First Business Reports Third Quarter 2020 Financial Results

First Business Financial Services, Inc. (the “Company” or “First Business”) (Nasdaq:FBIZ) reported stable net interest income and record non-interest income, resulting in net income of $4.3 million, or diluted earnings per share of $0.50, in the third quarter 2020. First Business’s solid operating performance during the quarter was offset by a $3.8 million provision for loan and lease losses and related 12.2% increase in the allowance for loan and lease losses primarily due to the COVID-19 pandemic.

“First Business’s commitment to provide extraordinary levels of service and responsiveness to a growing number of clients was evident in the third quarter, with record loan growth, in-market deposits and top-line revenue,” said Corey Chambas, President and Chief Executive Officer. “Strong revenue, which was boosted by fee income growing to 28% of total revenue, coupled with expense management, enabled us to increase net income. We accomplished this even as the Company continued to build reserves to prudently strengthen the balance sheet in light of the public health and economic challenges that we continue to face as a nation. We are also encouraged by favorable COVID-19 deferral trends, as 95% of clients whose first deferral concluded during the quarter resumed their scheduled payments.”

Summary results as of and for the quarter ended September 30, 2020:

• Net income totaled $4.3 million, or diluted earnings per share of $0.50, in the third quarter of 2020, compared to $3.3 million, or diluted earnings per share of $0.38, in the second quarter of 2020 and $5.1 million, or diluted earnings per share of $0.59, in the third quarter of 2019.
• Annualized return on average assets and annualized return on average equity measured 0.68% and 8.58%, respectively, compared to 0.55% and 6.70% for the linked quarter and 0.97% and 10.68% for the third quarter of 2019.
• As of September 30, 2020, the Company had $332.3 million in Paycheck Protection Program (“PPP”) loans outstanding and $6.9 million of deferred processing fees from the Small Business Administration (“SBA”). The processing fees are deferred and recognized as interest income over the contractual life of the loan, or accelerated at forgiveness. During the third quarter of 2020 and linked quarter, the Company recognized $1.1 million and $859,000, respectively, in processing fee income through interest income.
• Pre-tax, pre-provision adjusted earnings, which excludes certain one-time and discrete items as defined in the Non-GAAP Reconciliations at the end of this release, totaled $9.3 million, down 4.6% from the second quarter of 2020 and up 23.0% from the third quarter of 2019. Pre-tax, pre-provision adjusted return on average assets was 1.47% compared to 1.61% and 1.45% for the linked and prior year quarters, respectively.
• Record period-end gross loans and leases receivable were $2.170 billion as of September 30, 2020, up $113.4 million from June 30, 2020 and $449.8 million from September 30, 2019. PPP loan proceeds, net of deferred processing fees, reduced our clients’ borrowing needs during the second quarter of 2020, resulting in line of credit utilization of $217.6 million as of September 30, 2020, up from $212.6 million as of the second quarter of 2020 and down from $312.8 million as of the third quarter of 2019. Gross loans and leases receivable, excluding net PPP loans and lines of credit, were $1.627 billion as of September 30, 2020, up 27.0% annualized from the second quarter of 2020 and 15.6% from the third quarter of 2019.
• Non-performing assets were $36.7 million, or 1.41% of total assets, compared to $25.5 million, or 1.03%, at June 30, 2020 and $25.7 million, or 1.23%, at September 30, 2019. Non-performing assets to total assets, excluding net PPP loans was 1.61%, compared to 1.19%, at June 30, 2020.
• The allowance for loan and lease losses increased $3.4 million, or 12.2%, compared to June 30, 2020 primarily due to a $3.0 million increase in specific reserves and a $376,000 increase in general reserves, principally driven by the COVID-19 pandemic. The allowance for loan and lease losses increased to 1.41% of total loans, compared to 1.33% and 1.17% at June 30, 2020 and September 30, 2019, respectively. Excluding net PPP loans, the allowance for loan and lease losses increased to 1.67% of total loans as of September 30, 2020, compared to 1.57% as of June 30, 2020.
• Provision for loan and lease losses totaled $3.8 million in the third quarter of 2020, compared to $5.5 million in the second quarter of 2020 and $1.3 million in the third quarter of 2019.
• Robust liquidity position includes record in-market deposits of $1.667 billion, up $46.6 million from June 30, 2020 and $346.3 million from September 30, 2019.
• Net interest margin was 3.14% in the third quarter of 2020, compared to 3.34% in the second quarter of 2020 and 3.40% in the third quarter of 2019. Adjusted net interest margin, which excludes certain one-time and discrete items as defined in the Non-GAAP Reconciliations at the end of this release, was 3.24% in the third quarter of 2020, compared to 3.32% in the second quarter of 2020 and 3.24% in the third quarter of 2019.
• Fees in lieu of interest, defined as prepayment fees, asset-based loan fees, non-accrual interest, and loan fee amortization, totaled $1.5 million in the third quarter of 2020, compared to $2.3 million in the second quarter of 2020 and $1.1 million in the third quarter of 2019.
• Top line revenue, defined as net interest income plus non-interest income, totaled $26.0 million, up 13.0% annualized from the second quarter of 2020 and 15.3% from the third quarter of 2019.
• Non-interest income totaled $7.4 million, or 28.5% of total revenue, in the third quarter of 2020, surpassing the Company’s goal of 25% for the sixth consecutive quarter, compared to $6.3 million, or 25.1% of total revenue in the second quarter of 2020 and $5.8 million, or 25.7% of total revenue in the third quarter of 2019.
• Non-interest expense was $16.8 million in the third quarter of 2020, compared to $18.3 million in the second quarter of 2020 and $14.7 million in the third quarter of 2019. Operating expense, which excludes certain one-time and discrete items as defined in the Non-GAAP Reconciliations at the end of this release, totaled $16.7 million in the third quarter of 2020, compared to $15.4 million in the second quarter of 2020 and $15.0 million in the third quarter of 2019.
• The efficiency ratio, which excludes certain one-time and discrete items as defined in the Non-GAAP Reconciliations at the end of this release, was 64.16% in the third quarter of 2020, up from 61.22% and down from 66.41% in the linked and prior year quarters, respectively.

