time-consuming and needs to be re-evaluated frequently. The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting and for evaluating and reporting on its system of internal control. The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles (“GAAP”). The Company is in the process of documenting, reviewing and, if appropriate, improving the Company’s internal controls and procedures in anticipation of being subject to the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”), which will require annual management assessments of the effectiveness of the Company’s internal controls over financial reporting and, when the Company ceases to be an emerging growth company under the JOBS Act, a report by the Company’s independent auditors addressing its internal controls over financial reporting. The Company’s management may conclude that its internal controls over financial reporting are not effective due to the Company’s failure to cure any identified material weakness or otherwise. Moreover, even if the Company’s management concludes that the Company’s internal controls over financial reporting are effective, the Company’s independent registered public accounting firm may disagree. In the course of their review, the Company’s independent registered public accounting firm may not be satisfied with the Company’s internal controls over financial reporting or the level at which its controls are documented, designed, operated or reviewed, or it may interpret the relevant requirements differently from the Company. In addition, during the course of the evaluation, documentation and testing of the Company’s internal controls over financial reporting, the Company may identify deficiencies that it may not be able to remediate in time to meet the deadline imposed by the SEC for compliance with the requirements of Section 404 of the Sarbanes-Oxley Act. Any such deficiencies may also subject the Company to adverse regulatory consequences. If the Company fails to achieve and maintain the adequacy of its internal controls over financial reporting, as these standards are modified, supplemented or amended from time to time, the Company may be unable to report its financial information on a timely basis, the Company may not be able to conclude on an ongoing basis that it has effective internal controls over financial reporting in accordance with the Sarbanes-Oxley Act, and the Company may suffer adverse regulatory consequences or violations of listing standards. There could also be a negative reaction in the financial markets due to a loss of investor confidence in the reliability of the Company’s financial statements.
The Company is subject to certain operational risks, including, but not limited to, customer or employee fraud and data processing system failures and errors.
The Company is exposed to many types of operational risk, including the risk of fraud by employees and outsiders, clerical recordkeeping errors and transactional errors. The Company’s business is dependent on its employees as well as third-party service providers to process a large number of increasingly complex transactions. The Company could be materially adversely affected if one of its employees causes a significant operational breakdown or failure, either as a result of human error or where an individual purposefully sabotages or fraudulently manipulates the Company’s operations or systems or if one of its third-party service providers experiences an operational breakdown or failure. Employee errors and employee or customer misconduct could subject the Company to financial losses or regulatory sanctions and seriously harm its reputation. Misconduct by the Company’s employees could include hiding unauthorized activities from the Company, improper or unauthorized activities on behalf of its customers or improper use of confidential information. It is not always possible to prevent employee errors and misconduct, and the precautions the Company takes to prevent and detect this activity may not be effective in all cases. Employee errors could also subject the Company to financial claims for negligence.
The Company maintains a system of internal controls to mitigate against operational risks, including data processing system failures and errors and customer or employee fraud, as well as insurance coverage designed to protect the Company from material losses associated with these risks including losses resulting from any associated business interruption. However, if the Company’s internal controls fail to prevent or detect an occurrence, or if any resulting loss is not insured or exceeds applicable insurance limits, it could have a material adverse effect on the Company’s business, financial condition and results of operations.
In addition, when the Company originates loans, it relies upon information supplied by loan applicants and third parties, including the information contained in the loan application, property appraisal and title information, if applicable, and employment and income documentation provided by third parties. If any of this information is misrepresented and such misrepresentation is not detected prior to loan funding, the Company generally bears the risk of loss associated with the misrepresentation. Any of these occurrences could result in a diminished ability of the Company to operate its business, potential liability to customers, reputational damage and regulatory intervention, which could negatively impact the Company’s business, financial condition and results of operations.
The Company has a continuing need for technological change, and it may not have the resources to effectively implement new technology, or the Company may experience operational challenges when implementing new technology.
The financial services industry is changing rapidly, and to remain competitive, the Company must continue to enhance and improve the functionality and features of its products, services and technologies. In addition to better serving its customers, the effective use of technology increases efficiency and enables financial institutions to reduce costs. The Company’s future success will depend, at least in part, upon its ability to respond to future technological changes and the ability to address the needs of its customers. The Company addresses the needs of its customers by using technology to provide products and services that will satisfy customer demands for convenience as well as to create additional efficiencies in the Company’s operations as it continues to grow and expand the Company’s products and service offerings. The Company may experience operational challenges as it implements these new technology enhancements or products, which could result in the Company not fully realizing the anticipated benefits from such new technology or require the Company to incur significant costs to remedy any such challenges in a timely manner.
These changes may be more difficult or expensive than the Company anticipates. Many of the Company’s larger competitors have substantially greater resources to invest in technological improvements. As a result, they may be able to offer additional or superior products to those that the Company will be able to provide, which would put the Company at a competitive disadvantage. Accordingly, the Company may not be able to effectively implement new technology driven products and services or be successful in marketing such products and services to its customers.
The Company’s operations could be interrupted if its third-party service providers experience difficulty or terminate their services.
The Company depends on a number of relationships with third-party service providers. Specifically, the Company receives certain third-party services including, but not limited to, core systems processing, essential web hosting and other Internet systems, its online banking services, deposit processing and other processing services. While the Company has selected these third-party vendors carefully, it does not control their actions. Any complications caused by these third parties, including those resulting from disruptions in communication services provided by a vendor, failure of a vendor to handle current or higher volumes, cyber-attacks and security breaches at a vendor, failure of a vendor to provide services for any reason or poor performance of services, could adversely affect the Company’s ability to deliver products and services to its customers and otherwise conduct its business. If these third-party service providers experience difficulties, or terminate their services, and the Company is unable to replace them with other service providers, particularly on a timely basis, the Company’s operations could be interrupted. If an interruption were to continue for a significant period of time, the Company’s business, financial condition and results of operations could be adversely affected, perhaps materially. Even if the Company were able to replace third-party service providers, it may be at a higher cost to the Company, which could adversely affect its business, financial condition and results of operations.
System failure or breaches of the Company’s cyber security measures could subject the Company to increased operating costs as well as litigation and other liabilities.
The computer systems and network infrastructure the Company uses, including the systems and infrastructure of the Company’s third-party service providers, could be vulnerable to unforeseen problems. The Company’s operations are dependent upon its ability to protect the Company’s computer equipment, and the information stored therein, against damage from physical theft, fire, power loss, telecommunications failure or a similar catastrophic event, as well as from security breaches, denial of service attacks, viruses or other malware and other disruptive problems caused by hackers. Any damage or failure that causes breakdowns or disruptions in the Company’s general ledger, deposit, loan and other systems could damage its reputation, result in a loss of customer business, subject the Company to additional regulatory scrutiny, including enforcement actions that could restrict the Company’s operations, or expose it to civil litigation and possible financial liability, any of which could have a material adverse effect on the Company. Computer
break-ins, phishing and other disruptions could also jeopardize the security of information stored in and transmitted through the Company’s computer systems and network infrastructure, which may result in significant liability and reputational harm to the Company and may cause existing and potential customers to refrain from doing business with us. In addition, advances in computer capabilities could result in a compromise or breach of the systems the Company and its third-party service providers use to encrypt and protect customer transaction data. A failure of such security measures could have a material adverse effect on the Company’s business, financial condition and results of operations.
Security breaches at third parties may adversely affect the Company’s business.
The Company’s customers interact with their own and other third-party systems, which pose operational risks to us. The Company may be adversely affected by data breaches at retailers and other third parties who maintain data relating to our customers that involve the theft of customer data, including the theft of customers’ debit card, wire transfer and other identifying and/or access information used to make purchases or payments at such retailers and to other third parties. Despite third-party security risks that are beyond our control, the Company provides certain protections against fraud and attendant losses for unauthorized use of debit cards in order to stay competitive in the marketplace. Offering such protection to customers exposes us to significant expenses and potential losses related to reimbursing our customers for fraud losses, reissuing the compromised cards and increased monitoring for suspicious activity. In the event of a data breach at one or more retailers of considerable magnitude, our business, financial condition and results of operations may be adversely affected.
The Company may be subject to environmental liabilities and associated costs in connection with the foreclosure on real estate assets securing the Company loan portfolio, which could adversely affect it.
A significant portion of the Company’s loan portfolio is comprised of loans collateralized by real estate. There is a risk that hazardous or toxic substances could be discovered on the properties that secure the Company’s loans. If the Company acquires such properties as a result of foreclosure, it could be held responsible for the cost of cleaning up or removing this waste, as well as for personal injury and property damage. These costs could exceed the value of the underlying properties and materially and adversely affect the Company. Although the Company has not historically and does not currently hold a material amount of real property in its loan portfolio that the Company believes presents a potential for such environmental risks, the Company does lend to borrowers in segments of the economy that may expose it to heightened environmental risk if the Company was forced to foreclose on a material amount of real property securing such loans.
Risks Related to the Company’s Industry and Regulation
The Company’s business, financial condition, results of operations and future prospects could be adversely affected by the highly regulated environment for bank holding companies and the laws and regulations that govern its operations, corporate governance, executive compensation and accounting principles or changes in any of them.
As a bank holding company, the Company is subject to extensive examination, supervision and comprehensive regulation by various federal and state agencies that govern almost all aspects of its operations. These laws and regulations are not intended to protect the Company’s shareholders. Rather, these laws and regulations are intended to protect customers, depositors, the FDIC's DIF and the overall financial stability of the U.S. These laws and regulations, among other matters, prescribe minimum capital requirements, impose limitations on the business activities in which the Company can engage, limit the dividend or distributions that the Bank can pay to the Company, restrict the ability of institutions to guarantee its debt and impose certain specific accounting requirements on the Company that may be more restrictive and may result in greater or earlier charges to earnings or reductions in its capital than GAAP would require. Compliance with these laws and regulations is difficult and costly, and changes to these laws and regulations often impose additional compliance costs. The Company’s failure to comply with these laws and regulations, even if the failure follows good faith efforts to comply or reflects a difference in interpretation, could subject the Company to restrictions on its business activities, fines and other penalties, any of which could adversely affect the Company’s results of operations, capital base and the price of its securities. Further, any new laws, rules and regulations could make compliance more difficult or expensive.
State and federal banking agencies periodically conduct examinations of the Company’s business, including compliance with laws and regulations, and the Company’s failure to comply with any supervisory actions to which it is or becomes subject as a result of such examinations may adversely affect the Company.
Texas and federal banking agencies, including the TDB and the Federal Reserve, periodically conduct examinations of the Company’s business, including compliance with laws and regulations. If, as a result of an examination, a Texas or federal banking agency were to determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity or other aspects of any of the Company’s operations had become unsatisfactory, or that the Company, the Bank or their respective management were in violation of any law or regulation, it may take a number of different remedial actions as it deems appropriate. These actions include
the power to enjoin “unsafe or unsound” practices, to require affirmative actions to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in the Company’s and/or the Bank’s capital, to restrict its growth, to assess civil monetary penalties against the Company, the Bank or their respective officers or directors, to remove officers and directors and, if it is concluded that such conditions cannot be corrected or there is an imminent risk of loss to depositors, to terminate the Bank’s deposit insurance. If the Company becomes subject to such regulatory actions, its business, financial condition, results of operations, cash flows and reputation may be negatively impacted.
The Company may be unable to identify and consummate its new activities and expansion plans and successfully implement its growth strategy, which will require regulatory approvals, and failure to obtain them may restrict the Company’s growth.
The Company intends to continue to grow its business through strategic acquisitions of financial institutions coupled with organic growth. Generally, the Company must receive state and federal regulatory approval before it can acquire an FDIC-insured depository institution or related business. In determining whether to approve a proposed acquisition, federal banking regulators will consider, among other factors, the effect of the acquisition on competition, the Company’s financial condition, liquidity, its future prospects and the impact of the proposal on U.S. financial stability. The regulators also review current and projected capital ratios and levels, the competence, experience and integrity of management and its record of compliance with laws and regulations, the convenience and needs of the communities to be served (including the acquiring institution’s record of compliance under the CRA) and the effectiveness of the acquiring institution in combating money laundering activities. Such regulatory approvals may not be granted on terms that are acceptable to the Company, or at all, or may be granted only after lengthy delay. The Company may also be required to sell branches as a condition to receiving regulatory approval, which may not be acceptable to the Company or, if acceptable to the Company, may reduce the benefit of any acquisition.
In addition to the acquisition of existing financial institutions, as opportunities arise, the Company plans to continue de novo branching as a part of its organic growth strategy. De novo branching and any acquisitions carry with them numerous risks, including the inability to obtain all required regulatory approvals. The failure to obtain these regulatory approvals for potential future strategic acquisitions and de novo branches may impact the Company’s business plans and restrict its growth.
The Company faces a risk of noncompliance and enforcement action with the Bank Secrecy Act and other anti-money laundering statutes and regulations.
The federal Bank Secrecy Act, the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 and other laws and regulations require financial institutions, among other duties, to institute and maintain an effective anti-money laundering program and file suspicious activity and currency transaction reports as appropriate. The federal Financial Crimes Enforcement Network, established by the U.S. Department of the Treasury (“U.S. Treasury”) to administer the Bank Secrecy Act, is authorized to impose significant civil money penalties for violations of those requirements, and has recently engaged in coordinated enforcement efforts with the individual federal banking regulators, as well as the U.S. Department of Justice (the “Department of Justice”), Drug Enforcement Administration and Internal Revenue Service. There is also increased scrutiny of compliance with the sanctions programs and rules administered and enforced by OFAC.
The Company provides banking services to customers located outside the United States, primarily in Guatemala. These banking services are primarily deposit accounts, including checking, money market and short term certificates of deposit. As of December 31, 2016, the Company’s deposits from foreign nationals, primarily residents of Guatemala, accounted for less than 7.0% of its total deposits.
In order to comply with regulations, guidelines and examination procedures in this area, the Company has dedicated significant resources to its anti-money laundering program. If the Company’s policies, procedures and systems are deemed deficient, the Company could be subject to liability, including fines and regulatory actions such as restrictions on its ability to pay dividends and the necessity to obtain regulatory approvals to proceed with certain aspects of its business plans, including acquisitions and de novo branching. Failure to maintain and implement adequate programs to combat money laundering and terrorist financing could also have serious reputational consequences for us.
The Company is subject to numerous federal and state lending laws designed to protect consumers, including the Community Reinvestment Act and fair lending laws, and failure to comply with these laws could lead to material sanctions and penalties.
The CRA, the Equal Credit Opportunity Act, the Fair Housing Act and other fair lending laws and regulations impose nondiscriminatory lending requirements on financial institutions. The Consumer Financial Protection Bureau, the Department of Justice and other federal and state agencies are responsible for enforcing these laws and regulations. A successful challenge to an institution’s performance under the CRA or fair lending laws and regulations could result in a wide variety of sanctions, including the
required payment of damages and civil money penalties, injunctive relief, imposition of restrictions on mergers and acquisitions activity and restrictions on expansion activity. Private parties may also have the ability to challenge an institution’s performance under fair lending laws in private class action litigation.
The Company may be required to pay significantly higher FDIC deposit insurance assessments in the future, which could adversely affect the Company’s earnings.
As a result of historical economic conditions and the enactment of the Dodd-Frank Act, the FDIC’s current DIF restoration plan is designed to ensure that the fund reserve ratio reaches 1.35% by September 30, 2020. At least semi-annually, the FDIC updates its loss and income projections for the fund and, if needed, increases or decreases assessment rates. If any required increase is insufficient for the DIF to meet its funding requirements, further special assessments or increases in deposit insurance premiums may be required. The Company is generally unable to control the amount of premiums that it is required to pay for FDIC insurance. If there are additional financial institution failures that affect the DIF, the Company may be required to pay FDIC premiums higher than current levels. The Company’s regulatory assessments and FDIC insurance costs were $1.6 million compared with $1.3 million for the years ended December 31, 2016 and 2015, respectively. Any future additional assessments, increases or required prepayments in FDIC insurance premiums may materially adversely affect the Company’s business, financial condition and results of operations.
The Federal Reserve may require the Company to commit capital resources to support the Bank.
A bank holding company is required to act as a source of financial and managerial strength to its subsidiary banks and to commit resources to support its subsidiary banks. The Federal Reserve may require a bank holding company to make capital injections into a troubled subsidiary bank and may charge the bank holding company with engaging in unsafe and unsound practices for failure to commit resources to such a subsidiary bank. Under these requirements, in the future, the Company could be required to provide financial assistance to the Bank if it experiences financial distress.
A capital injection may be required at times when Company resources are limited and the Company may be required to borrow the funds to make the required capital injection. In the event of a bank holding company’s bankruptcy, the bankruptcy trustee will assume any commitment by the holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank. Moreover, bankruptcy law provides that claims based on any such commitment will be entitled to a priority of payment over the claims of the holding company’s general unsecured creditors, including the holders of any note obligations. Thus, any borrowing that must be done by the holding company in order to make the required capital injection becomes more difficult and expensive and will adversely impact the holding company’s business, financial condition and results of operations.
The Company may be materially and adversely affected by the soundness, creditworthiness and liquidity of other financial institutions.
Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. The Company has exposure to many different industries and counterparties, and routinely executes transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks and other institutional customers. Many of these transactions expose the Company to credit risk in the event of a default by a counterparty or customer. In addition, the Company’s credit risk may be exacerbated when the collateral held by the Company cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due to the Company. Any such losses could have a material adverse effect on the Company’s business, financial condition and results of operations.
Monetary policies and regulations of the Federal Reserve could adversely affect the Company’s business, financial condition and results of operations.
In addition to being affected by general economic conditions, the Company’s earnings and growth are affected by the policies of the Federal Reserve. An important function of the Federal Reserve is to regulate the U.S. money supply and credit conditions. Among the instruments used by the Federal Reserve to implement these objectives are open market operations in U.S. government securities, adjustments of both the discount rate and the federal funds rate and changes in reserve requirements against bank deposits. These instruments are used in varying combinations to influence overall economic growth and the distribution of credit, bank loans, investments and deposits. Their use also affects interest rates charged on loans or paid on deposits. The monetary policies and regulations of the Federal Reserve have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. Although the Company cannot determine the effects of such policies on it at this time, such policies could have a material adverse effect on the Company’s business, financial condition and results of operations.
Risks Related to Allegiance's Common Stock
The market price of Allegiance's common stock could be volatile and may fluctuate significantly, which could cause the value of an investment in Allegiance's common stock to decline.
The market price of Allegiance's common stock could fluctuate substantially due to a variety of factors, many of which are beyond the Company’s control, including, but not limited to:
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general economic conditions and overall market fluctuations;
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actual or anticipated fluctuations in the Company’s quarterly or annual financial results;
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operating and stock price performance of other companies that investors deem comparable to the Company’s;
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the perception that investment in Texas is unattractive or less attractive during periods of low oil prices;
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announcements by the Company or its competitors of significant acquisitions, dispositions, innovations or new programs and services;
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the public reaction to the Company’s press releases, other public announcements and filings with the SEC;
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changes in financial estimates and recommendations by securities analysts following Allegiance's stock, or the failure of securities analysts to cover Allegiance's common stock;
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changes in earnings estimates by securities analysts or the Company’s ability to meet those estimates;
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the trading volume of Allegiance's common stock;
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changes in governmental monetary policies, including the policies of the Federal Reserve;
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changes in business, legal or regulatory conditions, or other developments affecting participants in the Company’s industry, and publicity regarding the Company’s business or any of its significant customers or competitors;
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changes in accounting standards, policies, guidance, interpretations or principles; and
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future sales of Allegiance's common stock by the Company, directors, executives and significant shareholders.
The realization of any of the risks described in this “Risk Factors” section could have a material adverse effect on the market price of Allegiance's common stock and cause the value of an investment in Allegiance's common stock to decline. In addition, the stock market has experienced extreme volatility that has often been unrelated to the operating performance of particular companies. These types of broad market fluctuations may adversely affect investor confidence and could affect the trading price of Allegiance's common stock over the short, medium or long term, regardless of the Company’s actual performance. In the past, following periods of volatility in the market price of a company’s securities, shareholders have often instituted securities class action litigation. If the Company were to be involved in a class action lawsuit, the Company could incur substantial costs and it could divert the attention of senior management and have a material adverse effect on the Company’s business, financial condition and results of operations.
The obligations associated with being a public company require significant resources and management attention.
