Thesis:

I am recommending the 8.25% 03/31/33 publicly traded trust preferred of Independent Bank Corporation (trust preferred ticker:  IBCPO; equity ticker:  IBCP).  The preferred last traded at $30.25.  Par is $25 but the issuer has not paid the quarterly dividend of .515625 since the first quarter of 2010.  Through 03/31/13 the issuer had missed 14 quarterly dividends and these accumulated distributions earn interest at an annual rate of 8.25% compounded quarterly, until paid.  Through 03/31/13 I calculate accrued interest of $8.28. 

The issue is small (only 367k outstanding of the publicly traded trust preferred – issue was originally 2 mm shares but an exchange offer occurred in 2010 – see below for further details) and is illiquid so this idea is only suitable for personal accounts.  That said, I see the issue as very attractive – particularly on a risk-adjusted basis. 

Profits are soaring at IBCP as asset quality continues to improve. The Q1 provision for loan losses was actually negative due to a reversal of some provisions made in prior quarters.  IBCP gave guidance on their DTA which suggests that a $62.5 million gain will be realized in Q2 as the valuation allowance for their deferred tax assets is reversed.

Management also indicated that they will seek to convert their TARP preferred stock into common stock or raise capital at the parent to bring the accrued interest current.  Given the company’s profitability and improving balance sheet, a very favorable offer would be required for IBCPO holders to accept common shares.  Specifically, I believe the company would need to offer common shares valued at very close to 100% of par plus accrued interest.

I believe the most likely IRR is 17-30% based on my belief that the issue will trade at par once the dividends on the trust preferred are reinstituted or when the trust preferred is exchanged into common at par.  Were the security to trade at par+accrued by the end of 2013 you would realize a 30% IRR and were that not to happen until 09/30/14 you would still realize a 17% IRR.  Based on management commentary I believe the first outcome is more likely.  Please note the maximum interest deferral period is 20 quarters (ending 09/30/14).

Capitalization:

Company’s Public Statements on the Trust Preferred:

“Our capital initiatives remain centered on strategies to convert the preferred stock owned by the U.S. Treasury (“UST”) into common stock and exit TARP.”

Either through a return of capital from the Bank or through raising additional capital at the parent company (or a combination of both) we intend to have sufficient cash at the parent company to bring the interest current on the subordinated debentures by the fourth quarter of 2014. 

Trust Preferred Background:

We have four special purpose entities that originally issued $90.1 million of cumulative trust preferred securities. On June 23, 2010, we issued 5.1 million shares of our common stock (having a fair value of approximately $23.5 million on the date of the exchange) in exchange for $41.4 million in liquidation amount of trust preferred securities and $2.3 million of accrued and unpaid interest on such securities. As a result, at March 31, 2013 and December 31, 2012, $48.7 million of cumulative trust preferred securities remained outstanding. These special purpose entities issued common securities and provided cash to our parent company that in turn, issued subordinated debentures to these special purpose entities equal to the trust preferred securities and common securities. The subordinated debentures represent the sole asset of the special purpose entities. The common securities and subordinated debentures are included in our Condensed Consolidated Statements of Financial Condition.

We are deferring interest on our subordinated debentures and are not currently paying any dividends on our preferred or common stock. Interest on the subordinated debentures can continue to be deferred until the fourth quarter of 2014.  Because the Bank currently has negative “undivided profits” (i.e. a retained deficit) of $114.9 million at March 31, 2013, under Michigan banking regulations the Bank is not currently permitted to pay a dividend.  We can request regulatory approval for a return of capital from the Bank to the parent company.  However, such regulatory approval is uncertain. As a result, the only substantial near term source of cash to our parent company is under an equity line facility that is described below. We believe that the available cash on hand of approximately $5.6 million at the parent company as of March 31, 2013, as well as access to the equity line facility provide sufficient liquidity at the parent company to meet its operating expenses until the fourth quarter of 2014 (at which point the parent company can no longer defer interest on its subordinated debentures). 