1. This is a non-GAAP financial measure. Management believes these measures are meaningful because they reflect adjustments commonly made by management, investors, regulators, and analysts to evaluate financial performance, provide greater understanding of ongoing operations, and enhance comparability of results with prior periods. See the section titled Non-GAAP Reconciliations at the end of this release for a reconciliation of GAAP financial measures to non-GAAP financial measures.

COVID-19 Update

Paycheck Protection Program

As of September 30, 2020, the Company had $332.3 million in PPP loans outstanding and $6.9 million in deferred processing outstanding. The processing fees are deferred and recognized over the contractual life of the loan, or accelerated at forgiveness, as an adjustment of yield using the interest method. For the three and nine months ended September 30, 2020, $1.1 million and $2.0 million were recognized in interest income, respectively, compared to no PPP loan processing fee income for the three and nine months ended September 30, 2019. The SBA provides a guaranty to the lender of 100% of principal and interest, unless the lender violated an obligation under the agreement. As loan losses are expected to be immaterial, if any at all, due to the guaranty, management excluded the gross PPP loans from the allowance for loan and lease losses calculation. As of October 20, 2020, the Company had processed and submitted $97.9 million, or 29% of total gross PPP loans, to the SBA for forgiveness and clients have started to receive reimbursements.

Liquidity Sources

Management has reviewed all primary and secondary sources of liquidity in preparation for any unforeseen funding needs due to the COVID-19 pandemic and prioritized based on available capacity, term flexibility, and cost. As of September 30, 2020, the Company had the following sources of liquidity, including the Company’s ability to participate in the Federal Reserve’s Paycheck Protection Program Liquidity Facility (“PPPLF”):

In addition to the above primary sources of liquidity, as of September 30, 2020, the Company also had access to $53.5 million in federal funds lines with various correspondent banks and significant experience accessing the highly liquid brokered certificate of deposit market.

Capital Strength

The Company’s capital ratios continued to exceed the highest required regulatory benchmark levels.