As a public company, Allegiance faces increased legal, accounting, administrative and other costs and expenses that the Company did not incur as a private company, particularly after Allegiance is no longer an emerging growth company. As a public company, Allegiance is required to:
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prepare and distribute periodic reports, proxy statements and other shareholder communications in compliance with the federal securities laws and rules;
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expand the roles and duties of Allegiance's Board of Directors and committees thereof;
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maintain an internal audit function;
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institute more comprehensive financial reporting and disclosure compliance procedures;
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involve and retain to a greater degree outside counsel and accountants in the activities listed above;
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enhance Allegiance's investor relations function;
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establish new internal policies, including those relating to trading in the Company’s securities and disclosure controls and procedures;
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retain additional personnel;
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comply with The NASDAQ Stock Market listing standards; and
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comply with the Sarbanes-Oxley Act.
Allegiance expects these rules and regulations and changes in laws, regulations and standards relating to corporate governance and public disclosure, which have created uncertainty for public companies, to increase legal and financial compliance costs and make some activities more time consuming and costly relative to when Allegiance was not a public company. These laws, regulations and standards are subject to varying interpretations, in many cases due to their lack of specificity, and, as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies. This could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. The Company’s investment in compliance with existing and evolving regulatory requirements will result in increased administrative expenses and a diversion of management’s time and attention from revenue-generating activities to compliance activities, which could have a material adverse effect on the Company’s business, financial condition and results of operations. These increased costs may require the Company to divert a significant amount of money that it could otherwise use to expand the Company’s business and achieve its strategic objectives.
Allegiance may issue shares of preferred stock in the future, which could make it difficult for another company to acquire it or could otherwise adversely affect the rights of the holders of Allegiance's common stock, which could depress the price of its common stock.
Allegiance's amended and restated certificate of formation authorizes it to issue up to 1,000,000 shares of one or more series of preferred stock. Allegiance's Board of Directors, in its sole discretion, has the authority to determine the preferences, limitations and relative rights of shares of preferred stock and to fix the number of shares constituting any series, the designation of such series, and the dividend rate for each series, without any further vote or action by Allegiance's shareholders. Allegiance's preferred stock may be issued with voting, liquidation, dividend and other rights superior to the rights of Allegiance's common stock. The potential issuance of preferred stock may delay or prevent a change in control of the Company, discouraging bids for Allegiance's common stock at a premium over the market price, and materially adversely affect the market price and the voting and other rights of the holders of Allegiance's common stock.
Allegiance currently has no plans to pay dividends on its common stock, so holders of Allegiance's common stock may not receive funds without selling their common stock.
The Company has not paid dividends on its common stock in the past, and does not anticipate paying any dividends on Allegiance's common stock in the foreseeable future. Allegiance's ability to pay dividends on its common stock is dependent on the Bank’s ability to pay dividends to it, which is limited by applicable laws and banking regulations. Payments of future dividends, if any, will be at the discretion of Allegiance's Board of Directors after taking into account various factors, including the Company’s business, operating results and financial condition, current and anticipated cash needs, plans for expansion and any legal or contractual limitations on its ability to pay dividends. In addition, Allegiance's existing credit agreement restricts its ability to pay dividends.
Allegiance is dependent upon the Bank for cash flow, and the Bank’s ability to make cash distributions is restricted, which could impact Allegiance's ability to satisfy its obligations.
Allegiance's primary tangible asset is the Bank. As such, Allegiance depends upon the Bank for cash distributions (through dividends on the Bank’s stock) that Allegiance uses to pay its operating expenses and satisfy its obligations, including debt obligations. There are numerous laws and banking regulations that limit the Bank’s ability to pay dividends to Allegiance. If the Bank is unable to pay dividends to Allegiance, it will not be able to satisfy its obligations. These statutes and regulations require, among other things, that the Bank maintain certain levels of capital in order to pay a dividend. Further, federal and state banking authorities have the ability to restrict the Bank’s payment of dividends through supervisory action.
Allegiance is an “emerging growth company,” and it cannot be certain if the reduced disclosure requirements applicable to emerging growth companies will make its common stock less attractive to investors.
Allegiance is an “emerging growth company,” as defined in the JOBS Act. As such, Allegiance is eligible to take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies. These exemptions allow Allegiance, among other things;
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to present only two years of audited financial statements and discuss the Company’s results of operations for only two years in related Management’s Discussions and Analyses;
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not to provide an auditor attestation of the Company’s internal control over financial reporting;
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to choose not to comply with any new requirements adopted by the Public Company Accounting Oversight Board requiring mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the Company’s audited financial statements;
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to provide reduced disclosure regarding the Company’s executive compensation arrangements pursuant to the rules applicable to smaller reporting companies, which means it does not have to include a compensation discussion and analysis and certain other disclosure regarding the Company’s executive compensation; and
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not to seek a non-binding advisory vote on executive compensation or golden parachute arrangements.
In addition, even if Allegiance complies with the greater disclosure obligations of public companies that are not emerging growth companies, Allegiance may avail itself of these reduced requirements applicable to emerging growth companies from time to time in the future, so long as Allegiance is an emerging growth company. Allegiance will remain an emerging growth company for up to five years, though it may cease to be an emerging growth company earlier under certain circumstances, including if, before the end of such five years, Allegiance is deemed to be a large accelerated filer under the rules of the SEC (which depends on, among other things, having a market value of common stock held by non-affiliates in excess of $700.0 million). Investors and securities analysts may find it more difficult to evaluate Allegiance's common stock because it may rely on one or more of these exemptions, and, as a result, investor confidence and the market price of Allegiance's common stock may be materially and adversely affected.
Allegiance's corporate governance documents and certain corporate and banking provisions of Texas law applicable to the Company could have an anti-takeover effect and may delay, make more difficult or prevent an attempted acquisition of the Company and other actions.
Allegiance's amended and restated certificate of formation and bylaws contain certain provisions that may have an anti-takeover effect and may delay, discourage or prevent an attempted acquisition or change of control of the Company. These provisions include:
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staggered terms for directors, who may be removed from office only for cause;
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a provision establishing certain advance notice procedures for nomination of candidates for election as directors and for shareholder proposals; and
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a provision that any special meeting of Allegiance's shareholders may be called only by a majority of the Board of Directors, the President or a holder or group of holders of at least 50% of Allegiance shares entitled to vote at the meeting.
Allegiance's amended and restated certificate of formation does not provide for cumulative voting for directors and authorizes the Board of Directors to issue shares of its preferred stock without shareholder approval and upon such terms as the Board of Directors may determine. The issuance of Allegiance's preferred stock, while providing desirable flexibility in connection with possible acquisitions, financings and other corporate purposes, could have the effect of making it more difficult for a third party to acquire, or of discouraging a third-party from acquiring, a controlling interest in Allegiance. In addition, certain provisions of Texas law, including a provision that restricts certain business combinations between a Texas corporation and certain affiliated shareholders, may delay, discourage or prevent an attempted acquisition or change in control.
In addition, banking laws impose notice, approval and ongoing regulatory requirements on any shareholder or other party that seeks to acquire direct or indirect “control” of an FDIC-insured depository institution. These laws include the BHC Act and the Change in Bank Control Act. These laws could delay or prevent an acquisition.
Furthermore, Allegiance's amended and restated certificate of formation provides that the state and federal courts located in Harris County, Texas, the county in which the City of Houston lies, will be the exclusive forum for: (a) any derivative action or proceeding
brought on Allegiance's behalf; (b) any action asserting a breach of fiduciary duty; (c) any action asserting a claim against the Company arising pursuant to the Texas Business Organizations Code, Allegiance's certificate of formation, or Allegiance's bylaws; or (d) any action asserting a claim against Allegiance that is governed by the internal affairs doctrine. Shareholders of Allegiance are deemed to have notice of and have consented to the provisions of Allegiance's amended and restated certificate of formation related to choice of forum. The choice of forum provision in Allegiance's amended and restated certificate of formation may limit its shareholders’ ability to obtain a favorable judicial forum for disputes with Allegiance. Alternatively, if a court were to find the choice of forum provision contained in Allegiance's amended and restated certificate of formation to be inapplicable or unenforceable in an action, Allegiance may incur additional costs associated with resolving such action in other jurisdictions, which could harm Allegiance's business, operating results and financial condition.
Shareholders may be deemed to be acting in concert or otherwise in control of Allegiance, which could impose notice, approval and ongoing regulatory requirements and result in adverse regulatory consequences for such holders.
Allegiance is a bank holding company regulated by the Federal Reserve. Banking laws impose notice, approval and ongoing regulatory requirements on any shareholder or other party that seeks to acquire direct or indirect “control” of an FDIC-insured depository institution or a company that controls an FDIC-insured depository institution, such as a bank holding company. These laws include the BHC Act and the Change in Bank Control Act. The determination whether an investor “controls” a depository institution or holding company is based on all of the facts and circumstances surrounding the investment.
As a general matter, a party is deemed to control a depository institution or other company if the party (1) owns or controls 25% or more of any class of voting stock of the bank or other company, (2) controls the election of a majority of the directors of the bank or other company or (3) has the power to exercise a controlling influence over the management or policies of the bank or other company. In addition, subject to rebuttal, a party may be presumed to control a depository institution or other company if the investor owns or controls 10% or more of any class of voting stock. Ownership by affiliated parties, or parties acting in concert, is typically aggregated for these purposes. “Acting in concert” generally means knowing participation in a joint activity or parallel action towards the common goal of acquiring control of a bank or a parent company, whether or not pursuant to an express agreement. The manner in which this definition is applied in individual circumstances can vary and cannot always be predicted with certainty. Any shareholder that is deemed to “control” Allegiance for regulatory purposes would become subject to notice, approval and ongoing regulatory requirements and may be subject to adverse regulatory consequences. Potential investors are advised to consult with their legal counsel regarding the applicable regulations and requirements.
An investment in Allegiance's common stock is not an insured deposit and is not guaranteed by the FDIC, so investors could lose some or all of their investment.
An investment in Allegiance's common stock is not a bank deposit and, therefore, is not insured against loss or guaranteed by the FDIC, any other deposit insurance fund or by any other public or private entity. An investment in Allegiance's common stock is inherently risky for the reasons described herein. As a result, investors could lose some or all of their investment.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
Allegiance's principal executive office is located at 8847 W. Sam Houston Parkway N., Suite 200, Houston, Texas 77040. As of December 31, 2016, the Company had 16 full-service branches located in the Houston metropolitan area. On January 31, 2016, the Company completed the sale of its two Central Texas branches and their related assets, which the Company acquired on January 1, 2015 in connection with its acquisition of F&M Bancshares. In January 2017, the Company opened a loan production office in Houston, Texas.
The following table sets forth a list of Allegiance's principal executive office, Allegiance Bank branch locations and its loan production office.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
From time to time, the Company is subject to claims and litigation arising in the ordinary course of business. In the opinion of management, the Company is not party to any legal proceedings the resolution of which it believes would have a material adverse effect on the Company’s business, prospects, financial condition, liquidity, results of operation, cash flows or capital levels. However, one or more unfavorable outcomes in any claim or litigation against the Company could have a material adverse effect for the period in which such claim or litigation is resolved. In addition, regardless of their merits or their ultimate outcomes, such matters are costly, divert management’s attention and may materially adversely affect the Company’s reputation, even if resolved in its favor. The Company intends to defend itself vigorously against any future claims or litigation.
ITEM 4.
ITEM 4. MINE SAFETY DISCLOSURES
None.
PART II.
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Common Stock Market Prices
Allegiance's common stock is listed on the NASDAQ Global Market under the symbol “ABTX.” Quotations of the sales volume and the closing sales prices of the common stock of Allegiance are listed daily in the NASDAQ Global Market’s listings. As of March 8, 2017, there were 13,073,352 shares outstanding and 570 shareholders of record of Allegiance's common stock.
The following table presents the high and low intraday sales prices for Allegiance's common stock as reported by the NASDAQ Global Market:
Prior to Allegiance's initial public offering on October 8, 2015, there was no established public trading market for Allegiance's common stock.
Dividends
Allegiance has not declared or paid any dividends on its common stock in the past. Allegiance currently intends to retain all of its future earnings, if any, for use in its business and does not anticipate paying cash dividends on Allegiance's common stock in the foreseeable future. Payments of future dividends, if any, will be at the discretion of Allegiance's Board of Directors after taking into account various factors, including its business, operating results and financial condition, current and anticipated cash needs, plans for expansion and any legal or contractual limitations on Allegiance's ability to pay dividends.
As a bank holding company, Allegiance's ability to pay dividends is affected by the regulations promulgated by and the policies and enforcement powers of the Federal Reserve. In addition, because Allegiance is a holding company, it is dependent upon the payment of dividends by the Bank to Allegiance as its principal source of funds to pay dividends in the future, if any, and to make other payments. The Bank is also subject to various legal, regulatory and other restrictions on its ability to pay dividends and make other distributions and payments to Allegiance. See Item 1. “Business-Regulation and Supervision-Regulatory Limits on Dividends and Distributions.”
In connection with the F&M Bancshares acquisition, Allegiance assumed junior subordinated debentures that allow it to defer interest payments thereunder for a period of time. To the extent Allegiance elects to defer any interest payments under the junior subordinated debentures, Allegiance will be prohibited by the terms of the junior subordinated debentures from making dividend payments on its
common stock until it retires the arrearages on the junior subordinated debentures. In addition, Allegiance's existing credit agreement restricts its ability to pay dividends.
Recent Sales of Unregistered Securities
None.
Securities Authorized for Issuance under Equity Compensation Plans
The following table provides information as of December 31, 2016, regarding the equity compensation plans under which Allegiance’s equity securities are authorized for issuance:
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
None.
Performance Graph
The following Performance Graph compares the cumulative total shareholder return on Allegiance's common stock for the period beginning at the close of trading on October 8, 2015 (the end of the first day of trading of Allegiance's common stock on the NASDAQ Global Market) to December 31, 2016, with the cumulative total return of the S&P 500 Total Return Index and the NASDAQ Bank Index for the same period. Dividend reinvestment has been assumed. The Performance Graph assumes $100 invested on October 8, 2015 in Allegiance's common stock, the S&P 500 Total Return Index and the NASDAQ Bank Index. The historical stock price performance for Allegiance's common stock shown on the graph below is not necessarily indicative of future stock performance.
*$100 invested on 10/8/15 in Allegiance's common stock or 9/30/15 in index, including reinvestment of dividends. Fiscal year ending December 31.
(Copyright © 2017 Standard & Poor's, a division of S&P Global. All rights reserved.)
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth the Company’s selected historical consolidated financial data for the periods and as of the dates indicated. You should read this information together with Item 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with Item 6. “Selected Financial Data” and the Company’s consolidated financial statements and the accompanying notes included elsewhere in this Annual Report on Form 10-K. This discussion and analysis contains forward-looking statements that are subject to certain risks and uncertainties and are based on certain assumptions that the Company believes are reasonable but may prove to be inaccurate. Certain risks, uncertainties and other factors, including those set forth under “ - Cautionary Notice Regarding Forward-Looking Statements,” in this Item 7, under Item 1A. “Risk Factors” and elsewhere in this Annual Report on Form 10-K, may cause actual results to differ materially from those projected results discussed in the forward-looking statements appearing in this discussion and analysis. The Company assumes no obligation to update any of these forward-looking statements.
Cautionary Notice Regarding Forward-Looking Statements
Statements and financial discussion and analysis contained in this Annual Report on Form 10-K that are not historical facts are forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. We also may make forward-looking statements in our other documents filed or furnished with the SEC. In addition, our senior management may make forward-looking statements orally to investors, analysts, representatives of the media and others. Statements preceded by, followed by or that otherwise include the words “believes,” “expects,” “anticipates,” “intends,” “projects,” “estimates,” “plans” and similar expressions or future or conditional verbs such as “will,” “should,” “would,” “may” and “could” are generally forward-looking in nature and not historical facts, although not all forward looking statements include the foregoing. Forward-looking statements are based on assumptions and involve a number of risks and uncertainties, many of which are beyond our control. Many possible events or factors could affect our future financial results and performance and could cause such results or performance to differ materially from those expressed in our forward-looking statements.
While there is no assurance that any list of risks and uncertainties or risk factors is complete, below are certain factors which could cause our actual results to differ from those in our forward-looking statements:
•
risks related to the concentration of our business in the Houston metropolitan area, including risks associated with volatility or decreases in oil and gas prices or prolonged periods of lower oil and gas prices;
•
general market conditions and economic trends nationally, regionally and particularly in the Houston metropolitan area;
•
our ability to retain executive officers and key employees and their customer and community relationships;
•
our ability to recruit and retain successful bankers that meet our expectations in terms of customer and community relationships and profitability;
•
risks related to our strategic focus on lending to small to medium-sized businesses;
•
our ability to implement our growth strategy, including through the identification of acquisition candidates that will be accretive to our financial condition and results of operations, as well as permitting decision-making authority at the branch level;
•
risks related to any businesses we acquire in the future, including exposure to potential asset and credit quality risks and unknown or contingent liabilities, the time and costs associated with integrating systems, technology platforms, procedures and personnel, the need for additional capital to finance such transactions and possible failures in realizing the anticipated benefits from such acquisitions;
•
potential impairment on the goodwill we have recorded or may record in connection with business acquisitions;
•
risks associated with our owner-occupied commercial real estate loan and other commercial real estate loan portfolios, including the risks inherent in the valuation of the collateral securing such loans;
•
risks associated with our commercial and industrial loan portfolio, including the risk for deterioration in value of the general business assets that generally secure such loans;
•
the accuracy and sufficiency of the assumptions and estimates we make in establishing reserves for potential loan losses and other estimates;
•
risk of deteriorating asset quality and higher loan charge-offs, as well as the time and effort necessary to resolve nonperforming assets;
•
potential changes in the prices, values and sales volumes of commercial and residential real estate securing our real estate loans;
•
changes in market interest rates that affect the pricing of our loans and deposits and our net interest income;
•
potential fluctuations in the market value and liquidity of the securities we hold for sale;
•
risk of impairment of investment securities, goodwill, other intangible assets or deferred tax assets;
•
the effects of competition from a wide variety of local, regional, national and other providers of financial, investment and insurance services, which may adversely affect our pricing and terms;
•
risks associated with negative public perception of the Company;
•
our ability to maintain an effective system of disclosure controls and procedures and internal controls over financial reporting;
•
risks associated with fraudulent and negligent acts by our customers, employees or vendors;
•
our ability to keep pace with technological change or difficulties when implementing new technologies;
•
risks associated with system failures or failures to protect against cybersecurity threats, such as breaches of our network security;
•
risks associated with data processing system failures and errors;
•
potential risk of environmental liability related to lending activities;
•
the institution and outcome of litigation and other legal proceeding against us or to which we become subject;
•
our ability to maintain adequate liquidity and to raise necessary capital to fund our acquisition strategy and operations or to meet increased minimum regulatory capital levels;
•
our ability to comply with various governmental and regulatory requirements applicable to financial institutions;
•
the impact of recent and future legislative and regulatory changes, including changes in banking, securities and tax laws and regulations and their application by our regulators, such as the further implementation of the Dodd-Frank Act;
•
governmental monetary and fiscal policies, including the policies of the Federal Reserve;
•
our ability to comply with supervisory actions by federal and state banking agencies;
•
changes in the scope and cost of FDIC insurance and other coverage;
•
systemic risks associated with the soundness of other financial institutions;
•
the effects of war or other conflicts, acts of terrorism (including cyberattacks) or other catastrophic events, including storms, droughts, tornadoes and flooding, that may affect general economic conditions; and
•
other risks and uncertainties listed from time to time in our reports and documents filed with the SEC.
Further, these forward-looking statements speak only as of the date on which they were made and we undertake no obligation to update or revise any forward-looking statements to reflect events or circumstances after the date on which these statements are made or to reflect the occurrence of unanticipated events, unless required to do so under the federal securities laws. Other factors not identified above, including those described under the headings Item 1A. “Risk Factors” and Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” may also cause actual results to differ materially from those described in our forward looking statements. Most of these factors are difficult to anticipate and are generally beyond our control. You should consider these factors in connection with considering any forward-looking statements that may be made by us.
Overview
We generate most of our revenues from interest income on loans, service charges on customer accounts and interest income from investments in securities. We incur interest expense on deposits and other borrowed funds and noninterest expenses such as salaries and employee benefits and occupancy expenses. Net interest income is the difference between interest income on earning assets such as loans and securities and interest expense on liabilities such as deposits and borrowings that are used to fund those assets. Net interest income is our largest source of revenue. To evaluate net interest income, we measure and monitor (1) yields on our loans and other interest-earning assets, (2) the interest expenses of our deposits and other funding sources, (3) our net interest spread and (4) our net interest margin. Net interest spread is the difference between rates earned on interest-earning assets and rates paid on interest-bearing liabilities. Net interest margin is calculated as net interest income divided by average interest-earning assets. Because noninterest-bearing sources of funds, such as noninterest-bearing deposits and stockholders’ equity, also fund interest-earning assets, net interest margin includes the benefit of these noninterest-bearing sources.