Regulatory Matters and Seniority of Trust Preferred to Treasury’s Preferred:

Dividends from the Bank are restricted as described above and are also restricted by board resolutions adopted in March 2013 in connection with the termination of the Memorandum of Understanding (“MOU”) as described in Note #11 to the Condensed Consolidated Financial Statements included within this report. In particular, those resolutions prohibit the Bank from paying any dividends to the parent company without the prior written approval of the FRB and the Michigan Department of Insurance and Financial Services (“DIFS”). Also see “Regulatory development.”

Our parent company is also prohibited from paying any dividends on our common stock or on the preferred stock held by the UST while distributions on our trust preferred securities are being deferred.  Moreover, the resolutions adopted by our boards in March 2013 in connection with the termination of the MOU referenced above specifically prohibit the parent company from paying any dividends on our common stock or the preferred stock held by the UST or any distributions on our trust preferred securities without, in each case, the prior written approval of the FRB and the DIFS.

Deferral Period of Trust Preferred and Dividend Restrictions:

Payment of dividends and distributions on our outstanding common stock, preferred stock, and trust preferred securities is also restricted and governed by the terms of those instruments, as follows:

The terms of the subordinated debentures and trust indentures (the “Indentures”) related to our trust preferred securities allow us to defer payment of interest at any time or from time to time for up to 20 consecutive quarters provided no event of default (as defined in the Indentures) has occurred and is continuing. We are not in default with respect to the Indentures, and the deferral of interest does not constitute an event of default under the Indentures. While we defer the payment of interest, we will continue to accrue the interest expense owed at the applicable interest rate. Upon the expiration of the deferral, all accrued and unpaid interest is due and payable. During the deferral period on the Indentures, we may not declare or pay any dividends or distributions on, or redeem, purchase, acquire or make a liquidation payment with respect to, any of our capital stock.

So long as any shares of the Series B Preferred Stock remain outstanding, unless all accrued and unpaid dividends for all prior dividend periods have been paid or are contemporaneously declared and paid in full, (a) no dividend may be paid or declared on our common stock or other junior stock, other than a dividend payable solely in common stock and other than certain dividends or distributions of rights in connection with a shareholders’ rights plan; and (b) with limited exceptions, neither we nor any of our subsidiaries may purchase, redeem or otherwise acquire for consideration any shares of our common stock or other junior stock unless we have paid in full all accrued dividends on the Series B Preferred Stock for all prior dividend periods.

Company Overview:

Independent Bank Corporation is a Michigan-based bank holding company with total assets of approximately $2.1 billion.  Independent Bank Corporation operates locations across Michigan’s Lower Peninsula through one state-chartered bank subsidiary. This subsidiary (Independent Bank) provides a full range of financial services, including commercial banking, mortgage lending, investments and title services.  

IBCPs success depends to a great extent upon the economic conditions in Michigan’s Lower Peninsula.  IBCP’s loan portfolio, the ability of the borrowers to repay these loans and the value of the collateral securing these loans has been and will be impacted by local economic conditions.  Economic conditions in the state began to show signs of improvement during 2010 and generally these improvements have continued into 2013.

However, since early- to mid-2009, IBCP generally has seen an improvement in asset quality metrics.  In particular, since early 2012, they have experienced a decline in non-performing assets, reduced levels of new loan defaults and reduced levels of net loan charge-offs.  These factors have resulted in a more significant decline in the provision for loan losses over the past few quarters.  Additionally, housing prices and other related statistics (such as home sales and new building permits) have generally been improving.