• Total capital to risk-weighted assets at September 30, 2020 was 11.42%, tier 1 capital to risk-weighted assets was 9.09%, tier 1 leverage capital to adjusted average assets was 8.04%, and common equity tier 1 capital to risk-weighted assets was 8.64%. Tangible common equity to tangible assets was 7.29%. Excluding net PPP loans, tier 1 leverage capital to adjusted average assets and tangible common equity to tangible assets were 9.24% and 8.34%, respectively.
• Management suspended the Company’s stock repurchase program in March 2020 due to the uncertainty surrounding the COVID-19 pandemic. As of March 16, 2020, the Company had repurchased 141,137 shares of its common stock at a weighted average price of $24.62 per share, for a total value of $3.5 million. The Company has $1.5 million of buyback authority remaining.
• As previously announced, during the third quarter of 2020, the Company’s Board of Directors declared a regular quarterly dividend of $0.165 per share. The dividend was paid on August 13, 2020 to stockholders of record at the close of business on August 3, 2020. Measured against third quarter 2020 diluted earnings per share of $0.50, the dividend represents a 33.0% payout ratio. The Board of Directors routinely considers dividend declarations as part of its normal course of business.

Deferral Requests

The Company provided loan modifications deferring payments up to six months to certain borrowers impacted by COVID-19 who were current in their payments at the inception of the Company’s loan modification program. As of September 30, 2020, the Company had deferred loans outstanding of $131.5 million, or 7.1% of gross loans and leases, excluding gross PPP loans, compared to $323.2 million, or 18.6% of gross loans and leases, excluding gross PPP loans, as of June 30, 2020. As of October 20, 2020, 95% of clients whose first deferral concluded during the quarter resumed their scheduled payments. Management anticipates the loan modifications will continue through 2020 due to the remaining uncertainty surrounding the COVID-19 pandemic. The following tables represent a breakdown of the deferred loan balances by industry segment and collateral type:

Exposure to Stressed Industries

Certain industries are widely expected to be particularly impacted by social distancing, quarantines, and the economic impact of the COVID-19 pandemic, such as the following:

1. Excluding net PPP loans.
2. Includes $52.0 million and $51.7 million in loans secured by commercial real estate as of September 30, 2020 and June 30, 2020, respectively.

As of September 30, 2020, the Company had no meaningful direct exposure to the energy sector, airline industry or retail consumer, and does not participate in shared national credits.

Because of the significant uncertainties related to the ultimate duration of the COVID-19 pandemic and its effects on our clients and prospects, and on the national and local economy as a whole, there can be no assurances as to how the crisis may ultimately affect the Company’s loan portfolio.

Third Quarter 2020 Compared to Second Quarter 2020

Net interest income decreased $267,000, or 1.4%, to $18.6 million.

• Net interest income reflected an increase in average loans and leases, decrease in fees received in lieu of interest, and compression in adjusted net interest margin. Fees in lieu of interest, which can vary from quarter to quarter based on client-driven activity, totaled $1.5 million, compared to $2.3 million. Excluding fees in lieu of interest, net interest income increased $479,000, or 2.9%.
• Average loans and leases receivable increased $156.3 million to $2.139 billion. Excluding average net PPP loans and average line of credit utilization in both periods of comparison, average loans and leases receivable increased $110.9 million, or 29.8% annualized, to $1.597 billion.
• The yield on average interest-earning assets decreased 28 basis points to 3.75% from 4.03%. Excluding average net PPP loans, the PPP loan interest income of $833,000, and the aforementioned fees in lieu of interest, the yield earned on average interest-earning assets decreased 7 basis points to 3.89% from 3.96%. The rate paid for average total bank funding decreased seven basis points to 0.54% from 0.61%. Total bank funding is defined as total deposits plus Federal Home Loan Bank (“FHLB”) advances, Federal Reserve Discount Window advances, and Federal Reserve PPPLF advances.
• Net interest margin decreased 20 basis points to 3.14% from 3.34%. Adjusted net interest margin, excluding fees in lieu of interest and other recurring but volatile components of net interest margin, decreased eight basis points to 3.24% from 3.32% as a seven basis point benefit from the reduction in cost of funds was more than offset by 16 basis points of compression from the repricing of variable loans indexed to LIBOR and the reinvestment of security cash flows at rates below the average portfolio yield.

Non-interest income increased $1.1 million, or 17.2%, to $7.4 million.