Our net interest income is affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as a “volume change.” Periodic changes in the volume and types of loans in our loan portfolio are affected by, among other factors, economic and competitive conditions in Texas and specifically in the Houston metropolitan area, as well as developments affecting the real estate, technology, financial services, insurance, transportation, manufacturing and energy sectors within our target market and throughout the state of Texas.
Our net interest income is also affected by changes in yields earned on interest-earning assets and rates paid on interest-bearing deposits and other borrowed funds, referred to as a “rate change.” Fluctuations in market interest rates are driven by many factors, including governmental monetary policies, inflation, deflation, macroeconomic developments, changes in unemployment, the money supply, political and international conditions and conditions in domestic and foreign financial markets.
On January 1, 2015, we completed the acquisition of F&M Bancshares and its wholly-owned subsidiary bank, Enterprise Bank. The results for the year ended 2015 reflect the combined entity. The impact of this acquisition is not reflected in the discussion and analysis of our financial condition and results of operations as of and for the year ended December 31, 2014. As of December 31, 2014, F&M Bancshares, on a consolidated basis, reported total assets of $569.7 million, total loans of $410.2 million and total deposits of $488.9 million. Because the acquisition closed on January 1, 2015, our historical financial condition and results of operations as of and for periods ended on or before December 31, 2014 contained in this Annual Report on Form 10-K do not reflect the financial condition and results of operations of F&M Bancshares. In connection with the acquisition of F&M Bancshares, we incurred approximately $29.3 million in indebtedness, including by borrowing approximately $18.0 million under our revolving credit agreement to repay debt that F&M Bancshares owed to its shareholders and the assumption of junior subordinated debentures with an aggregate original principal amount of $11.3 million issued to two statutory trusts.
In addition to the impact of the acquisition of F&M Bancshares, the comparability of our consolidated results of operations for the years ended December 31, 2014 and 2013 may be affected by our acquisition of Independence Bank, National Association (“Independence”) during the fourth quarter of 2013. The results of the acquired operations of Independence were included in our results of operations for only a portion of 2013, as compared to the full years 2014, 2015 and 2016.
Initial Public Offering
We completed an initial public offering of 2,990,000 shares of Allegiance's common stock at $21.00 per share on October 7, 2015, generating net proceeds of $57.1 million. The period-over-period comparability of certain aspects of our results of operations and the changes in our financial condition from December 31, 2014 to December 31, 2016 are affected by the issuance of these shares in the offering and our receipt of the net proceeds of the sale of shares of Allegiance's common stock. In particular, the period-over-period comparability of our earnings per share and return of equity is also affected. Allegiance's common stock began trading on the NASDAQ Global Market on October 8, 2015 under the ticker symbol “ABTX.”
Critical Accounting Policies
Our accounting policies are integral to understanding our results of operations. Our accounting policies are described in detail in Note 1 included elsewhere in our annual consolidated financial statements. We believe that of our accounting policies, the following policies may involve a higher degree of judgment and complexity.
Securities
Debt securities are classified as available for sale when they might be sold before maturity. Securities available for sale are carried at fair value. Unrealized gains and losses are excluded from earnings and reported, net of tax, as a separate component of stockholders’ equity until realized. Securities within the available for sale portfolio may be used as part of our asset/liability strategy and may be sold in response to changes in interest rate risk, prepayment risk or other similar economic factors.
Interest earned on these assets is included in interest income. Interest income includes amortization of purchase premium or discount. Premiums and discounts on securities are amortized on the level-yield method, except for mortgage backed securities where prepayments are anticipated. Gains and losses on sales are recorded on the trade date and determined using the specific identification method.
Management evaluates debt securities for other-than-temporary impairment (“OTTI”) on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: (1) OTTI related to credit loss, which must be recognized in the income statement, and (2) OTTI related to other factors, which is recognized in other comprehensive income, net of applicable taxes. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. The previous amortized cost basis less the OTTI recognized in earnings becomes the new amortized cost basis of the security.
Loans Held for Investment
Loans held for investment are those that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of deferred loan fees and costs, and an allowance for loan losses. Loans are typically secured by specific items of collateral including business assets, consumer assets, and commercial and residential real estate. Commercial loans are expected to be repaid from cash flow from operations of businesses. Interest income is accrued on the unpaid principal balance.
Nonperforming and Past Due Loans
Loans are placed on nonaccrual status when payment in full of principal or interest is not expected or upon which principal or interest has been in default for a period of 90 days or more unless the asset is both well secured and in the process of collection. If the decision is made to continue accruing interest on the loan, periodic reviews are made to confirm the accruing status of the loan. Nonaccrual loans and loans past due 90 days include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans.
When available information confirms that specific loans, or portions thereof, are uncollectible, these amounts are charged off against the allowance. All loan types are considered delinquent after 30 days past due and are typically charged off or charged down no later than 120 days past due, with consideration of, but not limited to, the following criteria in determining the need and optional timing of the charge-off or charge-down: (1) the Bank is in the process of repossession or foreclosure and there appears to be a likely deficiency, (2) the collateral securing the loan has been sold and there is an actual deficiency, (3) the Bank is proceeding with lengthy legal action to collect its balance, (4) the borrower is unable to be located or (5) the borrower has filed bankruptcy. Events requiring charge-offs occur when a shortfall is identified between the recorded investment in the loan and the underlying value of the collateral.
Allowance for Loan Losses
The allowance for loan losses is a valuation allowance that is established through charges to earnings in the form of a provision for loan losses. The amount of the allowance for loan losses is affected by the following: (1) charge-offs of loans that decrease the allowance, (2) subsequent recoveries on loans previously charged off that increase the allowance and (3) provisions for loan losses charged to income that increase the allowance.
Throughout the year, management estimates the probable incurred losses in the loan portfolio to determine if the allowance for loan losses is adequate to absorb such losses. The allowance for loan losses consists of specific and general components. The specific component relates to loans that are individually classified as impaired. We follow a loan review program to evaluate the credit risk in the loan portfolio. Loans that have been identified as impaired are reviewed on a quarterly basis in order to determine whether a specific reserve is required. The general component covers non-impaired loans and is based on industry and our specific historical loan loss experience, volume, growth and composition of the loan portfolio, the evaluation of our loan portfolio through our internal loan review process, general current economic conditions both internal and external to us that may affect the borrower’s ability to pay, value of collateral and other qualitative relevant risk factors. Based on a review of these estimates, we adjust the allowance for loan losses to a level determined by management to be adequate. Estimates of loan losses are inherently subjective as they involve an exercise of judgment.
Our allowance for loan losses, both in dollars and as a percentage of total loans, may not be comparable to other similar sized institutions due to the impact of acquisition accounting. As part of acquisition accounting, acquired loans are initially recognized at fair value with no corresponding allowance for loan losses. Initial fair value of the loans includes consideration of expected credit losses.
Loans for which the terms have been modified, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and therefore classified as impaired. Subsequent to identification as a troubled debt restructuring, such loans are then evaluated for impairment on an individual basis whereby we determine the amount of reserve in accordance with the accounting policy for the impaired loans as part of our allowance for loan losses calculation. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral.
Accounting for Acquired Loans
At the time of an acquisition, we evaluate loans to determine if they are purchased credit impaired loans. Purchased credit impaired loans are those acquired loans with evidence of credit deterioration for which it was probable at acquisition that we would be unable to collect all contractual payments. We make this determination by considering past due and/or nonaccrual status, prior designation of a troubled debt restructuring or other factors that may suggest we will not be able to collect all contractual payments. Purchased credit impaired loans are initially recorded at fair value with the difference between fair value and estimated future cash flows accreted over the expected cash flow period as income only to the extent we can reasonably estimate the timing and amount of future cash flows. In this case, these loans would be classified as accruing. In the event we are unable to reasonably estimate timing and amount of future cash flows, the loan is classified as non-accrual. An acquired loan previously classified by the seller as a troubled debt restructuring is no longer classified as such at the date of acquisition. Past due status is reported based on contractual payment status.
Our purchased credit impaired loans have generally been de minimis and comprised less than 0.04% of our loan portfolio at December 31, 2016. Historically, purchased credit impaired loans have been placed on nonaccrual status and reported as such until we were able to reasonably estimate the timing and amount of future expected cash flows. Income associated with purchased credit impaired loans for 2016 and prior periods has been immaterial.
All loans not otherwise classified as purchased credit impaired are recorded at fair value with the discount to contractual value accreted over the life of the loan. When determining the allowance for loan losses on acquired loans, we bifurcate the allowance between legacy loans and acquired loans. Loans remain designated as acquired until either the loan is (1) renewed or (2) substantially modified whereby modification results in a new loan. When determining the allowance on acquired loans, the Company estimates principal losses as compared to the Company’s recorded investment, with the recorded investment being net of any unaccreted discounts from the acquisition. At December 31, 2016, we had $193.8 million in acquired loans that had not been renewed or substantially modified which is net of an unaccreted discount of $840 thousand or 0.43%.
Goodwill
Goodwill resulting from business combinations is generally determined as the excess of the fair value of the consideration transferred, plus the fair value of any noncontrolling interests in the acquiree, over the fair value of the net assets acquired and liabilities assumed as of the acquisition date. Goodwill is assessed annually for impairment or when events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. Goodwill acquired in a purchase business combination that is determined to have an indefinite useful life is not amortized, but is tested for impairment. We perform our annual impairment test on October 1st. Goodwill is the only intangible asset with an indefinite life on our balance sheet.
Emerging Growth Company
Pursuant to the JOBS Act, an emerging growth company can elect to opt in to any new or revised accounting standards that may be issued by the FASB or the SEC otherwise applicable to non-emerging growth companies. We have elected to opt in to such standards, which election is irrevocable.
We will likely take advantage of some of the reduced regulatory and reporting requirements that are available to us so long as we qualify as an emerging growth company, including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation and exemptions from the requirements of holding non-binding advisory votes on executive compensation and golden parachute payments.
Recently Issued Accounting Pronouncements
We have evaluated new accounting pronouncements that have recently been issued and have determined that there are no new accounting pronouncements that should be described in this section that will impact the Company’s operations, financial condition or liquidity in future periods. Refer to Note 1 of the Company’s audited consolidated financial statements for a discussion of recent accounting pronouncements that have been adopted by the Company or that will require enhanced disclosures in the Company’s financial statements in future periods.
Results of Operations
Net income attributable to common stockholders was $22.9 million, or $1.75 per diluted common share, for the year ended December 31, 2016 compared with $15.2 million, or $1.43 per diluted common share, for the year ended December 31, 2015, an increase in net income attributable to common stockholders of $7.6 million, or 50.1%. Net income attributable to common stockholders increased $6.2 million, or 69.1%, for the year ended December 31, 2015 compared with $9.0 million, or $1.26 per diluted common share, for the year ended December 31, 2014. Returns on average common equity were 8.36%, 7.43% and 7.73%, returns on average assets were 0.98%, 0.81% and 0.75% and efficiency ratios were 62.34%, 65.27% and 67.79% for the years ended December 31, 2016, 2015 and 2014, respectively. The efficiency ratio is calculated by dividing total noninterest expense by the sum of net interest income plus noninterest income, excluding net gains and losses on the sale of loans, securities and assets (including the sale of the two acquired Central Texas branches). Additionally, taxes and provision for loan losses are not part of the efficiency ratio calculation.
Net Interest Income
Year ended December 31, 2016 compared with the year ended December 31, 2015. Net interest income before the provision for loan losses for the year ended December 31, 2016 was $89.9 million compared with $80.2 million for the year ended December 31, 2015, an increase of $9.7 million, or 12.1%. The increase in net interest income was primarily due to the increase in average interest-earning assets of $378.0 million, or 21.8%, for the year ended December 31, 2016 compared with the year ended December 31, 2015. The increase in our average interest-earning assets during the year ended December 31, 2016 as compared to the year ended 2015 was primarily due to organic loan growth and an increase in the size of our securities portfolio.
Interest income was $100.8 million for the year ended December 31, 2016, an increase of $12.0 million, or 13.5%, compared with the year ended December 31, 2015 primarily due to an increase of $7.9 million of interest income and fees on loans during the year ended December 31, 2016 compared to the same period in 2015 as a result of the increase in average loans outstanding of $230.0 million for the same period. The increase in interest income during the years ended December 31, 2016 and 2015, included acquisition accounting loan discount accretion of $1.4 million and $3.5 million, respectively.
Interest expense was $10.9 million for the year ended December 31, 2016, an increase of $2.3 million, or 26.3%, compared with the year ended December 31, 2015. This increase was primarily due to an increase in average interest-bearing liabilities of $272.3 million for the year ended December 31, 2016 compared with the year ended December 31, 2015. The increase in average-bearing liabilities was primarily due to the increase in average interest-bearing deposits of $129.1 million and the increase in average other borrowed funds of $108.1 million during the year ended December 31, 2016 as we entered into $200.0 million of long-term FHLB borrowings during the second quarter of 2016. In October 2015, we paid down $27.5 million on the credit agreement with a portion of the proceeds from the initial public offering. The most significant increase in interest-bearing deposits for the year ended December 31, 2016 compared to the year ended December 31, 2015 was impacted by the increase in average certificates and other time deposits of $88.8 million, or 15.9%.
Tax equivalent net interest margin, defined as net interest income adjusted for tax-free income divided by average interest-earning assets, for the year ended December 31, 2016 was 4.37%, a decrease of 31 basis points compared to 4.68% for the year ended December 31, 2015. The decrease in the net interest margin on a tax equivalent basis was primarily due to the increase in securities as a percentage of interest-earnings assets and an increase in funding costs on certificates of deposit and other borrowed funds. Tax equivalent adjustments to net interest margin are the result of increasing income from tax-free securities by an amount equal to the taxes that would have been paid if the income were fully taxable based on a 35% federal tax rate, thus making tax-exempt yields comparable to taxable asset yields. The impact of net acquisition accounting adjustments of $1.5 million and $4.0 million on the tax equivalent net interest margin was an increase of 7 basis points and 24 basis points for the years ended December 31, 2016 and 2015, respectively.
Year ended December 31, 2015 compared with the year ended December 31, 2014. Net interest income before the provision for loan losses for the year ended December 31, 2015 was $80.2 million compared with $46.8 million for the year ended December 31, 2014, an increase of $33.3 million, or 71.2%. The increase in net interest income was primarily due to the increase in average interest-earning assets of $645.2 million or 59.2% for the year ended December 31, 2015 compared with the year ended December 31, 2014. The increase in our average interest-earning assets during the year ended December 31, 2015 as compared with the year ended 2014 was primarily the result of the acquisition of F&M Bancshares which was completed on January 1, 2015.
Interest income was $88.8 million for the year ended December 31, 2015, an increase of $36.4 million compared with the year ended December 31, 2014 primarily due to an increase of $35.2 million of interest income and fees on loans during the year ended December 31, 2015 compared with the same period in 2014 as a result of the increase in average loans outstanding of $608.1 million for the same period. The increase in interest income during the year ended December 31, 2015 and 2014, included acquisition accounting loan discount accretion of $3.5 million and loan premium amortization of $83 thousand, respectively.
Interest expense was $8.6 million for the year ended December 31, 2015, an increase of $3.1 million compared with the year ended December 31, 2014. This increase was primarily due to an increase in average interest-bearing liabilities of $419.9 million for the year ended December 31, 2015 compared with the year ended December 31, 2014. The increase in average-bearing liabilities was primarily due to deposits acquired in the F&M Bancshares acquisition. In addition, the increase in interest-bearing liabilities was impacted by the addition of $18.0 million borrowed under our credit agreement with another financial institution on January 1, 2015, to repay debt acquired from F&M Bancshares. We paid down $27.5 million on the credit agreement in October 2015 with a portion of the proceeds from the initial public offering. Additionally, we assumed $11.3 million of junior subordinated debentures as part of the acquisition of F&M Bancshares on January 1, 2015.
Tax equivalent net interest margin for the year ended December 31, 2015 was 4.68%, an increase of 37 basis points compared to 4.31% for the year ended December 31, 2014. The impact of net acquisition accounting adjustments of $4.0 million and $432 thousand on the tax equivalent net interest margin was an increase of 24 basis points and 3 basis points for the years ended December 31, 2015 and 2014, respectively.
The following table presents, for the periods indicated, the total dollar amount of average balances, interest income from average interest-earning assets and the annualized resultant yields, as well as the interest expense on average interest-bearing liabilities, expressed in both dollars and rates. Any nonaccruing loans have been included in the table as loans carrying a zero yield.
(1)
The net interest margin is equal to net interest income divided by average interest-earning assets.
(2)
In order to make pretax income and resultant yields on tax-exempt investments and loans comparable to those on taxable investments and loans, a tax-equivalent adjustment has been computed using a federal income tax rate of 35% for the years ended December 31, 2016, 2015 and 2014 and other applicable effective tax rates.
(3)
Includes loans held for sale.
The following table presents information regarding the dollar amount of changes in interest income and interest expense for the periods indicated for each major component of interest-earning assets and interest-bearing liabilities and distinguishes between the changes attributable to changes in volume and changes in interest rates. For purposes of this table, changes attributable to both rate and volume that cannot be segregated have been allocated to rate.
Provision for Loan Losses
Our allowance for loan losses is established through charges to income in the form of the provision in order to bring our allowance for loan losses to a level deemed appropriate by management. The allowance for loan losses at December 31, 2016 and December 31, 2015 was $17.9 million and $13.1 million, respectively, representing 0.95% and 0.78% of total loans as of such dates. Acquired loans are initially recorded at fair value based on a discounted cash flow valuation methodology that considers, among other things, projected default rates, losses given existing defaults and recovery rates. No carryover of any allowance for loan losses occurs when loans are acquired. We recorded a $5.5 million provision for loan losses for the year ended December 31, 2016 compared with $5.8 million for the year ended December 31, 2015.
The provision for loan losses for the year ended December 31, 2015 was $5.8 million compared with $2.2 million for the year ended December 31, 2014. The increase in the provision was primarily due to an increase in organic loan growth, an increase of $347 thousand of allowance on impaired loans and net charge-offs of $940 thousand during the year ended December 31, 2015.
Noninterest Income
Our primary sources of noninterest income are service charges on deposit accounts, nonsufficient funds fees and debit card and ATM card income. Noninterest income does not include loan origination fees which are recognized over the life of the related loan as an adjustment to yield using the interest method.
Year ended December 31, 2016 compared with the year ended December 31, 2015. Noninterest income totaled $7.3 million for the year ended December 31, 2016 compared to $4.0 million for the year ended December 31, 2015, an increase of $3.3 million, or 82.1%. This increase was primarily due to the $2.1 million gain, $1.3 million after-tax, on the sale of the two Central Texas branch locations completed during the first quarter 2016.
Year ended December 31, 2015 compared with the year ended December 31, 2014. Noninterest income totaled $4.0 million for the year ended December 31, 2015 compared to $2.6 million for the year ended December 31, 2014, an increase of $1.4 million, or 53.1%. This increase was partially due to the increase in transactional deposit accounts acquired in the acquisition of F&M Bancshares which increased service charge and nonsufficient funds income and gains on the sale of two individual loans from the
portfolio during the year. Additionally, noninterest income for the year ended December 31, 2015 increased compared to the year ended December 31, 2014 due to the addition of bank owned life insurance income as we purchased bank owned life insurance during the first quarter of 2015 and in conjunction with the acquisition of F&M Bancshares we acquired life insurance policies.
The following table presents, for the periods indicated, the major categories of noninterest income:
(1)
Other includes wire transfer and letter of credit fees, among other items.
Noninterest Expense
Year ended December 31, 2016 compared with the year ended December 31, 2015. Noninterest expense was $59.3 million for the year ended December 31, 2016 compared to $54.8 million for the year ended December 31, 2015, an increase of $4.5 million, or 8.1%. This increase is primarily attributable to increases in salaries and benefits and professional fees related to supporting growth initiatives.
Year ended December 31, 2015 compared with the year ended December 31, 2014. Noninterest expense was $54.8 million for the year ended December 31, 2015 compared to $33.5 million for the year ended December 31, 2014, an increase of $21.3 million or 63.8%. This increase is primarily attributable to additional personnel, facilities and infrastructure as a result of the F&M Bancshares acquisition on January 1, 2015.
The following table presents, for the periods indicated, the major categories of noninterest expense:
(1)
Total salaries and employee benefits includes $1.5 million, $1.4 million and $731 thousand in stock based compensation expense for the years ended December 31, 2016, 2015 and 2014, respectively.
Salaries and Employee Benefits. Salaries and benefits were $38.9 million for the year ended December 31, 2016, an increase of $3.5 million, or 10.0%, compared to the year ended December 31, 2015. This increase is primarily attributable to additional income-producing employees hired to support our growth over the past year.
Salaries and benefits were $35.3 million for the year ended December 31, 2015, an increase of $15.1 million, or 75.1%, compared to the year ended December 31, 2014. This increase is primarily attributable to the increase in the total size of our workforce between these periods as our full-time employees increased to 305 employees at December 31, 2015 from 195 employees at December 31, 2014. The increase is a result of the combination of the acquisition of F&M Bancshares and additional employees hired to support our growth during the year ended December 31, 2015. Additionally, we incurred severance expenses of approximately $555 thousand related to the F&M Bancshares acquisition during the year ended December 31, 2015.
Net Occupancy and Equipment. Net occupancy and equipment expenses increased $118 thousand, or 2.4%, for the year ended December 31, 2016 to $4.9 million compared to $4.8 million for the year ended December 31, 2015.
Net occupancy and equipment expenses were $4.8 million for the year ended December 31, 2015 compared to $3.3 million for the year ended December 31, 2014. This increase of $1.5 million, or 45.5%, for the year ended December 31, 2015 compared to the year ended December 31, 2014 was primarily attributable to the cost of the retail branches acquired in the acquisition of F&M Bancshares including utilities, rent and other occupancy expenses.
Data Processing and Software Amortization. Data processing and software amortization decreased $411 thousand, or 13.5%, for the year ended December 31, 2016 compared to the year ended December 31, 2015.
Data processing and software amortization increased $1.4 million, or 83.6%, for the year ended December 31, 2015, compared to the year ended December 31, 2014. This increase was primarily attributable to the additional hardware and software expenses incurred as part of the acquisition of F&M Bancshares and the resulting increase in transaction volume.
Professional Fees. Professional fees increased $563 thousand, or 33.7%, for the year ended December 31, 2016 to $2.2 million from $1.7 million for the year ended December 31, 2015. This increase was primarily attributable to consulting fees incurred to support our growth initiatives during the year.
Professional fees decreased $623 thousand, or 27.2%, for the year ended December 31, 2015 compared to the year ended December 31, 2014. This decrease was primarily attributable to expenses in 2014 related to the conversion to a new accounting system and the completion of the conversion of Independence Bank acquired in 2013. This decrease was partially offset by merger related expenses incurred to complete the conversion of F&M Bancshares during 2015.
Core Deposit Intangibles Amortization. Core deposit intangibles amortization decreased $45 thousand, or 5.4%, to $785 thousand for the year ended December 31, 2016 compared to the year ended December 31, 2015. Core deposit intangibles are being amortized using a straight-line amortization method over their useful lives.
Core deposit intangibles amortization increased $532 thousand to $830 thousand for the year ended December 31, 2015 compared to the year ended December 31, 2014. This increase is attributable to the acquisition of F&M Bancshares.
Efficiency Ratio
The efficiency ratio is a supplemental financial measure utilized in management’s internal evaluation of our performance and is not calculated based on generally accepted accounting principles. We calculate our efficiency ratio by dividing total noninterest expense, excluding loan loss provisions, by net interest income plus noninterest income, excluding net gains and losses on the sale of loans, securities and assets (including the sale of the two acquired Central Texas branches). Additionally, taxes and provision for loan losses are not part of this calculation. An increase in the efficiency ratio indicates that more resources are being utilized to generate the same volume of income, while a decrease would indicate a more efficient allocation of resources. Our efficiency ratio was 62.34% for the year ended December 31, 2016 compared with 65.27% for the year ended December 31, 2015.
Our efficiency ratio was 65.27% for the year ended December 31, 2015 compared with 67.79% for the year ended December 31, 2014. The efficiency ratios for 2015 and 2014 were impacted by merger-related expenses of approximately $941 thousand and $638 thousand, respectively, related to the F&M Bancshares acquisition completed in 2015 and the Independence acquisition completed in 2013.
We monitor the efficiency ratio in comparison with changes in our total assets and loans, and we believe that maintaining or reducing the efficiency ratio during periods of growth, as we did from 2015 to 2016, demonstrates the scalability of our operating platform. We expect to continue to benefit from our scalable platform in future periods as we continue to monitor overhead expenses necessary to support our growth.
Income Taxes
The amount of federal and state income tax expense is influenced by the amount of pre-tax income, the amount of tax-exempt income and the amount of other nondeductible expenses. Income tax expense increased $1.8 million, or 22.9%, to $9.6 million for the year ended December 31, 2016 compared with $7.8 million for the same period in 2015. For the year ended December 31, 2015, income tax expense was $7.8 million compared with $4.8 million for the year ended December 31, 2014. The increases in income tax expense year over year were primarily attributable to higher pre-tax net income.
The effective tax rates were 29.5%, 33.0% and 34.9% for the years ended December 31, 2016, 2015 and 2014, respectively. The effective tax rate decreased for the year ended December 31, 2016 compared to the same period in 2015 and 2014 due to the increase in tax-exempt income from the purchase of additional municipal securities and from cashless exercises of stock options by employees.
Quarterly Financial Information
The following table presents certain unaudited consolidated quarterly financial information regarding the results of operations for the quarters ended December 31, September 30, June 30 and March 31 in the years ended December 31, 2016 and 2015. This information should be read in conjunction with the our consolidated financial statements as of and for the fiscal years ended December 31, 2016 and 2015 appearing elsewhere in this Annual Report on Form 10-K.
(1)
Earnings per share are computed independently for each of the quarters presented and therefore may not total earnings per share for the year.
Financial Condition
Loan Portfolio
At December 31, 2016, total loans were $1.89 billion, an increase of $210.6 million, or 12.5%, compared with December 31, 2015 primarily due to organic growth in our loan portfolio.
Total loans (including loans held for sale) as a percentage of deposits were 101.1% and 95.6% as of December 31, 2016 and December 31, 2015, respectively. Our capital positions in 2016 and 2015 allowed us to grow our loan portfolio at a faster rate than we grew our deposits. Total loans as a percentage of assets were 77.2% and 80.6% as of December 31, 2016 and December 31, 2015, respectively.
Lending activities originate from the efforts of our lenders, with an emphasis on lending to small to medium-sized businesses and companies, professionals and individuals located in the Houston metropolitan area.
The following table summarizes our loan portfolio by type of loan as of the dates indicated:
(1)
Consists of loans at two former F&M Bancshares branch locations that the Company acquired on January 1, 2015. As of December 31, 2015, loans held for sale consisted of $13.2 million of commercial and industrial loans, $11.6 million of commercial real estate (including multifamily residential) loans, $2.3 million of l-4 family residential (including home equity) loans and $803 thousand of consumer and other loans. Loans held for sale are carried at lower of aggregate cost or fair value.
Our lending activities originate from the efforts of our bankers with an emphasis on lending to individuals, professionals, small to medium-sized businesses and commercial companies generally located in the Houston metropolitan area. Our strategy for credit risk management generally includes well-defined, centralized credit policies, uniform underwriting criteria and ongoing risk monitoring and review processes for all credit exposures. The strategy generally emphasizes regular credit examinations and management reviews of loans. We have certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. We maintain an independent loan review department that reviews and validates the credit risk program on a periodic basis. In addition, an independent third-party loan review is performed on an annual basis. Results of these reviews are presented to management. The loan review process complements and reinforces the risk identification and assessment decisions made by lenders and credit personnel and contained in our policies and procedures.
The principal categories of our loan portfolio (including loans held for sale) are discussed below:
Commercial and Industrial. We make commercial loans in our market area that are underwritten on the basis of the borrower’s ability to service the debt from income. Our commercial and industrial loan portfolio increased $20.5 million, or 5.2%, to $416.8 million as of December 31, 2016 compared to $396.2 million as of December 31, 2015.
Our exposure to oil and gas and oil and gas related customers is 3.7% of our total loan portfolio, as of December 31, 2016. We defined these customers as those on whom the prices of oil and gas have a significant operational or financial impact. These loans carry an overall allowance of 2.4% at December 31, 2016. The collateral on these loans includes industrial commercial real estate, working capital assets, machining equipment, drilling equipment, general industrial equipment, vehicles, airplanes, ranch property, insurance policies, notes receivable and a hotel. In addition, these loans are all personally guaranteed by the owners of the borrower.
Mortgage Warehouse. We make loans to unaffiliated mortgage loan originators collateralized by mortgage promissory notes which are segregated in our mortgage warehouse portfolio. These promissory notes originated by our mortgage warehouse customers carry terms and conditions as would be expected in the competitive permanent mortgage market and serve as collateral under a traditional mortgage warehouse arrangement whereby such promissory notes are warehoused under a revolving credit facility to
allow for the end investor (or purchaser) of the note to receive a complete loan package and remit funds to the bank. The maturity of each revolving line of credit facility is normally less than 24 months, while the promissory notes that are warehoused under such facilities may have a much shorter length of time outstanding. For mortgage promissory notes secured by residential property, the warehouse time is normally 10 to 20 days. For mortgage promissory notes secured by commercial property, the warehouse time is normally 40 to 50 days. The funded balance of the mortgage warehouse portfolio can have significant fluctuation based upon market demand for the product, level of home sales and refinancing activity, market interest rates and velocity of end investor processing times. Volumes tend to peak at the end of each month. Our mortgage warehouse portfolio increased $8.0 million, or 13.5%, to $67.0 million as of December 31, 2016 compared to $59.1 million as of December 31, 2015.
Commercial Real Estate (Including Multi-Family Residential). We make loans collateralized by owner-occupied, nonowner-occupied and multi-family real estate to finance the purchase or ownership of real estate. As of December 31, 2016 and December 31, 2015, 53.5% and 52.8%, respectively, of our commercial real estate loans were owner-occupied. Our commercial real estate loan portfolio increased $134.8 million, or 17.8%, to $892.0 million as of December 31, 2016 from $757.2 million as of December 31, 2015. Included in our commercial real estate portfolio are multi-family residential loans. Our multi-family loans increased $12.5 million, or 30.9%, to $52.9 million as of December 31, 2016 from $40.4 million as of December 31, 2015. We had 81 multi-family loans with an average loan size of $653 thousand as of December 31, 2016.
Commercial Real Estate Construction and Land Development. We make commercial real estate construction and land development loans to fund commercial construction, land acquisition and real estate development construction. Commercial real estate construction and land development land loans increased $4.6 million, or 3.0% to $159.2 million as of December 31, 2016 compared to $154.6 million as of December 31, 2015.
1-4 Family Residential (Including Home Equity). Our residential real estate loans include the origination of 1-4 family residential mortgage loans (including home equity and home improvement loans and home equity lines of credit) collateralized by owner-occupied residential properties located in our market areas. Our residential real estate portfolio (including home equity) increased $39.5 million, or 19.0%, to $247.0 million as of December 31, 2016 from $207.5 million as of December 31, 2015. The home equity portion of our residential real estate portfolio increased $5.8 million, or 25.3%, to $28.7 million as of December 31, 2016 from $22.9 million as of December 31, 2015. These increases were primarily the result of increased lending activity due to an increase in demand for residential real estate in the growing Houston metropolitan area.
Residential Construction. We make residential construction loans to home builders and individuals to fund the construction of single-family residences with the understanding that such loans will be repaid from the proceeds of the sale of the homes by builders or with the proceeds of a mortgage loan. These loans are secured by the real property being built and are made based on our assessment of the value of the property on an as-completed basis. Our residential construction loans portfolio increased $4.8 million, or 5.1%, to $98.7 million as of December 31, 2016 from $93.8 million as of December 31, 2015.
Consumer and Other. Our consumer and other loan portfolio is made up of loans made to individuals for personal purposes. Our consumer and other loan portfolio decreased $1.6 million, or 12.7%, to $11.0 million as of December 31, 2016 from $12.6 million as of December 31, 2015.
The contractual maturity ranges of total loans in our loan portfolio and the amount of such loans with predetermined interest rates in each maturity range and the amount of loans with predetermined (fixed) interest rates and floating interest rates in each maturity range, in each case as of the date indicated, are summarized in the following tables:
Concentrations of Credit
The vast majority of our lending activity occurs in the Houston metropolitan area. Our loans are primarily secured by real estate, including commercial and residential construction, owner-occupied and nonowner-occupied and multi-family commercial real estate, raw land and other real estate based loans located in the Houston metropolitan area. As of December 31, 2016, 2015 and 2014, commercial real estate and commercial construction loans represented 55.6%, 54.2% and 51.4%, respectively, of our total loans including loans held for sale.
Asset Quality
Nonperforming Loans
We have procedures in place to assist us in maintaining the overall quality of our loan portfolio. We have established underwriting guidelines to be followed by our officers and monitor our delinquency levels for any negative or adverse trends.
We had $16.7 million, $5.2 million and $3.2 million in nonperforming loans as of December 31, 2016, 2015 and 2014, respectively. If interest on nonaccrual loans had been accrued under the original loan terms, $892 thousand, $404 thousand and $187 thousand would have been recorded as income for the years ended December 31, 2016, 2015 and 2014, respectively.
The following table presents information regarding nonperforming assets as of the dates indicated:
(1)
Restructured loans represent the balance at the end of the respective period for those performing loans modified in a troubled debt restructuring that are not already presented as a nonperforming loan.
Potential problem loans consist of loans that are performing in accordance with contractual terms but for which management has concerns about the ability of an obligor to continue to comply with repayment terms because of the obligor’s potential operating or financial difficulties. Management monitors these loans closely and reviews their performance on a regular basis. Potential problem loans contain potential weaknesses that could improve, persist or further deteriorate. At December 31, 2016 and 2015, we had $5.2 million and $6.4 million, respectively, in loans of this type which are not included in any of the nonaccrual or 90 days past due loan categories. At December 31, 2016, potential problem loans consisted of 11 credit relationships. Of the total outstanding balance at December 31, 2016, 94.3% related to 10 customers in the energy related industry and 5.7% related to one customer in the clothing industry. Weakness in these organizations’ operating performance, financial condition and borrowing base deficits for certain energy related credits, among other factors, have caused us to heighten the attention given to these credits. As such, all of the loans identified as potential problem loans at December 31, 2016 were graded as substandard accruing loans. Potential problem loans impact the allocation of our allowance for loan losses as a result of our risk grade based allocation methodology. See Note 6 - Loans in the accompanying consolidated financial statements for details regarding our allowance allocation methodology.
Nonperforming assets increased $13.2 million to $18.5 million at December 31, 2016, from $5.3 million at December 31, 2015. Nonaccrual loans consisted of 62 separate credits at December 31, 2016 compared to 31 separate credits at December 31, 2015. The increase in nonaccrual loans was primarily due to an increase of $9.9 million in nonaccrual commercial real estate loans, largely the
result of a $7.0 million increase in nonaccrual energy-related commercial real estate loans. Nonperforming assets were 0.88% of total loans at December 31, 2016 compared to 0.31% at December 31, 2015.
Allowance for Loan Losses
The allowance for loan losses is a valuation allowance that is established through charges to earnings in the form of a provision for loan losses. The amount of the allowance for loan losses is affected by the following: (1) charge-offs of loans that decrease the allowance, (2) subsequent recoveries on loans previously charged off that increase the allowance and (3) provisions for loan losses charged to income that increase the allowance.
All loans acquired from F&M Bancshares were recorded at fair value without a carryover of the F&M Bancshares allowance for loan losses. The discount recognized on acquired loans is prospectively accreted, increasing our basis in such loans. Due to acquisition accounting, our allowance for loan losses to total loans may not be comparable to our peers particularly as it relates to the allowance to gross loan percentage and the allowance to nonperforming loans. Recognizing that acquired purchased credit impaired loans have been de minimis, we monitor credit quality trends on a post-acquisition basis with an emphasis on past due, charge-off, classified loan and nonperforming trends. The amount of discount recorded by the Company on the acquisition date of the F&M Bancshares acquisition was $6.0 million, or 1.47%, on loans acquired.
The remaining discount on the balance of acquired loans as of December 31, 2016 was $840 thousand, or 0.43%. The discount on purchased loans considers anticipated credit losses on that portfolio, therefore no allowance for credit losses was established on the acquisition date. The unaccreted discount represents additional protection against potential losses and is presented as a reduction of the recorded investment in the loans rather than an allowance for loan losses. We will continue to look at the portfolio for credit deterioration and establish additional allowances over the remaining discount as needed.
At December 31, 2016, our allowance for loan losses amounted to $17.9 million, or 0.95% of total loans, compared with $13.1 million, or 0.78%, as of December 31, 2015.
Excluding the acquired loans at December 31, 2016, the allowance would have been 1.05% of total loans. The increase in the allowance of $4.8 million for the year ended December 31, 2016 as compared to the year ended December 31, 2015 was primarily due to an increase in required reserves associated with organic loan growth, an increase in potential problem loans, an increase of $456 thousand of allowance on impaired loans and net charge-offs of $656 thousand during the year 2016. We believe that the allowance for loan losses at December 31, 2016 was adequate to cover probable incurred losses in the loan portfolio as of such date.
The ratio of net charge-offs to average loans outstanding decreased to 0.04% for the year ended December 31, 2016 from 0.06% at December 31, 2015.
The following table presents, as of and for the periods indicated, an analysis of the allowance for loan losses and other related data:
In connection with our review of our loan portfolio, we consider the following risk elements attributable to particular loan types or categories in assessing the quality of individual loans:
•
for commercial and industrial loans, the operating results of the commercial, industrial or professional enterprise, the borrower’s business, professional and financial ability and expertise, the specific risks and volatility of income and operating results typical for businesses in that category and the value, nature and marketability of collateral;
•
for commercial real estate (including multi-family residential) loans, the debt service coverage ratio (income from the property in excess of operating expenses compared to loan payment requirements), operating results of the owner in the case of owner-occupied properties, the loan to value ratio, the age and condition of the collateral and the volatility of income, property value and future operating results typical of properties of that type;
•
for commercial real estate construction and land development and residential construction loans, the perceived feasibility of the project including the ability to sell developed lots or improvements constructed for resale or the ability to lease property constructed for lease, the quality and nature of contracts for presale or prelease, if any, experience and ability of the developer and loan to value ratio;
•
for 1-4 family residential (including home equity) loans, the borrower’s ability to repay the loan, including a consideration of the debt to income ratio and employment and income stability, the loan to value ratio, and the age, condition and marketability of collateral; and
•
for consumer and other loans, the individual borrower’s income, current debt level, past credit history and the value of any available collateral.
Based on our review of our loan portfolio, we classify our loans by credit risk and track risk ratings. The following is a general description of the risk ratings we use:
•
Loans classified as “watch” loans may still be of high quality, but have an element of risk added to the credit such as declining payment history, deteriorating financial position of the borrower or a decrease in collateral value.
•
Loans classified as “special mention” have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of our credit position at some future date. They are characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected.
•
Loans classified as “substandard” have well-defined weaknesses on a continuing basis and are inadequately protected by the current net worth and paying capacity of the borrower, impaired or declining collateral values, or a continuing downturn in their industry which is reducing their profits to below zero and having a significantly negative impact on their cash flow. Such loans are characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected.
•
Loans classified as “doubtful” have all the weaknesses inherent in those classified as substandard with the added characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values highly questionable and improbable.
Loans not meeting the criteria above that are analyzed individually are considered to be pass rated loans.
See Item 7. “ Management’s Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies-Allowance for Loan Losses” for additional information regarding how we estimate and evaluate the credit risk in our loan portfolio.
The following table shows the allocation of the allowance for loan losses among our loan categories and certain other information as of the dates indicated. The allocation is made for analytical purposes and is not necessarily indicative of the categories in which future losses may occur. The total allowance is available to absorb losses from any loan category.
Available for Sale Securities
We use our securities portfolio to provide a source of liquidity, to provide an appropriate return on funds invested, to manage interest rate risk, to meet pledging requirements and to meet regulatory capital requirements. As of December 31, 2016, the carrying amount of investment securities totaled $316.5 million, an increase of $151.4 million or 91.7% compared with $165.1 million as of December 31, 2015. Securities represented 12.9% and 7.9% of total assets as of December 31, 2016 and 2015, respectively.
All of the securities in our securities portfolio are classified as available for sale. Securities classified as available for sale are measured at fair value in the financial statements with unrealized gains and losses reported, net of tax, as accumulated comprehensive income or loss until realized. Interest earned on securities is included in interest income.
The following table summarizes the amortized cost and fair value of the securities in our securities portfolio as of the dates shown:
Certain investment securities are valued at less than their historical cost. Management evaluates securities for OTTI at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. See Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operation-Critical Accounting Policies-Securities” for additional information regarding how and when management evaluates securities for OTTI.