• Commercial loan interest rate swap fee income increased $791,000, or 47.8%, to $2.4 million compared to $1.7 million. Interest rate swaps continue to be an attractive product for the Company’s commercial borrowers, although associated fee income can vary from period to period based on client demand and the interest rate environment in any given quarter.
• Gains on sale of SBA loans increased $186,000, or 32.4%, to $760,000 compared to $574,000. The Company’s pipeline continues to grow period over period and management believes the gain on sale of traditional SBA loans (i.e., SBA loans unrelated to PPP loans) will increase at a measured pace over time. Loans held for sale, consisting entirely of SBA loans closed but not fully funded, increased $1.4 million, or 10.1%, to $15.0 million.
• Private wealth management fee income increased $43,000, or 2.0% to $2.2 million. Trust assets under management and administration measured $2.018 billion at September 30, 2020, up $144.1 million, or 30.8% annualized, primarily due to increased equity market values.

Non-interest expense decreased $1.6 million, or 8.6%, to $16.8 million. Operating expense increased $1.3 million, or 8.2%, to $16.7 million.

• Compensation expense increased $1.1 million, or 9.8%, to $11.9 million mainly due to a $1.0 million increase in the Company’s performance-based incentive compensation accrual based on estimated full year 2020 results. Despite an elevated provision for loan and lease losses tempering the Company’s return on average assets, record loans, deposits, and fee income are driving very strong revenue growth and improved efficiency in 2020. In addition, average full-time equivalent employees were 295 for the quarter ended September 30, 2020, compared to 281 for the quarter ended June 30, 2020.
• No impairment of historic tax credit investments was recognized in the current quarter, compared to $1.7 million in expense due to the impairment of federal historic tax credit investments, which corresponded with the recognition of $2.5 million in tax credits during the prior quarter.
• The Company incurred a $744,000 loss on the early extinguishment of $59.5 million in FHLB term advances late in the second quarter of 2020. No loss on early extinguishment of debt was incurred in the third quarter of 2020.
• The Company recognized a gain on foreclosed properties of $121,000 mainly due to the sale of two properties, compared to a loss of $348,000 in the prior quarter.

Total period-end loans and leases receivable increased $113.4 million to $2.170 billion. Excluding net PPP loans and lines of credit in both periods of comparison, total period-end loans and leases receivable increased $103.0 million, or 27.0% annualized, to $1.627 billion.

• Commercial and industrial (“C&I”) loans, excluding net PPP loans and lines of credit, decreased $1.3 million, or 2.0% annualized. Management remains confident timely personnel investments made in our counter cyclical commercial banking products, such as asset-based lending and receivable financing, position C&I lending to increase throughout the current economic cycle.
• Commercial real estate (“CRE”) loans increased $104.3 million, or 34.2% annualized, with growth across all CRE categories, led by multi-family. Recent success in driving above average CRE growth comes as established commercial lenders hired over the past 18 months were able to bring many of their high quality relationships with them to the Bank. However, management does not expect this exceptionally high growth rate to continue.

Total period-end in-market deposits increased $46.6 million to $1.667 billion and the average rate paid decreased six basis points to 0.27%.

• Transaction accounts increased $90.1 million as both existing and new clients received PPP loan funds and certificates of deposits and money market accounts decreased $23.6 million and $19.9 million, respectively.
• Client preferences continued to shift away from term deposits due to the low interest rate environment, while management attributes the transition from money market accounts to reciprocal transaction accounts with full FDIC insurance to our clients’ preferences for safety and soundness amid the economic uncertainty created by the COVID-19 pandemic.

Period-end wholesale funding, including FHLB advances, Federal Reserve Discount Window advances, Federal Reserve PPPLF advances, brokered certificates of deposit, and deposits gathered through internet deposit listing services, increased $82.9 million to $613.2 million.

• Wholesale deposits increased $64.4 million to $154.1 million, mainly due to receiving $85.0 million from a reciprocal deposit network at a favorable rate compared to alternative funding sources. Excluding these deposits, brokered deposits decreased $20.6 million to $69.1 million, as the existing portfolio runoff is replaced by in-market deposits and lower cost FHLB advances to match-fund long-term fixed rate loans and fund loan growth. The average rate paid on wholesale deposits decreased 109 basis points to 1.33% and the weighted average original maturity of brokered certificates of deposit decreased to 4.3 years from 4.6 years.
• FHLB advances increased $18.5 million to $429.5 million. The average rate paid on FHLB advances increased 18 basis points to 1.43% and the weighted average original maturity decreased to 5.1 years from 5.3 years.
• During the second quarter of 2020, management tested the availability of the Federal Reserve PPPLF due to the uncertainty of when PPP loans would be required to close and fund. As of September 30, 2020, the Company had one $29.6 million PPPLF advance outstanding.