As of December 31, 2016, we did not expect to sell any securities classified as available for sale with material unrealized losses, and management believes that we more likely than not will not be required to sell any securities before their anticipated recovery at which time we will receive full value for the securities. The unrealized losses are largely due to increases in market interest rates over the yields available at the time the underlying securities were purchased. Management does not believe any of the securities are impaired due to reasons of credit quality. The fair value is expected to recover as the securities approach their maturity date or repricing date or if market yields for such investments decline. Accordingly, as of December 31, 2016, management believes any impairment in our securities is temporary, and no impairment loss has been realized in our consolidated statements of income.
The following table summarizes the contractual maturity of securities and their weighted average yields as of the dates indicated. The contractual maturity of a mortgage-backed security is the date at which the last underlying mortgage matures. Available for sale securities are shown at amortized cost. For purposes of the table below, municipal securities are calculated on a tax equivalent basis.
The contractual maturity of mortgage-backed securities and collateralized mortgage obligations is not a reliable indicator of their expected life because borrowers generally have the right to prepay their obligations. Mortgage-backed securities and collateralized mortgage obligations are typically issued with stated principal amounts and are backed by pools of mortgage loans with varying maturities. The term of the underlying mortgages and loans may vary significantly due to the ability of a borrower to prepay and, in particular, monthly pay downs on mortgage-backed securities tend to cause the average life of the securities to be much different than the stated contractual maturity. During a period of increasing interest rates, fixed rate mortgage-backed securities do not tend to experience heavy prepayments of principal and, consequently, the average life of this security will be lengthened. If interest rates begin to fall, prepayments may increase, thereby shortening the estimated life of this security.
As of December 31, 2016 and 2015, we did not own securities of any one issuer (other than the U.S. government and its agencies or sponsored entities) for which the aggregate adjusted cost exceeded 10% of our consolidated stockholders’ equity.
The average yield of our securities portfolio was 2.53% during the year ended December 31, 2016 compared with 2.29% for the year ended December 31, 2015. The increase in average yield during 2016 compared to 2015 was primarily due to our increased investment in longer-term securities. This investment in higher-yielding securities replaced lower-yielding securities that matured or were called or prepaid.
Goodwill and Core Deposit Intangibles
Our goodwill as of December 31, 2016 and 2015 was $39.4 million. Goodwill resulting from business combinations represents the excess of the consideration paid over the fair value of the net assets acquired. Goodwill is assessed annually for impairment or when events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable.
Our core deposit intangibles, net as of December 31, 2016 and 2015 was $4.1 million and $5.2 million, respectively. Core deposit intangibles are amortized using a straight-line amortization method over its estimated useful life of seven to nine years.
Deposits
Our lending and investing activities are primarily funded by deposits. We offer a variety of deposit accounts having a wide range of interest rates and terms including demand, savings, money market and certificates and other time accounts. We rely primarily on convenient locations, personalized service and our customer relationships to attract and retain these deposits. We seek customers that will both engage in a lending and deposit relationship with us.
Total deposits at December 31, 2016 were $1.87 billion, an increase of $111.1 million, or 6.3%, compared with $1.76 billion at December 31, 2015. The deposit growth we experienced was largely the result of the growth in our customer lending base, many of whom also established a deposit relationship with us. Noninterest-bearing deposits at December 31, 2016 were $593.8 million, a decrease of $26.6 million, or 4.3%, compared with $620.3 million at December 31, 2015. Interest-bearing deposits at December 31, 2016 were $1.3 billion, an increase of $137.6 million, or 12.1%, compared with $1.14 billion at December 31, 2015.
Total deposits at December 31, 2015 were $1.76 billion, an increase of $625.4 million, or 55.2%, compared with $1.13 billion at December 31, 2014. Noninterest-bearing deposits at December 31, 2015 were $620.3 million, an increase of $246.5 million, or 66.0%, compared with $373.8 million at December 31, 2014. Interest-bearing deposits at December 31, 2015 were $1.11 billion, an increase of $378.9 million, or 49.9%, compared with $759.9 million at December 31, 2014. The increase in deposits was primarily due to the deposits acquired in the F&M Bancshares acquisition.
The following table presents the daily average balances and weighted average rates paid on deposits for the periods indicated:
Our ratio of average noninterest-bearing deposits to average total deposits was 33.8% for the years ended December 31, 2016 and 2015 and 30.9% for the year ended December 31, 2014.
The following table sets forth the amount of our certificates of deposit that are $100 thousand or greater by time remaining until maturity:
Borrowings
We have an available line of credit with the FHLB of Dallas, which allows us to borrow on a collateralized basis. Our FHLB advances are used to manage liquidity as needed. The advances are secured by a blanket lien on certain loans. Maturing advances are replaced by drawing on available cash, making additional borrowings or through increased customer deposits. At December 31, 2016, the Company had total borrowing capacity of $683.1 million, of which $362.7 million was available under this agreement and $320.4 million was outstanding. Short-term FHLB advances of $85.0 million were outstanding at December 31, 2016, at a weighted average rate of 0.55%. Long-term FHLB borrowings of $200.0 million were outstanding at December 31, 2016, at a weighted
average rate of 0.56%. Letters of credit were $35.4 million at December 31, 2016, of which $3.0 million expired in February 2017, $7.3 million will expire in August 2017 and $25.0 million will expire in October 2017.
On December 22, 2014, in connection with the acquisition of F&M Bancshares, we entered into a credit agreement with another financial institution. Pursuant to this credit agreement, we borrowed approximately $10.1 million in December 2014 to pay off prior indebtedness. In January 2015, we borrowed an additional $18.0 million under the credit agreement to repay debt that F&M Bancshares owed. In October 2015, we paid down $27.5 million on the credit agreement using a portion of the proceeds from the Initial Public Offering. As of December 31, 2016 and 2015, we had $569 thousand of indebtedness owed under the credit agreement and $10.1 million as of December 31, 2014.
Credit Agreement
Our borrowing under the revolving credit agreement matures in December 2021. Interest accrues on borrowed funds at the Prime Rate minus 25 basis points, which equated to approximately 3.50% at December 31, 2016. Interest payments are due quarterly. The credit agreement is secured by 100% of the capital stock of the Bank.
The maximum commitment to advance funds under our credit agreement was originally $30.0 million, which has been and will continue to be reduced by $4.285 million on each December 22nd. We are required to repay any outstanding balance in excess of the then-current maximum commitment amount.
Our credit agreement contains certain restrictive covenants, including limitations on our ability to incur additional indebtedness or engage in certain fundamental corporate transactions, such as mergers, reorganizations and recapitalizations. Additionally, the Bank is required to maintain a “well-capitalized” rating, a minimum return on assets of 0.65%, measured quarterly, a ratio of loan loss reserve to non-performing loans equal to or greater than 75%, measured quarterly, and a ratio of non-performing assets to aggregate equity plus loan loss reserves minus intangible assets of less than 35%, measured quarterly. As of December 31, 2016, we believe we are in compliance with these debt covenants and the lender has not delivered any notice of noncompliance under the terms of the credit documents.
Junior Subordinated Debentures
In connection with the F&M Bancshares acquisition, we assumed junior subordinated debentures with an aggregate original principal amount of $11.3 million and a current fair value of $9.2 million at December 31, 2016. At acquisition, we recorded a discount of $2.5 million on the debentures. The difference between the carrying value and contractual balance will be recognized as a yield adjustment over the remaining term for the debentures. See Note 11 to our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K.
Contractual Obligations
The following tables summarize our contractual obligations and other commitments to make future payments as of December 31, 2016 and 2015 (other than deposit obligations), which consist of our future cash payments associated with our contractual obligations pursuant to our non-cancelable operating leases and our indebtedness owed to another financial institution. Payments related to leases are based on actual payments specified in underlying contracts.
Off-Balance Sheet Items
In the normal course of business, we enter into various transactions, which, in accordance with GAAP, are not included in our consolidated balance sheets. We enter into these transactions to meet the financing needs of our customers. These transactions include both commitments to extend credit and standby letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in our consolidated balance sheets.
Our commitments associated with outstanding standby letters of credit and commitments to extend credit expiring by period are summarized below as of December 31, 2016. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements:
Commitments to Extend Credit. We enter into contractual commitments to extend credit, normally with fixed expiration dates or termination clauses, at specified rates and for specific purposes. Substantially all of our commitments to extend credit are contingent upon customers maintaining specific credit standards at the time of loan funding. We minimize our exposure to loss under these commitments by subjecting them to credit approval and monitoring procedures. The amount and type of collateral obtained, if considered necessary by us, upon extension of credit, is based on management’s credit evaluation of the customer. Management assesses the credit risk associated with certain commitments to extend credit in determining the level of the allowance for loan losses.
Standby Letters of Credit. Standby letters of credit are conditional commitments issued by us to guarantee the performance of a customer to a third party. If the customer does not perform in accordance with the terms of the agreement with the third party, we would be required to fund the commitment and we would have the rights to the underlying collateral. The maximum potential amount of future payments we could be required to make is represented by the contractual amount of the commitment. Our policies generally require that standby letter of credit arrangements contain security and debt covenants similar to those contained in loan agreements.
Liquidity and Capital Resources
Liquidity
Liquidity is the measure of our ability to meet the cash flow requirements of depositors and borrowers, while at the same time meeting our operating, capital and strategic cash flow needs and to maintain reserve requirements to operate on an ongoing basis and manage unexpected events, all at a reasonable cost. During the years ended December 31, 2016, 2015 and 2014, our liquidity needs have been met by core deposits, security and loan maturities and amortizing investment and loan portfolios. The Bank has access to purchased funds from correspondent banks and advances from the FHLB are available under a security and pledge agreement to take advantage of investment opportunities.
Average assets totaled $2.34 billion, $1.94 billion and $1.19 billion for the years ended December 31, 2016, 2015 and 2014, respectively. The following table illustrates, during the periods presented, the mix of our funding sources and the average assets in which those funds are invested as a percentage of our average total assets for the period indicated.
Our largest source of funds is deposits and our largest use of funds is loans. Our average loans increased $230.0 million, or 15.1%, for the year ended December 31, 2016 compared to the year ended December 31, 2015. We predominantly invest excess deposits in Federal Reserve Bank of Dallas balances, securities, interest-bearing deposits at other banks or other short-term liquid investments until the funds are needed to fund loan growth. Our securities portfolio had a weighted average life of 6.7 years and modified duration of 5.8 years at December 31, 2016, and a weighted average life of 7.0 years and modified duration of 6.0 years at December 31, 2015.
As of December 31, 2016 and December 31, 2015, we had outstanding $586.4 million and $474.9 million, respectively, in commitments to extend credit and $9.5 million for both years in commitments associated with outstanding standby letters of credit. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the total outstanding may not necessarily reflect the actual future cash funding requirements.
As of December 31, 2016, 2015 and 2014, we had no exposure to future cash requirements associated with known uncertainties or capital expenditures of a material nature.
As of December 31, 2016, we had cash and cash equivalents of $142.1 million compared with $148.4 million at December 31, 2015, a decrease of $6.3 million. This decrease in cash and cash equivalents was primarily due to the purchase of securities of $2.73 billion, an increase in total loans of $229.3 million, paydowns of short-term borrowings of $20.0 million partially offset by proceeds from the maturities and paydowns of securities of $2.57 billion, proceeds of long-term borrowings of $200.0 million and proceeds from short-term borrowings of $55.0 million from FHLB.
Capital Resources
Capital management consists of providing equity to support our current and future operations. We are subject to capital adequacy requirements imposed by the Federal Reserve and the Bank is subject to capital adequacy requirements imposed by the FDIC. Both the Federal Reserve and the FDIC have adopted risk-based capital requirements for assessing bank holding companies and bank capital adequacy. These standards define capital and establish minimum capital requirements in relation to assets and off-balance sheet exposure, adjusted for credit risk. The risk-based capital standards currently in effect are designed to make regulatory capital requirements more sensitive to differences in risk profiles among bank holding companies and banks, to account for off-balance sheet exposure and to minimize disincentives for holding liquid assets. Assets and off-balance sheet items are assigned to broad risk
categories, each with appropriate relative risk weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off-balance sheet items.
Under current guidelines, the minimum ratio of total capital to risk-weighted assets (which are primarily the credit risk equivalents of balance sheet assets and certain off-balance sheet items such as standby letters of credit) is 8.0%. At least half of total capital must be composed of tier 1 capital, which includes common stockholders’ equity (including retained earnings), less goodwill, other disallowed intangibles and disallowed deferred tax assets, among other items. The Federal Reserve also has adopted a minimum leverage ratio, requiring tier 1 capital of at least 4.0% of average quarterly total consolidated assets, net of goodwill and certain other intangible assets, for all but the most highly rated bank holding companies. The federal banking agencies have also established risk-based and leverage capital guidelines that FDIC-insured depository institutions are required to meet. These regulations are generally similar to those established by the Federal Reserve for bank holding companies.
Under the Federal Deposit Insurance Act, the federal bank regulatory agencies must take “prompt corrective action” against undercapitalized U.S. depository institutions. U.S. depository institutions are assigned one of five capital categories: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized,” and are subjected to different regulation corresponding to the capital category within which the institution falls. A depository institution is deemed to be “well capitalized” if the banking institution has a total risk-based capital ratio of 10.0% or greater, a tier 1 risk-based capital ratio of 8.0% or greater, a common equity Tier 1 capital ratio of 6.5% and a leverage ratio of 5.0% or greater, and the institution is not subject to an order, written agreement, capital directive or prompt corrective action directive to meet and maintain a specific level for any capital measure. Under certain circumstances, a well-capitalized, adequately capitalized or undercapitalized institution may be treated as if the institution were in the next lower capital category.
Failure to meet capital guidelines could subject the institution to a variety of enforcement remedies by federal bank regulatory agencies, including: termination of deposit insurance by the FDIC, restrictions on certain business activities and appointment of the FDIC as conservator or receiver. As of December 31, 2016, 2015 and 2014, the Bank was well-capitalized.
The following table provides a comparison of the Company’s and the Bank’s leverage and risk-weighted capital ratios as of December 31, 2016 to the minimum and well-capitalized regulatory standards:
Total stockholder’s equity was $279.8 million at December 31, 2016, compared with $258.5 million at December 31, 2015, an increase of $21.3 million, or 8.3%. This increase was primarily due to net income of $22.9 million for the year ended December 31, 2016.
Asset/Liability Management and Interest Rate Risk
Our asset liability and interest rate risk policy provides management with the guidelines for effective balance sheet management. We have established a measurement system for monitoring our net interest rate sensitivity position. We manage our sensitivity position within our established guidelines.
As a financial institution, a component of the market risk that we face is interest rate volatility. Fluctuations in interest rates will ultimately impact both the level of income and expense recorded on most of our assets and liabilities, and the market value of all interest-earning assets and interest-bearing liabilities, other than those which have a short term to maturity. Interest rate risk is the potential for economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income.
We have not entered into instruments such as leveraged derivatives, interest rate swaps, financial options, financial future contracts or forward delivery contracts for the purpose of reducing interest rate risk. Based upon the nature of our operations, we are not subject to foreign exchange rate or commodity price risk. We do not own any trading assets. We manage our exposure to interest rates by structuring our balance sheet in the ordinary course of a community banking business.
Our exposure to interest rate risk is managed by our Asset Liability Committee (“ALCO”), which is composed of certain members of our Board of Directors and Bank management, in accordance with policies approved by our Board of Directors. The ALCO formulates strategies based on appropriate levels of interest rate risk. In determining the appropriate level of interest rate risk, the ALCO considers the impact on earnings and capital of the current outlook on interest rates, potential changes in interest rates, regional economies, liquidity, business strategies and other factors. The ALCO meets regularly to review, among other things, the sensitivity of assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses, purchase and sale activities, commitments to originate loans and the maturities of investments and borrowings. Additionally, the ALCO reviews liquidity, cash flow flexibility, maturities of deposits and consumer and commercial deposit activity.
We use an interest rate risk simulation model and shock analysis to test the interest rate sensitivity of net interest income and the balance sheet, respectively. All instruments on the balance sheet are modeled at the instrument level, incorporating all relevant attributes such as next reset date, reset frequency and call dates, as well as prepayment assumptions for loans and securities and decay rates for nonmaturity deposits. Assumptions based on past experience are incorporated into the model for nonmaturity deposit account decay rates. The assumptions used are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income. Actual results will differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and the application and timing of various management strategies.
We utilize static balance sheet rate shocks to estimate the potential impact on net interest income of changes in interest rates under various rate scenarios. This analysis estimates a percentage of change in the metric from the stable rate base scenario versus alternative scenarios of rising and falling market interest rates by instantaneously shocking a static balance sheet.
The following table summarizes the simulated change in net interest income and the economic value of equity over a 12-month horizon as of the dates indicated:
These results are primarily due to the duration of our loan and securities portfolio and the expected behavior of demand, money market and savings deposits during such rate fluctuations. During 2016, the overall duration of our combined loan and securities portfolios increased and FHLB borrowings represented a larger proportion of our funding mix at year end.
GAAP Reconciliation and Management’s Explanation of Non-GAAP Financial Measures
We identify certain financial measures discussed in this Annual Report on Form 10-K as being “non-GAAP financial measures.” In accordance with the SEC’s rules, we classify a financial measure as being a non-GAAP financial measure if that financial measure excludes or includes amounts, or is subject to adjustments that have the effect of excluding or including amounts, that are included or excluded, as the case may be, in the most directly comparable measure calculated and presented in accordance with generally accepted accounting principles as in effect from time to time in the United States in our statements of income, balance sheet or statements of cash flows. Non-GAAP financial measures do not include operating and other statistical measures or ratios or
statistical measures calculated using exclusively either financial measures calculated in accordance with GAAP, operating measures or other measures that are not non-GAAP financial measures or both.
The non-GAAP financial measures that we discuss in this Annual Report on Form 10-K 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 Annual Report on Form 10-K may differ from that of other companies reporting measures with similar names. You should understand how such other banking organizations calculate their financial measures similar or with names similar to the non-GAAP financial measures we have discussed in this Annual Report on Form 10-K when comparing such non-GAAP financial measures.
Our management uses these non-GAAP financial measures in its analysis of our performance:
•
“Tangible Stockholders’ Equity” is stockholders’ equity reduced by goodwill and core deposit intangibles, net of accumulated amortization.
•
“Tangible Book Value Per Share” is a non-GAAP measure generally used by financial analysts and investment bankers to evaluate financial institutions. Tangible book value per share is defined as total stockholders’ equity reduced by goodwill and core deposit intangibles, net of accumulated amortization, divided by total shares outstanding. This measure is important to investors interested in changes from period to period in book value per share, exclusive of changes in intangible assets. For tangible book value per share, the most directly comparable financial measure calculated in accordance with GAAP is our book value per share.
•
“Tangible Equity to Tangible Assets” is a non-GAAP measure generally used by financial analysts and investment bankers to evaluate financial institutions. Tangible equity to tangible assets is defined as total stockholders’ equity reduced by goodwill and core deposit intangibles, net of accumulated amortization, divided by tangible assets, which are total assets reduced by goodwill and core deposit intangibles, net of accumulated amortization. This measure is important to investors interested in changes from period to period in equity and total assets, each exclusive of changes in intangible assets. For tangible equity to tangible assets, the most directly comparable financial measure calculated in accordance with GAAP is total stockholders’ equity to total assets. Goodwill and other intangible assets have the effect of increasing both total stockholders’ equity and assets while not increasing our tangible common equity or tangible assets.
We believe these non-GAAP financial measures provide useful information to management and investors that is supplementary to our financial condition, results of operations and cash flows computed in accordance with GAAP; however, we acknowledge that our non-GAAP financial measures have a number of limitations. As such, you should not view these disclosures as a substitute for results determined in accordance with GAAP, and they are not necessarily comparable to non-GAAP financial measures that other companies use. The following reconciliation tables provide a more detailed analysis of these non-GAAP financial measures:
(1)
Does not include 1,711, 11,426 and 8,366 shares of treasury stock as of December 31, 2015, 2013 and 2012, respectively. There were no shares of treasury stock outstanding as of December 31, 2016 or 2014.
(2)
As a result of system conversions, we are unable to calculate daily average balances for 2012. For these periods, average loans, securities, deposits in other financial institutions, assets and equity are calculated by averaging the ending balance of the prior month and the ending balance of the current month and multiplying the average by the number of days in the current month. The twelve resulting products were then added together and the resulting sum is divided by the number of days in the year.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
For information regarding the market risk of the Company’s financial instruments, see Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operation-Financial Condition-Asset/Liability Management and Interest Rate Risk.” Our principal market risk exposure is to changes in interest rates.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements, the reports thereon, the notes thereto and supplementary data commence at page 71 of this Annual Report on Form 10-K.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures. As of the end of the period covered by this Annual Report on Form 10-K, the Company carried out an evaluation, under the supervision and with the participation of its management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management was required to apply judgment in evaluating its controls and procedures. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were effective as of the end of the period covered by this report. See Exhibits 31.1 and 31.2 for the Certification statements issued by the Company’s Chief Executive Officer and Chief Financial Officer, respectively.
Changes in Internal Control over Financial Reporting. There were no changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended December 31, 2016, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Reporting on Management’s Assessment of Internal Controls over Financial Reporting. Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act). Our internal control system is a process designed to provide reasonable assurance regarding the preparation and fair presentation of published financial statements in accordance with GAAP. All internal control systems, no matter how well designed, have inherent limitations and can only provide reasonable assurance with respect to financial reporting.
As of December 31, 2016, management assessed the effectiveness of the Company’s internal control over financial reporting based on the criteria for effective internal control over financial reporting established in “Internal Control-Integrated Framework,” issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013. Based on this assessment, management determined that the Company maintained effective internal control over financial reporting as of December 31, 2016.
Crowe Horwath LLP, the independent registered public accounting firm, audited the consolidated financial statements of the Company included in this Annual Report on Form 10-K. Their report is included in Part IV, Item 15. under the heading “Report of Independent Registered Public Accounting Firm.” Pursuant to SEC rules applicable to emerging growth companies, this Annual Report on Form 10-K does not include an attestation report on management’s assessment of internal control over financial reporting from the Company's independent registered public accounting firm.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III.
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information required by this Item is incorporated herein by reference to the Company’s definitive Proxy Statement for its 2017 Annual Meeting of Shareholders (the “2017 Proxy Statement”) to be filed with the SEC pursuant to Regulation 14A under the Exchange Act within 120 days of the Company’s fiscal year end.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item is incorporated herein by reference to the 2017 Proxy Statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Certain information required by this Item is included under “Securities Authorized for Issuance under Equity Compensation Plans” in Part II, Item 5 of this Annual Report on Form 10-K. The other information required by this Item is incorporated herein by reference to the 2017 Proxy Statement.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE
The information required by this Item is incorporated herein by reference to the 2017 Proxy Statement.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this Item is incorporated herein by reference to the 2017 Proxy Statement.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) The following documents are filed as part of this Annual Report on Form 10-K:
1. Consolidated Financial Statements. Reference is made to the Consolidated Financial Statements, the report thereon and the notes thereto commencing at page 71 of this Annual Report on Form 10-K. Set forth below is a list of such Consolidated Financial Statements:
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of December 31, 2016 and 2015
Consolidated Statements of Income for the Years Ended December 31, 2016, 2015, and 2014
Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2016, 2015 and 2014
Consolidated Statements of Changes in Stockholders’ Equity for the Years Ended December 31, 2016, 2015 and 2014
Consolidated Statements of Cash Flows for the Years Ended December 31, 2016, 2015 and 2014
Notes to Consolidated Financial Statements
2. Financial Statement Schedules. All supplemental schedules are omitted as inapplicable or because the required information is included in the Consolidated Financial Statements or notes thereto.
3. The exhibits to this Annual Report on Form 10-K listed below have been included only with the copy of this report filed with the SEC. The Company will furnish a copy of any exhibit to shareholders upon written request to the Company and payment of a reasonable fee not to exceed the Company’s reasonable expense.
Each exhibit marked with an asterisk is filed or furnished with this Annual Report on Form 10-K as noted below.
EXHIBITS
ITEM 16. FORM 10-K SUMMARY
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant, has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: March 10, 2017
ALLEGIANCE BANCSHARES, INC.
By:
/s/ George Martinez
George Martinez
Chairman and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Crowe Horwath LLP
Independent Member Crowe Horwath
Board of Directors and Shareholders
Allegiance Bancshares, Inc.
Houston, Texas
We have audited the accompanying consolidated balance sheets of Allegiance Bancshares, Inc. (the “Company”) as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2016. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Allegiance Bancshares, Inc. as of December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2016 in conformity with U.S. generally accepted accounting principles.
/s/ Crowe Horwath LLP
Dallas, Texas
March 10, 2017
ALLEGIANCE BANCSHARES, INC.
CONSOLIDATED BALANCE SHEETS
See notes to consolidated financial statements.
ALLEGIANCE BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
See notes to consolidated financial statements.
ALLEGIANCE BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
See notes to consolidated financial statements.
ALLEGIANCE BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
See notes to consolidated financial statements.
ALLEGIANCE BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See notes to consolidated financial statements.
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING POLICIES
Nature of Operations and Principles of Consolidation-The consolidated financial statements include Allegiance Bancshares, Inc. (“Allegiance”) and its wholly-owned subsidiary, Allegiance Bank (the “Bank”, and together with Allegiance, collectively referred to as the “Company”) provide commercial and retail loans and commercial banking services. Intercompany transactions and balances are eliminated in consolidation under U.S. generally accepted accounting principles (“GAAP”). The Company derives substantially all of its revenues and income from the operation of the Bank. Allegiance Bank is a Texas banking association which began operations in October 2007. The Company is focused on delivering a wide variety of relationship-driven commercial banking products and community-oriented services tailored to meet the needs of small to mid-sized businesses, professionals and individuals through its 16 offices in Houston, Texas and the surrounding region, as of the year ended December 31, 2016. The Bank provides its customers with a variety of banking services including checking accounts, savings accounts and certificates of deposit and its primary lending products are commercial, personal, automobile, mortgage and home improvement loans. The Bank also offers safe deposit boxes, automated teller machines, drive-through services and 24-hour depository facilities.
Use of Estimates-The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions based on available information. These estimates and assumptions affect the reporting of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Initial Public Offering (IPO) - In October 2015, Allegiance completed the Initial Public Offering of its Common Stock. In connection with Allegiance's Initial Public Offering, Allegiance issued and sold 2,990,000 shares of Common Stock at $21 per share resulting in total proceeds received by Allegiance net of offering costs of $57.1 million.
Cash and cash equivalents-Cash and cash equivalents include cash, deposits with other financial institutions with maturities not greater than one year. Net cash flows are reported for customer loan and deposit transactions.
Securities-Debt securities are classified as available for sale when they might be sold before maturity. Equity securities with readily determinable fair values are classified as available for sale. Securities available for sale are carried at fair value. Unrealized gains and losses are excluded from earnings and reported, net of tax, as a separate component of stockholders’ equity until realized. Securities within the available for sale portfolio may be used as part of the Company’s asset/liability strategy and may be sold in response to changes in interest rate risk, prepayment risk or other similar economic factors.
Interest earned on these assets is included in interest income. Interest income includes amortization of purchase premium or discount. Premiums and discounts on securities are amortized on the level-yield method, except for mortgage backed securities where prepayments are anticipated. Gains and losses on sales are recorded on the trade date and determined using the specific identification method.
Management evaluates debt securities for other-than-temporary impairment (“OTTI”) on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss, and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: (1) OTTI related to credit loss, which must be recognized in the income statement and (2) OTTI related to other factors, which is recognized in other comprehensive income, net of applicable taxes. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. The previous amortized cost bases less the OTTI recognized in earnings shall become the new amortized cost basis of the security.
Loans held for Sale-Loans held for sale are carried at lower of aggregate cost or fair value. During 2015, the Company purchased F&M Bancshares, Inc. At December 31, 2015, loans held for sale consisted of loans at two former F&M Bancshares branches in Central Texas that were for sale. On January 31, 2016, the Company completed the sale of these two branches.
Loans Held for Investment-Loans held for investment are those that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of deferred loan fees and costs, and an allowance for loan losses. Loans are typically secured by specific items of collateral including business assets, consumer assets and
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commercial and residential real estate. Commercial loans are expected to be repaid from cash flow from operations of businesses. Interest income is accrued on the unpaid principal balance.
Nonrefundable Fees and Costs Associated with Lending Activities- Loan commitment and loan origination fees, and certain direct origination costs, are deferred and recognized in interest income as an adjustment to yield without anticipating prepayments using the interest method over the related loan life or; if the commitment expires unexercised, balances are recognized in income upon expiration of the commitment.
Nonperforming and Past Due Loans-The Company has several procedures in place to assist it in maintaining the overall quality of its loan portfolio. The Company has established underwriting guidelines to be followed by its officers, and monitors its delinquency levels for any negative or adverse trends. There can be no assurance, however, that the Company’s loan portfolio will not become subject to increasing pressures from deteriorating borrower credit due to general economic conditions or other factors.
Past due status is based on the contractual terms of the loan. Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. The Company generally classifies a loan as nonperforming, automatically places the loan on nonaccrual status, ceases accruing interest and reverses all unpaid accrued interest against interest income, when, in management’s opinion, the borrower may be unable to meet payment obligations, when the payment of principal or interest on a loan is delinquent for 90 days, as well as when required by regulatory provisions, unless the loan is in the process of collection and the underlying collateral fully supports the carrying value of the loan. Any payments received on nonaccrual loans are applied first to outstanding loan amounts. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Any excess is treated as recovery of lost interest. Loans are returned to accrual status when all of the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. If the decision is made to continue accruing interest on the loan, periodic reviews are made to confirm the accruing status of the loan. Nonaccrual loans and loans past due 90 days include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans. When available information confirms that specific loans, or portions thereof, are uncollectible, these amounts are charged-off against the allowance. All loan types are considered delinquent after 30 days past due and are typically charged-off or charged-down no later than 120 days past due, with consideration of, but not limited to, the following criteria in determining the need and optional timing of the charge-off or charge-down: (1) the Bank is in the process of repossession or foreclosure and there appears to be a likely deficiency, (2) the collateral securing the loan has been sold and there is an actual deficiency, (3) the Bank is proceeding with lengthy legal action to collect its balance, (4) the borrower is unable to be located or (5) the borrower has filed bankruptcy. Charge-offs occur when the Company confirms a loss on a loan.
Troubled debt restructurings (TDRs)-Loans on which terms have been modified resulting in a concession have been granted because of a borrower’s financial difficulty are considered troubled debt restructurings and classified as impaired. The restructuring of a loan is considered a troubled debt restructuring if both (1) the borrower is experiencing financial difficulties and (2) the creditor has granted a concession that it would not otherwise consider. Concessions may include reductions of interest rates to a below market interest rate: extension of the terms of the debt, principal forgiveness, restructuring the payment of the debt obligation; and other actions intended to minimize potential losses. Subsequent to identification as a troubled debt restructuring such loans are then evaluated for impairment on an individual basis whereby the loans are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a troubled debt restructuring is considered to be a collateral dependent loan: the loan is reported, net, at the fair value of the collateral.
Impaired Loans-On a continuous basis, loans are evaluated for impairment classification. Loans are considered impaired when based on current information and events, it is probable the Company will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement including scheduled principal and interest payments. Impairment is evaluated in total for smaller-balance loans of a similar nature and on an individual loan basis for other loans. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on case-by-case basis taking into consideration all of the circumstances surrounding the loan and the borrower including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed.
Allowance for Loan Losses-The allowance for loan losses is a valuation allowance that is established through charges to earnings in the form of a provision for loan losses. The amount of the allowance for loan losses is affected by the following: (1) charge-offs of
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loans that decrease the allowance, (2) subsequent recoveries on loans previously charged off that increase the allowance and (3) provisions for loan losses charged to income that increase the allowance.
Throughout the year, management estimates the probable incurred losses in the loan portfolio to determine if the allowance for loan losses is adequate to absorb such losses. The allowance for loan losses consists of specific and general components. The specific component relates to loans that are individually classified as impaired. The Company follows a loan review program to evaluate the credit risk in the loan portfolio. Loans that have been identified as impaired are generally reviewed on a quarterly basis in order to determine whether a specific reserve is required. The general component covers non-impaired loans and is based on industry and Company specific historical loan loss experience, volume, growth and composition of the loan portfolio, the evaluation of the Company’s loan portfolio through its internal loan review process, general current economic conditions both internal and external to the Company that may affect the borrower’s ability to pay, value of collateral and other qualitative relevant risk factors. Based on a review of these estimates, the allowance for loan losses is adjusted to a level determined to be adequate. Estimates of loan losses are inherently subjective as it involves an exercise of judgment. It is the judgment of management that the allowance for loan losses reflected in the consolidated balance sheets is adequate to absorb probable losses that exist in the loan portfolio as of the reporting date.
For troubled debt restructurings that subsequently default, the Company determines the amount of reserve in accordance with the accounting policy for the allowance for loan losses. The Company assesses the exposure for each modification, either by collateral discounting or by calculation of the present value of future cash flows, and determines if a specific allocation to the allowance for loan losses is needed. Once an obligation has been restructured because of such credit problems, it continues to be considered a troubled debt restructuring until paid in full. The Company returns troubled debt restructurings to accrual status only if (1) all contractual amounts due can reasonably be expected to be repaid within a prudent period and (2) repayment has been in accordance with the contract for a sustained period, typically at least twelve months.
Loans acquired in business combinations are initially recorded at fair value, which includes an estimate of loan losses expected to be realized over the remaining lives of the loans. Therefore no corresponding allowance for loan losses is recorded for these loans at acquisition. Methods utilized to estimate any subsequently required allowance for loan losses for acquired loans not deemed credit-impaired at acquisition are similar to originated loans. However, the estimate of loss is based on the unpaid principal balance and then compared to any remaining unaccreted purchase discount. To the extent that the calculated loss is greater than the remaining unaccreted purchase discount, an allowance is recorded for such difference.
Premises and Equipment-Premises and equipment are carried at cost less accumulated depreciation. Depreciation expense is calculated principally using the straight-line method over the estimated useful lives of the assets which range from 3 to 40 years. Leasehold improvements are amortized using the straight-line method over the periods of the leases or the estimated useful lives, whichever is shorter. Land is carried at cost.
Other Real Estate Owned-Assets acquired through or instead of loan foreclosure are held for sale and are initially recorded at fair value less estimated selling costs when acquired, establishing a new cost basis. Costs after acquisition are generally expensed. If the fair value of the asset declines, a write-down is recorded through expense. The valuation of foreclosed assets is subjective in nature and may be adjusted in the future because of changes in economic conditions. At December 31, 2016, the $1.5 million balance of other real estate owned was secured by residential real estate properties for which formal foreclosure proceeds were in process.
Federal Home Loan Bank (“FHLB”) Stock-The Bank is a member of the FHLB system. Members are required to own a certain amount of stock based on the level of borrowings and other factors and may invest in additional amounts. FHLB stock is carried at cost, classified as a restricted security and periodically evaluated for impairment based on ultimate recovery of par value. Both cash and stock dividends are reported as income.
Bank Owned Life Insurance-During 2015, the Company purchased bank owned life insurance policies on certain key executives, and in conjunction with the acquisition of F&M Bancshares, the Company acquired life insurance policies. Bank owned life insurance is recorded at the amount that can be realized under the insurance contract at the balance sheet date, which is the cash surrender value, which is the most reasonable estimate of fair value, adjusted for other charges or other amounts due that are probable at settlement.
Goodwill-Goodwill resulting from business combinations is generally determined as the excess of the fair value of the consideration transferred, plus the fair value of any noncontrolling interests in the acquiree, over the fair value of the net assets acquired and liabilities assumed as of the acquisition date.
Goodwill is determined to have an indefinite useful life and is not amortized, but is tested for impairment at least annually or more frequently if events and circumstances exists that indicate that a goodwill impairment test should be performed. The Company
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performs its annual impairment test on October 1. Goodwill is the only intangible asset with an indefinite life on the Company’s balance sheet.
Core Deposit Intangibles-Core deposit and acquired customer relationship intangibles arising from acquisitions are amortized using a straight-line amortization method over their estimated useful lives, which is seven to nine years.
Other Borrowed Funds-The Company has a credit agreement with another financial institution. The Company pledged its shares in the Bank’s stock as collateral for the borrowing.
Loan Commitments and Related Financial Instruments-Financial instruments include off-balance sheet credit instruments, such as commitments to extend credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.
Stock Based Compensation-Compensation cost is recognized for stock options and restricted stock awards issued to employees, based on the fair value of these awards at the date of grant. The expense associated with stock based compensation is recognized over the required service period, generally defined as the vesting period of each individual arrangement. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award.
The fair value of stock options granted and employee stock purchase plan awards are estimated at the date of grant using the Black-Scholes option-pricing model and the market price of the Company’s common stock on the date of grant is used to value restricted stock awards.
Employee Stock Purchase Plan-The cost of shares issued in the ESPP, but not allocated to participants, is shown as a reduction of shareholder’s equity. Compensation expense is based on the market price of the shares as they are committed to be released to participant accounts.
Income Taxes-Income tax expense is the total of the current year income tax due and the change in deferred tax assets or liabilities. Deferred tax assets and liabilities are recognized for the estimated tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and are recorded in other assets on the Company’s consolidated balance sheets.
The Company records uncertain tax positions on the basis of a two-step process whereby (1) the Company determines whether it is more likely than not that the tax positions will be sustained on the basis of the technical merits of the position and (2) for those tax positions that meet the more likely than not recognition threshold, the Company recognizes the largest amount of tax benefit that is greater than 50 percent likely of being realized upon ultimate settlement with the related tax authority. For tax positions not meeting the more likely than not test, no tax benefit is recorded. Any interest and/or penalties related to income taxes are reported as a component of income tax expense.
The Company files a consolidated federal income tax return.
Comprehensive income-Comprehensive income consists of net income and other comprehensive income which includes unrealized gains and losses on securities available for sale which are also recognized as separate components of equity.
Fair Value of Financial Instruments-Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in a separate note. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect these estimates.
Operating Segments-While management monitors the revenue streams of the various products and services, operations are managed and financial performance is evaluated on a Company-wide basis. All of the financial service operations are considered by management to be aggregated in one reportable operating segment.
Reclassifications-Some items in the prior year financial statements were reclassified to conform to the current presentation. Reclassifications had no effect on prior year net income or stockholders’ equity. The Company recorded measurement period adjustments to goodwill related to a previous acquisition as noted in Note 3 - Goodwill and Core Deposit Intangibles in 2014.
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Earnings per Common Share-Basic earnings per common share is calculated as net income divided by the weighted average number of common shares outstanding during the period. Diluted earnings per common share includes the dilutive effect of additional potential common shares issuable under stock options, restricted stock awards and the Employee Stock Purchase Plan.
Loss Contingencies-Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there are such matters that will have a material effect on the financial statements.
Dividend Restrictions-Banking regulations require maintaining certain capital levels and may limit the dividends paid by the Bank to Allegiance or by Allegiance to its shareholders.
New Accounting Standards
Adoption of New Accounting Standards
On January 1, 2016, the Company adopted ASU 2015-16, “Business Combinations (Topic 805) - Simplifying the Accounting for Measurement-Period Adjustments.” ASU 2015-16 requires that an acquirer recognize adjustments to provisional amounts that are identified during the measurement period in the reporting period in which the adjustment amounts are determined. The acquirer must record, in the same period’s financial statements, the effect on earnings of changes in depreciation, amortization, or other income effects, if any, as a result of the change to the provisional amounts, calculated as if the accounting had been completed at the acquisition date. Additionally, the entity is required to present separately on the face of the income statement or disclose in the notes the portion of the amount recorded in current-period earnings by line item that would have been recorded in previous reporting periods if the adjustment to the provisional amounts had been recognized as of the acquisition date. The adoption of ASU 2015-16 did not have a significant impact on the Company’s financial statements.
On January 1, 2016, the Company adopted ASU 2016-09, “Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting.” Under ASU 2016-09 all excess tax benefits and tax deficiencies related to share-based payment awards should be recognized as income tax expense or benefit in the income statement during the period in which they occur. Previously, such amounts were recorded in the pool of excess tax benefits included in additional paid-in capital, if such pool was available. Because excess tax benefits are no longer recognized in additional paid-in capital, the assumed proceeds from applying the treasury stock method when computing earnings per share should exclude the amount of excess tax benefits that would have previously been recognized in additional paid-in capital. Additionally, excess tax benefits should be classified along with other income tax cash flows as an operating activity rather than a financing activity, as was previously the case. ASU 2016-09 also provides that an entity can make an entity-wide accounting policy election to either estimate the number of awards that are expected to vest (current GAAP) or account for forfeitures when they occur. ASU 2016-09 changes the threshold to qualify for equity classification (rather than as a liability) to permit withholding up to the maximum statutory tax rates (rather than the minimum as was previously the case) in the applicable jurisdictions. The Company adopted ASU 2016-09 without a significant impact on its financial statements.