Non-performing assets increased to $36.7 million, or 1.41% of total assets, compared to $25.5 million, or 1.03% of total assets, principally due to the impairment of two previously identified stressed relationships in the hospitality and wholesale food distributor industries with balances outstanding as of September 30, 2020 of $5.8 million and $4.3 million, respectively. Excluding net PPP loans, non-performing assets were 1.61% of total assets, compared to 1.19% as of June 30, 2020.

The allowance for loan and lease losses increased $3.4 million, or 12.2%, compared to June 30, 2020 primarily due to a $376,000 increase in general reserve and a $3.0 million increase in specific reserve related to the economic conditions caused by the pandemic. The $3.0 million increase in specific reserves was principally driven by deterioration of one previously identified stressed relationship in the hospitality industry.

• The allowance for loan and lease losses as a percent of total gross loans and leases was 1.41% compared to 1.33%.
• Excluding net PPP loans, the allowance for loan and leases losses as a percent of total gross loans and leases was 1.67%, compared to 1.57% as of June 30, 2020.

Third Quarter 2020 Compared to Third Quarter 2019

Net interest income increased $1.8 million, or 11.0%, to $18.6 million.

• Net interest income reflected an increase in average loans and leases, increase in fees received in lieu of interest, and significant reduction in interest expense paid on deposits. Fees in lieu of interest totaled $1.5 million, compared to $1.1 million. Excluding fees in lieu of interest, net interest income increased $1.4 million, or 9.1%.
• Average loans and leases receivable increased $408.0 million, or 23.6%, to $2.139 billion. Excluding average net PPP loans and average line of credit utilization in both periods of comparison, average loans and leases receivable increased $179.2 million, or 12.6%, to $1.597 billion.
• The yield earned on average interest-earning assets decreased 141 basis points to 3.75% from 5.16%. Excluding average net PPP loans, related interest income of $833,000, and the aforementioned fees in lieu of interest, the yield earned on average interest-earning assets decreased 105 basis points to 3.89% from 4.94%. The rate paid for average total bank funding decreased 115 basis points to 0.54% from 1.69%. The average effective federal funds rate decreased 213 basis points to 0.09% from 2.19%.
• Net interest margin decreased 26 basis points to 3.14% from 3.40%. Adjusted net interest margin was 3.24% in both periods of comparison.

Non-interest income increased $1.6 million, or 27.9%, to $7.4 million.

• Commercial loan interest rate swap fee income increased $2.1 million to $2.4 million compared to $374,000.
• Gains on sale of SBA loans increased $306,000, or 67.4%, to $760,000 compared to $454,000.
• Private wealth management fee income increased $107,000, or 5.2%, to $2.2 million primarily due to increased values in equity markets during the third quarter 2020 compared to the prior year quarter. Trust assets under management and administration measured $2.018 billion at September 30, 2020, up $217.0 million, or 12.1%.
• Other fee income decreased $998,000, or 59.6%, to $676,000 compared to $1.7 million. The decrease is primarily due to above average returns on investments in mezzanine funds totaling $770,000 in the prior year quarter.

Non-interest expense increased $2.0 million, or 13.9%, to $16.8 million. Operating expense increased $1.7 million, or 11.4%, to $16.7 million.

• Compensation expense increased $1.5 million, or 14.8%, to $11.9 million. Average full-time equivalent employees were 295 for the quarter ended September 30, 2020, compared to 274 for the quarter ended September 30, 2019.
• Marketing expense decreased $192,000, or 35.0%, to $356,000 due to temporary postponement of various marketing plans due to the COVID-19 pandemic.
• No impairment of historic tax credit investments was recognized in the current quarter, compared to a benefit from a recovery in tax credit investments as a result of discounts received on previously impaired tax credit investments in the prior year quarter.
• Other non-interest expense decreased $277,000, or 30.9%, to $620,000. The reasons for the decrease in other non-interest expense are consistent with the linked quarter variance discussed above.