Newly Issued But Not Yet Effective Accounting Standards
ASU 2014-09 “Revenue from Contracts with Customers (Topic 606).” ASU 2014-09 supersedes the revenue recognition requirements in Revenue Recognition (Topic 605), and most industry-specific guidance throughout the Industry Topics of the Codification. The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 is effective for the Company beginning on January 1, 2018, with retrospective application to each prior reporting period presented. The Company expects to adopt ASU 2014-09 in the first quarter 2018 using the modified retrospective approach, which includes presenting the cumulative effect of initial application along with supplementary disclosures. The Company is evaluating the full effect that ASU 2014-09 will have on its consolidated financial statements and related disclosures, however, adoption of the ASU is not expected to have a significant impact. The Company’s primary sources of revenues are derived from interest and dividends earned on loans, investment securities and other financial instruments that are not within the scope of ASU 2014-09.
ASU No. 2016-01, "Financial Instruments - Overall (Subtopic 825-10): Recognition of Financial Assets and Financial Liabilities." ASU 2016-01 makes targeted amendments to fair value measurement and disclosure guidance. ASU 2016-01 requires equity investments (other than equity method investments) to be measured at fair value with changes in fair value recognized in net income. This change is only applied if a readily determinable fair value can be obtained. The update also requires the use of exit prices to measure fair value for disclosure purposes as well as other enhanced disclosure requirements. ASU 2016-01 will be effective for the Company on January 1, 2018 and is not expected to have a significant impact on its financial statements and related disclosures.
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ASU 2016-02 “Leases (Topic 842)." ASU 2016-02 will, among other things, require lessees to recognize a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. ASU 2016-02 does not significantly change lease accounting requirements applicable to lessors; however, certain changes were made to align, where necessary, lessor accounting with the lessee accounting model and ASC Topic 606, “Revenue from Contracts with Customers.” ASU 2016-02 will be effective for the Company on January 1, 2019 and will require transition using a modified retrospective approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. Early application of this ASU is permitted for all entities. Adoption of ASU 2016-02 is not expected to have a material impact on the Company’s financial statements. The Company leases certain properties and equipment under operating leases that will result in the recognition of lease assets and lease liabilities on the Company’s balance sheet under the ASU.
ASU No. 2016-10, “Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing.” ASU 2016-10 was issued to clarify ASC Topic 606, “Revenue from Contracts with Customers” related to (1) identifying performance obligations and (2) the licensing implementation guidance. The effective date and transition of ASU 2016-10 is the same as the effective date and transition of ASU 2014-09, “Revenue from Contracts with Customers (Topic 606),” as discussed above. The Company is currently evaluating the potential impact of ASU 2016-10 on its financial statements.
ASU 2016-13, “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” Among other things, ASU 2016-13 requires the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to better form their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. In addition, ASU 2016-13 amends the accounting for credit losses on available for sale debt securities and purchased financial assets with credit deterioration. ASU 2016-13 is effective for the Company on January 1, 2020 and must be applied using the modified retrospective approach with limited exceptions. Early adoption is permitted for fiscal years, and interim periods within those years, beginning after December 15, 2018. The Company is currently assessing the impact that the adoption of this standard will have on the financial condition and results of operations of the Company.
ASU 2016-15, “Statement of Cash Flows (Topic 230) - Classification of Certain Cash Receipts and Cash Payments." ASU 2016-15 provides guidance related to certain cash flow issues in order to reduce the current and potential future diversity in practice. Among other things, the update clarifies the appropriate classification for proceeds from settlement of bank owned life insurance (BOLI) policies. Based on preliminary assessments, the Company expects to change the classification of proceeds from settlement of BOLI policies from operating activities to investing activities. Other changes in classification resulting from this update are not expected to be significant. ASU 2016-15 is effective for the Company on January 1, 2018 and must be applied using the retrospective approach. Early adoption is permitted.
ASU No. 2017-04, “Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment,” ASU 2017-04 intends to simplify goodwill impairment testing by eliminating the second step of the analysis under which the implied fair value of goodwill is determined as if the reporting unit were being acquired in a business combination. The update instead requires entities to compare the fair value of a reporting unit with its carrying amount and recognize an impairment charge for any amount by which the carrying amount exceeds the reporting unit’s fair value, to the extent that the loss recognized does not exceed the amount of goodwill allocated to that reporting unit. ASU 2017-04 must be applied prospectively and is effective for the Company on January 1, 2020. Early adoption is permitted. The Company does not expect the new guidance to have a material impact on its financial condition or results of operation.
2. ACQUISITIONS
Acquisitions are accounted for using the acquisition method of accounting. Accordingly, the assets and liabilities of an acquired entity are recorded at their fair value at the acquisition date. The excess of the purchase price over the estimated fair value of the net assets is recorded as goodwill. The results of operations for an acquisition have been included in the Company’s consolidated financial results beginning on the respective acquisition date.
The measurement period for the Company to determine the fair values of acquired identifiable assets and assumed liabilities will end at the earlier of (1) twelve months from the date of the acquisition or (2) as soon as the Company receives the information it was seeking about facts and circumstances that existed as of the acquisition date or learns that more information is not obtainable. The following acquisitions were completed on the dates indicated below:
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2015 Acquisition
Acquisition of F&M Bancshares, Inc.-On January 1, 2015, the Company completed the acquisition of F&M Bancshares, Inc. (“F&M Bancshares”) and its wholly-owned subsidiary Enterprise Bank (“Enterprise”) headquartered in Houston, Texas. Enterprise operated nine banking locations, seven in Houston, Texas and two in Central Texas. The two Central Texas locations and their related assets have been classified within loans held for sale and branch assets held for sale as of December 31, 2015. During the first quarter of 2015, the Company consolidated two of the seven acquired Houston area locations due to the close proximity of these locations to its existing banking locations. The Company acquired F&M Bancshares to further expand its Houston, Texas area market. Goodwill resulted from a combination of expected operational synergies and an enhanced branching network. Goodwill is not expected to be deductible for tax purposes.
Pursuant to the merger agreement, the Company issued 2,338,520 shares of Allegiance common stock for all outstanding shares of F&M Bancshares capital stock and paid $642 thousand in cash for any fractional and out of state shares held by F&M Bancshares shareholders. The Company recognized goodwill of $28.2 million which is calculated as the excess of both the consideration exchanged and liabilities assumed as compared to the fair value of identifiable assets acquired, none of which is expected to be deductible for tax purposes. F&M Bancshares’ results of operations were included in the Company’s results beginning January 1, 2015. For the year ended December 31, 2015, net interest income associated with F&M Bancshares was $17.1 million. The Company does not track separately the noninterest income and noninterest expense of the F&M Bancshares branches.
As of December 31, 2015, the Company finalized its valuation of all assets and liabilities acquired, resulting in no changes to preliminary acquisition accounting adjustments. A summary of the final purchase price allocation is as follows (dollars in thousands):
Subsequent to the acquisition, the Company paid off the $18.0 million of funds borrowed from F&M Bancshares shareholders by drawing on its credit agreement with another financial institution. Additionally, the securities acquired from F&M Bancshares were sold subsequent to the acquisition with no income statement impact.
Additionally, on July 15, 2015, the Company redeemed all of the outstanding shares of Series A and Series B preferred stock for an aggregate redemption price of $11.7 million (which is the sum of the liquidation amount plus accrued and unpaid dividends up to, but excluding the redemption date). The Company issued the shares of Series A and Series B preferred stock in connection with the F&M Bancshares acquisition, which had preferred stock pursuant to the U.S. Treasury’s Troubled Asset Relief Program.
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The fair value of net assets acquired includes fair value adjustments to certain acquired loans that were not considered impaired as of the acquisition date. The fair value adjustments were determined using discounted contractual cash flows. The following presents details of all loans acquired as of January 1, 2015:
The following table presents unaudited pro forma financial information as if the acquisition had occurred at the beginning of 2014. The pro forma financial information is not necessarily indicative of the results of operations that would have occurred had the transactions been effected on the assumed dates.
To determine pro forma information, the Company adjusted its year ended December 31, 2015 and 2014 historical results to include the historical results for F&M Bancshares for the year ended December 31, 2014.
The pro forma information includes acquisition accounting adjustments to interest on loans, certificates of deposit and subordinated debt, difference in the rate of borrowed funds, amortization of intangibles arising from the transaction and the related income tax effects.
The Company incurred approximately $941 thousand and $245 thousand of pre-tax merger related expenses during the years ended December 31, 2015 and 2014, respectively, related to the F&M Bancshares acquisition. The merger expenses are reflected on the Company’s income statement for the applicable periods and are reported primarily in the categories of salaries and benefits and professional fees but are excluded from the calculation of pro forma income above.
As of December 31, 2015, the Company held the two Central Texas locations and their related assets for sale. The assets held for sale of these locations included loans, the related accrued interest receivable on those loans and premises and equipment. The loans are presented as loans held for sale on the balance sheet. The branch assets held for sale reported on the balance sheet include accrued interest receivable and premises and equipment for these two respective locations. The Company completed the sale of the two Central Texas banking locations in January 2016 for a gain of $2.1 million, or $1.3 million after-tax.
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3. GOODWILL AND CORE DEPOSIT INTANGIBLES
Changes in the carrying amount of the Company’s goodwill and core deposit intangibles were as follows:
Goodwill is recorded on the acquisition date of an entity. During the measurement period, the Company may record subsequent adjustments to goodwill for provisional amounts recorded at the acquisition date. There was a $145 thousand measurement-period adjustment recorded during 2014 related to the Independence Bank acquisition.
At October 1, 2015, the Company elected to perform a quantitative (Step 1) goodwill assessment. A Step 1 assessment includes the determination of the carrying value of the reporting unit, including the existing goodwill and intangible assets, and estimating the fair value of the reporting unit. The Step 1 assessment indicated that the fair value of the reporting unit exceeded its carrying value, resulting in no impairment.
The estimated aggregate future amortization expense for core deposit intangibles remaining as of December 31, 2016 is as follows (dollars in thousands):
4. CASH AND DUE FROM BANKS
The Bank can be required by the Federal Reserve Bank of Dallas to maintain average reserve balances. “Cash and due from banks” in the consolidated balance sheets included a restricted amount of $50.3 million at December 31, 2015. The Bank was not required to maintain reserve balances at December 31, 2016.
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5. SECURITIES
The amortized cost and fair value of investment securities were as follows:
As of December 31, 2016, the Company's management does not expect to sell any securities classified as available for sale with material unrealized losses; and the Company believes that it is more likely than not it will not be required to sell any of these securities before their anticipated recovery at which time the Company will receive full value for the securities. The fair value is expected to recover as the securities approach their maturity date or repricing date or if market yields for such investments decline. Management does not believe any of the securities are impaired due to reasons of credit quality. Accordingly, as of December 31, 2016, management believes the unrealized losses in the previous table are temporary and no other than temporary impairment loss has been realized in the Company’s consolidated statements of income.
The amortized cost and fair value of investment securities at December 31, 2016, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities if borrowers have the right to call or prepay obligations at any time with or without call or prepayment penalties.
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Securities with unrealized losses segregated by length of time such securities have been in a continuous loss position are as follows:
As of December 31, 2016, the Company’s security portfolio consisted of 314 securities, two of which were mortgage-backed securities that were in an unrealized loss position for more than 12 months. There were no realized losses on these securities as the Company believes these securities are temporarily impaired due to changes in market interest rates. The majority of the securities in an unrealized loss position are related to the Company's municipal securities.
The Company sold $2.5 million in securities during 2016 and recorded a gain on the sale of $30 thousand. The Company sold $2.2 million in securities during 2015 and recorded a loss on the sale of $37 thousand. During the first quarter of 2015, the Company sold all securities acquired in the F&M Bancshares transaction resulting in gross proceeds of approximately $15.0 million. No gains or losses were recognized. The Company sold $2.0 million in securities in 2014 and recorded a gain on the sale of $82 thousand.
At December 31, 2016 and 2015, the Company did not own securities of any one issuer, other than the U.S. government and its agencies, in an amount greater than 10% of the consolidated stockholders’ equity at such respective dates.
The carrying value of pledged securities was $4.9 million at December 31, 2016. The securities are pledged to further collateralize letters of credit issued by the Bank but confirmed by another financial institution. The Company did not have pledged securities at December 31, 2015.
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
6. LOANS AND ALLOWANCE FOR LOAN LOSSES
The loan portfolio balances, net of unearned income and fees, consist of various types of loans primarily all made to borrowers located within Texas and are classified by major type as follows:
(1)
Consists of loans at two former F&M Bancshares locations acquired on January 1, 2015. As of December 31, 2015, loans held for sale consists of $13.2 million of commercial and industrial loans, $11.6 million of commercial real estate (including multi-family residential) loans, $2.3 million of 1-4 family residential (including home equity) loans and $803 thousand of consumer and other loans. Loans held for sale are carried at lower of aggregate cost or fair value. On January 31, 2016, the Company completed the sale of these former F&M Bancshares branches and their related assets located in Central Texas.
(2)
Mortgage warehouse loans are to unaffiliated mortgage loan originators collateralized by mortgage promissory notes which are segregated in the Company’s mortgage warehouse portfolio. These promissory notes originated by the Company’s mortgage warehouse customers carry terms and conditions as would be expected in the competitive permanent mortgage market and serve as collateral under a traditional mortgage warehouse arrangement whereby such promissory notes are warehoused under a revolving credit facility to allow for the end investor (or purchaser) of the note to receive a complete loan package and remit funds to the bank. The maturity of each revolving line of credit facility is normally less than 24 months, while the promissory notes that are warehoused under such facilities may have a much shorter length of time outstanding. For mortgage promissory notes secured by residential property, the warehouse time is normally 10 to 20 days. For mortgage promissory notes secured by commercial property, the warehouse time is normally 40 to 50 days. The funded balance of the mortgage warehouse portfolio can have significant fluctuation based upon market demand for the product, level of home sales and refinancing activity, market interest rates and velocity of end investor processing times.
Loan Origination/Risk Management
The Company has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. The Company maintains an independent loan review department that reviews and validates the credit risk program on a periodic basis. In addition, an independent third party loan review is performed on an annual basis.
(i) Commercial and Industrial Loans. The Company makes commercial and industrial loans in its market area that are underwritten on the basis of the borrower’s ability to service the debt from income. The Company generally takes as collateral a lien on any available real estate, equipment or other assets owned by the borrower and typically obtains a personal guaranty of the borrower or principal. In general, commercial loans involve more credit risk than residential mortgage loans and commercial mortgage loans and therefore typically yield a higher return. The increased risk in commercial loans derives from the expectation that commercial and industrial loans generally are serviced principally from the operations of the business, which may not be successful and from the type of collateral securing these loans. As a result, commercial and industrial loans require more extensive underwriting and servicing than other types of loans.
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(ii) Commercial Real Estate. The Company makes loans collateralized by owner-occupied, nonowner-occupied and multi-family real estate to finance the purchase or ownership of real estate.
The Company’s nonowner-occupied and multi-family commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is dependent, in large part, on sufficient income from the properties securing the loans to cover operating expenses and debt service. The Company generally requires the borrower to have had an existing relationship with the Company and have a proven record of success. In addition, these loans are generally guaranteed by individual owners of the borrower and have typically lower loan to value ratios.
Loans secured by owner-occupied properties generally involve less risk and represented 53.5% of the outstanding principal balance of the Company’s commercial real estate loans at December 31, 2016. The Company is dependent on the cash flows of the business occupying the property and its owners and requires these loans to be secured by property with adequate margins and to be guaranteed by the individual owners. The Company’s owner-occupied commercial real estate loans collateralized by first liens on real estate typically have fixed interest rates and amortize over a 10 to 20 year period.
(iii) Construction and Land Development Loans. The Company makes loans to finance the construction of residential and to a lesser extent nonresidential properties. Construction loans generally are collateralized by first liens on real estate and have floating interest rates. The Company generally conducts periodic inspections, either directly or through an agent, prior to approval of periodic draws on these loans. Underwriting guidelines similar to those described above are also used in the Company’s construction lending activities. Construction loans involve additional risks as they often involve the disbursement of funds with the repayment dependent on the ultimate success of the project’s completion. Sources of repayment for these loans may be pre-committed permanent financing or sale of the developed property. The loans in this portfolio are monitored closely by management. Due to uncertainties inherent in estimating construction costs, the market value of the completed project and the effects of governmental regulation on real property, it can be difficult to accurately evaluate the total funds required to complete a project and the related loan to value ratio. As a result of these uncertainties, construction lending often involves the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project rather than the ability of a borrower or guarantor to repay the loan. If the Company is forced to foreclose on a project prior to completion, there is no assurance that the Company will be able to recover all of the unpaid portion of the loan. In addition, the Company may be required to fund additional amounts to complete a project and may have to hold the property for an indeterminate period of time.
(iv) Residential Real Estate Loans. The Company’s lending activities also include the origination of 1-4 family residential mortgage loans (including home equity loans) collateralized by owner-occupied residential properties located in the Company’s market areas. The Company offers a variety of mortgage loan portfolio products which have a term of 5 to 7 years and generally amortize over 10 to 20 years. Loans collateralized by 1-4 family residential real estate generally have been originated in amounts of no more than 90% of appraised value.
(v) Consumer and Other Loans. The Company makes a variety of loans to individuals for personal and household purposes including secured and unsecured installment and term loans. Consumer loans are underwritten based on the individual borrower’s income, current debt level, past credit history and the value of any available collateral. The terms of these loans typically range from 12 to 60 months and vary based upon the nature of collateral and size of loan. Generally, consumer loans entail greater risk than residential real estate loans because they may be unsecured or if secured the value of the collateral, such as an automobile or boat, may be more difficult to assess and more likely to decrease in value than real estate. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan balance. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws may limit the amount which can be recovered on such loans.
Concentrations of Credit
The vast majority of the Company’s lending activity occurs in and around the Houston, Texas area. The Company’s loans are primarily loans secured by real estate, including commercial and residential construction, owner-occupied and nonowner-occupied and multi-family commercial real estate, raw land and other real estate based loans.
Related Party Loans
As of December 31, 2016 and 2015, loans outstanding to directors, officers and their affiliates totaled $3.9 million and $2.5 million, respectively.
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
An analysis of activity with respect to these related-party loans is as follows:
Nonaccrual and Past Due Loans
An aging analysis of the recorded investment in past due loans, segregated by class of loans, is as follows:
(1) Includes $1.3 million of loans acquired from F&M Bancshares.
(2) Includes $676 thousand of loans acquired from F&M Bancshares.
If interest on nonaccrual loans had been accrued under the original loan terms, approximately $892 thousand and $404 thousand would have been recorded as income for the years ended December 31, 2016 and 2015, respectively.
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Impaired Loans
Impaired loans by class of loans are set forth in the following tables.
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following table presents the average recorded investment of impaired loans and interest recognized on impaired loans.
The average recorded investment of impaired loans for the year ended December 31, 2014 was $9.1 million. Interest income recognized for the year ended December 31, 2014 was $405 thousand.
Credit Quality Indicators
The company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt including factors such as: current financial information, historical payment experience, credit documentation, public information and current economic trends. The Company analyzes loans individually by classifying the loans by credit risk. As part of the ongoing monitoring of the credit quality of the Company’s loan portfolio and methodology for calculating the allowance for credit losses, management assigns and tracks risk ratings to be used as credit quality indicators.
The following is a general description of the risk ratings used:
Watch-Loans classified as watch loans may still be of high quality, but have an element of risk added to the credit such as declining payment history, deteriorating financial position of the borrower or a decrease in collateral value.
Special Mention-Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
Substandard-Loans classified as substandard have well-defined weaknesses on a continuing basis and are inadequately protected by the current net worth and paying capacity of the borrower, impaired or declining collateral values, or a continuing downturn in their industry which is reducing their profits to below zero and having a significantly negative impact on their cash flow. These loans so classified are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
Doubtful-Loans classified as doubtful have all the weaknesses inherent in those classified as substandard with the added characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values, highly questionable and improbable.
Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans.
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Based on the most recent analysis performed, the risk category of loans by class of loan at December 31, 2016 is as follows:
The following table presents the risk category of loans by class of loan at December 31, 2015:
Allowance for Loan Losses
At December 31, 2016, the allowance for loan losses totaled $17.9 million, or 0.95% of total loans. At December 31, 2015, the allowance aggregated $13.1 million or 0.78% of total loans.
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following table presents the activity in the allowance for loan losses by portfolio type for the years ended December 31, 2016, 2015 and 2014:
The following table presents the balance in the allowance for loan losses by portfolio type based on the impairment method as of December 31, 2016 and 2015:
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following table presents the recorded investment in loans held for investment by portfolio type based on the impairment method as of December 31, 2016 and 2015:
Troubled Debt Restructurings
As of December 31, 2016 and 2015, the Company had a recorded investment in troubled debt restructurings of $12.6 million and $3.1 million, respectively. The Company allocated $879 thousand and $681 thousand of specific reserves for these loans at December 31, 2016 and 2015, respectively, and did not commit to lend additional amounts on these loans.