Total period-end loans and leases receivable increased $449.8 million, or 26.1%, to $2.170 billion primarily due to an increase in net PPP loans of $325.5 million. Line of credit utilization decreased by $95.2 million, as borrowers accessed PPP loan proceeds as an alternative source of funding in 2020. Excluding net PPP loans and lines of credit in both periods of comparison, total period-end loans and leases receivable increased $219.5 million, or 15.6%, to $1.627 billion.

• C&I loans, excluding net PPP loans and lines of credit, increased $46.4 million, or 23.1%.
• CRE loans increased $177.5 million, or 15.4%, driven by an increase across all CRE categories.

Total period-end in-market deposits increased $346.3 million, or 26.2%, to $1.667 billion and the average rate paid decreased 120 basis points to 0.27%.

• Transaction accounts increased $449.8 million and money market accounts decreased $42.1 million.
• Certificates of deposits decreased $61.4 million as client preferences continued to shift towards more liquid products due to the low interest rate environment.

Period-end wholesale funding increased $116.9 million to $613.2 million.

• Brokered certificates of deposit decreased $33.7 million to $154.1 million, as the existing portfolio runs off and is replaced by in-market deposits and, as needed, lower cost FHLB advances to match fund long-term fixed-rate loans and fund loan growth. The average rate paid on brokered certificates of deposit decreased 103 basis points to 1.33% and the weighted average original maturity decreased to 4.3 years from 5.5 years.
• FHLB advances increased $121.0 million to $429.5 million. The average rate paid on FHLB advances decreased 75 basis points to 1.43% and the weighted average original maturity decreased to 5.1 years from 5.2 years.

Non-performing assets increased to $36.7 million, or 1.41% of total assets, compared to $25.7 million, or 1.23% of total assets. The reason for the increase is consistent with the linked quarter variance discussed above. Excluding net PPP loans, non-performing assets were 1.61% of total assets.

The allowance for loan and lease losses increased 52.8% primarily due to an increase in the general and specific reserve driven by the COVID-19 pandemic.

• The allowance for loan and lease losses as a percent of total gross loans and leases was 1.41% compared to 1.17%.
• Excluding net PPP loans, the allowance for loan and leases losses as a percent of total gross loans and leases was 1.67%.

About First Business Financial Services, Inc.

First Business Financial Services, Inc. (Nasdaq:FBIZ) is a Wisconsin-based bank holding company focused on the unique needs of businesses, business executives, and high net worth individuals. First Business offers commercial banking, specialty finance, and private wealth management solutions, and because of its niche focus, is able to provide its clients with unmatched expertise, accessibility, and responsiveness. For additional information, visit www.firstbusiness.com or call 608-238-8008.

This release may include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995, which reflect First Business’s current views with respect to future events and financial performance. Forward-looking statements are not based on historical information, but rather are related to future operations, strategies, financial results, or other developments. Forward-looking statements are based on management’s expectations as well as certain assumptions and estimates made by, and information available to, management at the time the statements are made. Those statements are based on general assumptions and are subject to various risks, uncertainties, and other factors that may cause actual results to differ materially from the views, beliefs, and projections expressed in such statements. Such statements are subject to risks and uncertainties, including among other things:

• Adverse changes in the economy or business conditions, either nationally or in our markets, including, without limitation, the adverse effects of the COVID-19 pandemic on the global, national, and local economy.
• The effect of the COVID-19 pandemic on the Corporation’s credit quality, revenue, and business operations.
• Competitive pressures among depository and other financial institutions nationally and in our markets.
• Increases in defaults by borrowers and other delinquencies.
• Our ability to manage growth effectively, including the successful expansion of our client service, administrative infrastructure, and internal management systems.
• Fluctuations in interest rates and market prices.
• Changes in legislative or regulatory requirements applicable to us and our subsidiaries.
• Changes in tax requirements, including tax rate changes, new tax laws, and revised tax law interpretations.
• Fraud, including client and system failure or breaches of our network security, including our internet banking activities.
• Failure to comply with the applicable SBA regulations in order to maintain the eligibility of the guaranteed portion of SBA loans.

For further information about the factors that could affect the Company’s future results, please see the Company’s annual report on Form 10-K for the year ended December 31, 2019, the Company’s quarterly report on Form 10-Q for the quarter ended March 31, 2020, and other filings with the Securities and Exchange Commission.

1. Excluding participating securities.