The following table presents information regarding loans modified in a troubled debt restructuring during the years ended December 31, 2016, 2015 and 2014:
Troubled debt restructurings resulted in charge-offs of $211 thousand, $45 thousand and $38 thousand during the years ended December 31, 2016, 2015 and 2014, respectively.
As of December 31, 2016, there have been no defaults on any loans that were modified as troubled debt restructurings during the preceding 12 months. Default is determined at 90 or more days past due. The modifications primarily related to extending the amortization periods of the loans. The Company did not grant principal reductions on any restructured loans. During the year ended December 31, 2016, the Company added $10.9 million in new troubled debt restructurings, of which $10.8 million were still outstanding on December 31, 2016.
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
7. FAIR VALUE
The Company uses fair value measurements to record fair value adjustments to certain assets and to determine fair value disclosures. Fair value represents the estimated exchange price that would be received from selling an asset or paid to transfer a liability, otherwise known as an “exit price” in the principal or most advantageous market available to the entity in an orderly transaction between market participants on the measurement date.
Fair Value Hierarchy
•
Level 1-Quoted prices for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
•
Level 2-Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.
•
Level 3-Significant unobservable inputs that reflect management’s judgment and assumptions that market participants would use in pricing an asset or liability that are supported by little or no market activity.
The carrying amounts and estimated fair values of financial instruments that are reported on the balance sheet are as follows:
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The fair value estimates presented herein are based on pertinent information available to management as of the dates indicated. The following is a description of valuation methodologies used for assets and liabilities recorded at fair value, non-financial assets and non-financial liabilities and for estimating fair value for financial instruments not recorded at fair value:
Cash and Cash Equivalents-For these short-term instruments, the carrying amount is a reasonable estimate of fair value. The Company classifies the estimated fair value of these instruments as Level 1.
Available for Sale Securities-Fair values for investment securities are based upon quoted market prices, if available, and are considered Level 1 inputs. For all other available for sale securities, if quoted prices are not available, fair values are measured based on market prices for similar securities and are considered Level 2 inputs. For these securities, the Company generally obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things.
Available for sale securities are recorded at fair value on a recurring basis.
Loans Held For Sale-Loans held for sale are carried at the lower of aggregate cost or fair value, which is evaluated on a pool-level basis. The fair value of loans held for sale was determined using assets, adjusted for specific attributes of that loan or other observable market data. The Company classifies the fair value of loans held for sale as Level 3.
Loans Held for Investment-The estimated fair value approximates carrying value for variable-rate loans that reprice frequently and that have no significant change in credit risk resulting in a Level 3 classification. Fair values for fixed-rate loans and variable rate loans which reprice infrequently are estimated by discounting future cash flows based on interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.
Federal Home Loan Bank Stock-The fair value of FHLB stock is estimated to be equal to its carrying amount as it is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.
Deposits-The fair value of demand deposits (e.g., interest and noninterest checking, savings and certain types of money market deposits) is the amount payable on demand at the reporting date (i.e., their carrying amount) resulting in a Level 2 classification. The fair value of fixed rate certificates of deposit is estimated using a discounted cash flows calculation that applies interest rates currently offered on certificates of deposit to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.
Short-term Borrowings-The carrying amounts of short-term borrowings, generally maturing within ninety days, approximate their fair values resulting in a Level 2 classification.
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Subordinated Debentures-The fair value of subordinated debentures is estimated using discounted cash flow analyses based on the Company’s current borrowing rates for similar types of borrowing arrangements and are measured utilizing Level 2 inputs.
Other Borrowed Funds-The fair value of the Company’s other borrowed funds are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements and are measured utilizing Level 2 inputs.
Accrued Interest-The carrying amounts of accrued interest approximate their fair values resulting in a Level 2 or 3 classification.
Off-balance sheet instruments-The fair values of off-balance sheet commitments to extend credit and standby letters of credit financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The Company has reviewed the unfunded portion of commitments to extend credit as well as standby and other letters of credit and has determined that the fair value of such financial instruments is not material.
The following tables present fair values for assets measured at fair value on a recurring basis:
There were no liabilities measured at fair value on a recurring basis as of December 31, 2016 or 2015. There were no transfers between levels during 2016 or 2015.
Certain assets and liabilities are measured at fair value on a nonrecurring basis; that is the instruments are not measured at fair value on an ongoing basis, but are subject to fair value adjustments in certain circumstances such as evidence of impairment.
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Historically, we measure fair value for certain loans and other real estate owned on a nonrecurring basis as described below.
Other real estate owned
Other real estate owned is comprised of real estate acquired in partial or full satisfaction of loans. Other real estate owned is recorded at its estimated fair value less estimated selling and closing costs at the date of transfer. Any excess of the related loan balance over the fair value less expected selling costs is charged to the allowance. Subsequent declines in fair value are reported as adjustments to the carrying amount and are recorded against earnings. The fair value of other real estate owned is determined using appraisals or other indications of value based on recent comparable sales of similar properties or assumptions generally observable in the marketplace.
Impaired Loans with Specific Allocation of Allowance
Impaired loans are those loans the Company has measured at fair value, generally based on the fair value of the loan’s collateral. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due pursuant to the contractual terms of the loan agreement. Fair value is generally determined based on appraisals of the collateral which are then adjusted for the estimated selling and closing costs related to liquidation of the collateral, or discounted cash flows based upon the expected proceeds. Estimated selling and closing costs range from 5% to 10% of the value of the underlying collateral.
During the years ended December 31, 2016 and 2015, certain impaired loans were reevaluated and reported at fair value through a specific allocation of the allowance for loan losses. At December 31, 2016, the total reported fair value of impaired loans of $2.3 million based on collateral valuations utilizing Level 3 valuation inputs had a carrying value of $3.9 million that was reduced by specific allowance allocations totaling $1.7 million. At December 31, 2015, the total reported fair value of impaired loans of $1.9 million based on collateral valuations utilizing Level 3 valuation inputs had a carrying value of $2.7 million that was reduced by specific allowance allocations totaling $859 thousand.
8. PREMISES AND EQUIPMENT
Premises and equipment are summarized as follows:
Depreciation expense was $1.6 million, $1.6 million and $1.1 million for the years ended December 31, 2016, 2015 and 2014, respectively.
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
9. DEPOSITS
Time deposits that meet or exceed the Federal Deposit Insurance Corporation (the “FDIC”) Insurance limit of $250 thousand at December 31, 2016 and December 31, 2015 were $196.5 million and $164.7 million, respectively.
Scheduled maturities of time deposits for the next five years are as follows (dollars in thousands):
The Company has $65.9 million and $56.5 million of brokered deposits; and there are no major concentrations of deposits with any one depositor at December 31, 2016 and 2015, respectively. Included in these amounts are reciprocal deposits that the Company has placed through the Certificates of Deposits Account Registry Service (CDARS) Network of $64.8 million and $55.5 million, at December 31, 2016 and 2015, respectively.
Related party deposits from principal officers, directors and their affiliates at December 31, 2016 and 2015 were $14.8 million and $12.0 million, respectively.
10. BORROWINGS AND BORROWING CAPACITY
The Company has an available line of credit with the FHLB of Dallas, which allows the Company to borrow on a collateralized basis. FHLB advances are used to manage liquidity as needed. The advances are secured by a blanket lien on certain loans. Maturing advances are replaced by drawing on available cash, making additional borrowings or through increased customer deposits. At December 31, 2016, the Company had a total borrowing capacity of $683.1 million, of which $362.7 million was available and $320.4 million was outstanding. Short-term FHLB advances of $85.0 million were outstanding at December 31, 2016, at a weighted average rate of 0.55%. Long-term FHLB borrowings of $200.0 million were outstanding at December 31, 2016, at a weighted average rate of 0.56%. Of the total long-term FHLB borrowings, $100.0 million will expire in April 2018 and another $100.0 million will expire in May 2018. Letters of credit were $35.4 million at December 31, 2016, of which $3.0 million expired in February 2017, $7.3 million will expire in August 2017 and $25.0 million will expire in October 2017.
In 2015, the Company borrowed an additional $18.0 million under its credit agreement with another financial institution, which was in addition to the $10.1 million of indebtedness incurred under the credit agreement in 2014. The credit agreement matures in December 2021. The Company used the funds borrowed in 2015 to repay debt that F&M Bancshares owed and used the funds borrowed in 2014 to pay off a previous borrowing with another financial institution that had been entered into during 2013 in conjunction with the Independence Bank acquisition. In October 2015, the Company paid down $27.5 million of the credit agreement with a portion of the proceeds from the Initial Public Offering. The credit agreement includes certain restrictive covenants. At December 31, 2016, the Company believes it is in compliance with its debt covenants and had not been made aware of any noncompliance by the lender. The interest rate on the debt is the Prime Rate minus 25 basis points, or 3.50%, at December 31, 2016, and is paid quarterly. Scheduled principal maturities are as follows (dollars in thousands):
11. SUBORDINATED DEBENTURES
On January 1, 2015, the Company acquired F&M Bancshares and assumed Farmers & Merchants Capital Trust II and Farmers & Merchants Capital Trust III. Each of the trusts is a capital or statutory business trust organized for the sole purpose of issuing trust securities and investing the proceeds in the Company’s junior subordinated debentures. The preferred trust securities of each trust represent preferred beneficial interests in the assets of the respective trusts and are subject to mandatory redemption upon payment of
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
the junior subordinated debentures held by the trust. The common securities of each trust are wholly owned by the Company. Each trust’s ability to pay amounts due on the trust preferred securities is solely dependent upon the Company making payment on the related junior subordinated debentures. The debentures, which are the only assets of each trust, are subordinate and junior in right of payment to all of the Company’s present and future senior indebtedness. The Company has fully and unconditionally guaranteed each trust’s obligations under the trust securities issued by such trust to the extent not paid or made by each trust, provided such trust has funds available for such obligations.
Under the provisions of each issue of the debentures, the Company has the right to defer payment of interest on the debentures at any time, or from time to time, for periods not exceeding five years. If interest payments on either issue of the debentures are deferred, the distributions on the applicable trust preferred securities and common securities will also be deferred.
The Company assumed the junior subordinated debentures with an aggregate original principal amount of $11.3 million and a current fair value of $9.2 million at December 31, 2016. At acquisition, the Company recorded a discount of $2.5 million on the debentures. The difference between the carrying value and contractual balance will be recognized as a yield adjustment over the remaining term for the debentures. At December 31, 2016, the Company had $11.3 million outstanding in junior subordinated debentures issued to the Company’s unconsolidated subsidiary trusts. The junior subordinated debentures are included in Tier 1 capital under current regulatory guidelines and interpretations.
A summary of pertinent information related to the Company’s issues of junior subordinated debentures outstanding at December 31, 2016 is set forth in the table below:
_____________
(1)
The 3-month LIBOR in effect as of December 31, 2016 was 0.9773%.
(2)
All debentures are currently callable.
12. INCOME TAXES
The components of the provision for federal income taxes are as follows:
Reported income tax expense differs from the amounts computed by applying the U.S. federal statutory income tax rate of 35% to income before income taxes for the years ended December 31, 2016, 2015 and 2014 due to the following:
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Deferred tax assets and liabilities are as follows:
The amount of federal and state income tax expense is influenced by the amount of pre-tax income, the amount of tax-exempt income and the amount of other nondeductible items. For the year ended December 31, 2016, income tax expense was $9.6 million compared with $7.8 million for the year ended December 31, 2015 and $4.8 million for the year ended December 31, 2014. The increase in income tax expense year over year was primarily attributable to higher pre-tax earnings. The effective income tax rate for the year ended December 31, 2016 was 29.5% compared to 33.0% for the year ended December 31, 2015 and 34.9% for the year ended December 31, 2014. The effective tax rate decreased for the year ended 2016 compared to the same period in 2015 and 2014 due to the increase in tax free income from the purchase of additional municipal securities and from cashless exercises of stock options by employees in 2016.
Interest and penalties related to tax positions are recognized in the period in which they begin accruing or when the entity claims the position that does not meet the minimum statutory thresholds. The Company does not have any uncertain tax positions and does not have any interest and penalties recorded in the income statement for the years ended December 31, 2016, 2015 and 2014. The Company is no longer subject to examination by the US Federal Tax Jurisdiction for the years prior to 2013.
13. STOCK BASED COMPENSATION
During 2008, the Company’s Board of Directors and shareholders approved the 2008 Stock Awards and Incentive Plan (the “Plan”) covering certain key employees to purchase shares of the Company’s stock. The Plan was amended in 2015 as the shareholders authorized a maximum aggregate number of shares of stock to be issued of 1,460,000, any or all of which may be issued through incentive stock options. The Company accounts for stock based employee compensation plans using the fair value-based method of accounting. The Company recognized total stock based compensation expense of $1.5 million, $1.4 million and $731 thousand for the years ended December 31, 2016, 2015 and 2014, respectively.
Stock Options
Options to purchase a total of 1,240,431 shares of Company stock have been granted as of December 31, 2016. Under the Plan, options are exercisable up to 10 years from the date of the grant, unless otherwise provided by the Board of Directors and are fully vested 4 years after the date of grant. The fair value of stock options granted is estimated at the date of grant using the Black-Scholes option-pricing model. The expected volatility was determined based on historical volatilities of Allegiance's common stock. The expected term of options granted is based on historical data and represents the period of time that options granted are expected to be outstanding and takes into account that the options are not transferable. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of the grant.
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Black-Scholes pricing model utilizes certain assumptions noted in the table below.
A summary of the activity in the stock option plan during the years ended December 31, 2016 and 2015 is set forth below:
The Company expects all outstanding options at December 31, 2016 to vest.
Information related to the stock option plan during each year is as follows:
As of December 31, 2016, there was $2.2 million of total unrecognized compensation cost related to nonvested stock options granted under the Plan. The cost is expected to be recognized over a weighted-average period of 1.99 years.
Restricted Stock Awards
The Company has issued 76,356 restricted stock awards under the Plan as of December 31, 2016. During 2014, the Company issued 8,385 shares of restricted stock with a grant date fair value of $20.34 per share. During 2015, the Company awarded 3,983 shares of restricted stock with a grant date fair value of $22.00. During 2016, the Company awarded 15,401 shares of restricted stock with a weighted average grant date fair value of $17.52. The restricted stock shares will vest over a period of 4 years but are considered outstanding at the date of issuance. The Company accounts for restricted stock grants by recording the fair value of the grant as compensation expense over the vesting period.
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A summary of the activity of the nonvested shares of restricted stock as of December 31, 2016 and 2015 including changes during the years then ended is as follows:
At December 31, 2016, there was $258 thousand of unrecognized compensation expense related to the restricted stock awards which is expected to be recognized over a remaining period of 2.85 years. The total fair value of restricted stock awards that fully vested during the years ended December 31, 2016, 2015 and 2014 was approximately $172 thousand, $220 thousand and $200 thousand, respectively.
14. OTHER EMPLOYEE BENEFITS
401(k) benefit plan
The Company has a 401(k) benefit plan whereby participants may contribute a percentage of their compensation. The Company matches 50% of an employee contributions up to 6% of the employee’s compensation, for a maximum match of 3% of compensation. Matching contribution expense as of December 31, 2016, 2015 and 2014 was $637 thousand, $551 thousand and $303 thousand, respectively.
Profit sharing plan
The financial statements include an accrual for $1.7 million, $1.2 million and $823 thousand for a contribution to the plan as a profit sharing contribution for the years ended December 31, 2016, 2015 and 2014, respectively.
Employee Stock Purchase Plan
The Company offers its employees an opportunity to purchase shares of the Company’s common stock, pursuant to the terms of the Allegiance Bancshares, Inc. Amended and Restated Employee Stock Purchase Plan (“ESPP Plan”). The ESPP Plan was adopted by the Board of Directors to provide employees with an opportunity to purchase shares of the Company in order to provide employees a more direct opportunity to participate in the Company’s growth. The Company allows the employees to purchase shares at a 15% discount to market value and thus incurs stock based compensation expense for the fair value of the discount given. The Company recognized total stock based compensation expense of $90 thousand and $96 thousand for the years ended December 31, 2016 and 2015, respectively.
15. OFF-BALANCE SHEET ARRANGEMENTS, COMMITMENTS AND CONTINGENCIES
In the normal course of business, the Company enters into various transactions, which, in accordance with accounting principles generally accepted in the United States are not included in the Company’s consolidated balance sheets. The Company enters into these transactions to meet the financing needs of its customers. These transactions include commitments to extend credit and standby and commercial letters of credit, which involve to varying degrees elements of credit risk and interest rate risk in excess of the amounts recognized in the consolidated balance sheets. The Company uses the same credit policies in making commitments and conditional obligations as it does for on balance sheet instruments.
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Commitments to Extend Credit
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being fully drawn upon, the total commitment amounts disclosed do not necessarily represent future cash funding requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The Company minimizes its exposure to loss under these commitments by subjecting them to credit approval and monitoring procedures. Management assesses the credit risk associated with certain commitments to extend credit in determining the level of the allowance for credit losses. The amount and type of collateral, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the customer.
Standby Letters of Credit
Standby letters of credit are written conditional commitments issued by the Company to guarantee the performance of a customer to a third party. In the event of nonperformance by the customer, the Company has the rights to the underlying collateral. The credit risk to the Company in issuing letters of credit is essentially the same as that involved in extending loan facilities to its customers. The Company’s policy for obtaining collateral, and the nature of such collateral, is essentially the same as that involved in making commitments to extend credit.
The contractual amounts of financial instruments with off-balance sheet risk are as follows:
Commitments to make loans are generally made for periods of 120 days or less. As of December 31, 2016, the fixed rate loan commitments have interest rates ranging from 1.60% to 7.50% with a weighted average maturity and rate of 1.97 years and 4.65%, respectively.
Leases
The following table presents a summary of non-cancelable future operating lease commitments as of December 31, 2016 (dollars in thousands):
It is expected that in the normal course of business, expiring leases will be renewed or replaced by leases on other property or equipment. Rent expense under all noncancelable operating lease obligations aggregated approximately $2.7 million, $2.6 million and $2.0 million for the years ended December 31, 2016, 2015 and 2014, respectively.
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
16. REGULATORY CAPITAL MATTERS
The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations involve quantitative measures of assets, liabilities and certain off balance sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weightings and other factors. Failure to meet minimum capital requirements can initiate actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements. The final rules implementing Basel Committee on Banking Supervision’s capital guideline for U.S. Banks (Basel III Rules) became effective for the Company on January 1, 2015 with full compliance with all of the requirements being phased in over a multi-year schedule, and fully phased in by January 1, 2019. Management believes as of December 31, 2016 and 2015, the Company and the Bank meet all capital adequacy requirements to which they are subject.
Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited as is asset growth and expansion, and capital restoration plans are required. At year end 2016 and 2015, the most recent regulatory notifications categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the institution’s category.
The following is a summary of the Company’s and the Bank’s actual and required capital ratios at December 31, 2016 and 2015:
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Dividend Restrictions
Allegiance's principal source of funds for dividend payments is dividends received from the Bank. Banking regulations limit the amount of dividends that may be paid without prior approval of regulatory agencies. Under these regulations, the amount of dividends that may be paid by the Bank in any calendar year is limited to the current year’s net profits combined with the retained net profits of the preceding two years, subject to the capital requirements described above.
17. EARNINGS PER COMMON SHARE
Diluted earnings per common share is computed using the weighted-average number of common shares determined for the basic earnings per common share computation plus the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock using the treasury stock method. Outstanding stock options issued by the Company represent the only dilutive effect reflected in diluted weighted average shares. Restricted shares are considered outstanding at the date of grant, accounted for as participating securities and are included in basic and diluted weighted average common shares outstanding.
All stock options as of December 31, 2016 and December 31, 2015 were dilutive and considered in computing diluted earnings per share.
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
18. PARENT COMPANY ONLY FINANCIAL STATEMENTS
ALLEGIANCE BANCSHARES, INC
(PARENT COMPANY ONLY)
CONDENSED BALANCE SHEETS
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
ALLEGIANCE BANCSHARES, INC
(PARENT COMPANY ONLY)
CONDENSED STATEMENTS OF INCOME
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
ALLEGIANCE BANCSHARES, INC
(PARENT COMPANY ONLY)
CONDENSED STATEMENTS OF CASH FLOWS
ALLEGIANCE BANCSHARES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
19. QUARTERLY FINANCIAL DATA (UNAUDITED)
(1)
Earnings per share are computed independently for each of the quarters presented and therefore may not total earnings per share for the year.