1Q13 Summary Results:

The Company’s recent 1Q13 results were very strong.  The Company’s fifth consecutive profitable quarter was highlighted by:

• Additional improvement in asset quality, with non-performing assets down 13% during the quarter and 38% since Mar. 31, 2012.
• A $5.8 million, or 113%, year-over-year decline in the quarterly provision for loan losses.
• Regulatory capital ratios that increased significantly and remain substantially above minimum requirements for “well-capitalized”

William B. (“Brad”) Kessel, the President and Chief Executive Officer of Independent Bank Corporation, commented: “We are very pleased to report our fifth consecutive quarter of profitability as well as further progress in improving asset quality, as evidenced by a reduction in our non-performing loans, loan net charge-offs and the provision for loan losses as compared to the year ago quarter.  Our capital initiatives remain centered on strategies to convert the preferred stock owned by the U.S. Treasury (“UST”) into common stock and exit TARP.  We are also focused on preserving the potential future use of our net deferred tax asset, which totaled approximately $62.5 million at Mar. 31, 2013, and on which we have established a full valuation allowance.  The potential future recovery of this valuation allowance represents a source of capital that would be of meaningful value to our shareholders.”

Detailed Operating Results:

The Company’s net interest income totaled $19.6 million during the first quarter of 2013, a decrease of $2.5 million, or 11.5%, from the year-ago period, and a decrease of $1.3 million, or 6.3% from the fourth quarter of 2012.  The Company’s net interest income as a percent of average interest-earning assets (the “net interest margin”) was 4.21% during the first quarter of 2013 compared to 4.14% in the year ago period, and 3.96% in the fourth quarter of 2012.  The decrease in net interest income is primarily due to a decline in average interest-earning assets resulting from the branch sale.

The provision for loan losses decreased by $5.8 million, or 113.5%, in the first quarter of 2013 as compared to the year-ago level, primarily reflecting a reduction in non-performing loans, a lower level of watch credits, reduced loan net charge-offs, and an overall decline in total loan balances.  Since Mar. 31, 2012, non-performing loans and commercial loan watch credits have declined by approximately 46% and 30%, respectively.  In addition, thirty- to eighty-nine day delinquency rates at Mar. 31, 2013 were 0.61% for commercial loans and 1.47% for mortgage and consumer loans. These delinquency rates continue to be well managed as we strive to further improve asset quality and further reduce credit related costs."

Non-performing loans have declined by $5.1 million, or 15.4%, since year-end 2012.  All categories of non-performing loans declined; the principal decreases since year-end 2012 were in commercial loans and residential mortgage loans. The decline in non-performing loans primarily reflects loan net charge-offs, pay-offs, negotiated transactions and the migration of loans into ORE during 2013.  Non-performing commercial loans have declined by $66.5 million, or 85.1%, since they peaked in 2008.  Non-performing retail (residential mortgage and consumer/installment) loans have declined by $42.9 million, or 72.5%, since they peaked in 2009.  Other real estate and repossessed assets totaled $23.6 million at Mar. 31, 2013, compared to $26.1 million at Dec. 31, 2012.

The provision for loan losses was a credit of $0.7 million and an expense of $5.1 million in the first quarters of 2013 and 2012, respectively.  The level of the provision for loan losses in each period reflects the Company’s overall assessment of the allowance for loan losses, taking into consideration factors such as loan mix, levels of non-performing and classified loans and loan net charge-offs.  Loan net charge-offs were $2.8 million (0.82% annualized of average loans) in the first quarter of 2013, compared to $8.0 million (2.07% annualized of average loans) in the first quarter of 2012.  The decline in first quarter 2013 loan net charge-offs compared to year ago levels is primarily due to a $2.2 million decline in commercial loan net charge-offs and a $2.7 million decline in mortgage loan net charge-offs.  At Mar. 31, 2013, the allowance for loan losses totaled $40.8 million, or 2.93% of portfolio loans, compared to $44.3 million, or 3.12% of portfolio loans, at Dec. 31, 2012.

Balance Sheet, Liquidity and Capital:

Total assets were $2.11 billion at Mar. 31, 2013, an increase of $81.5 million from Dec. 31, 2012.  Loans, excluding loans held for sale, were $1.39 billion at Mar. 31, 2013, compared to $1.42 billion at Dec. 31, 2012.  Deposits totaled $1.85 billion at Mar. 31, 2012, an increase of $71.3 million from Dec. 31, 2012.  The increase in deposits is primarily due to growth in checking and savings accounts.

Cash and cash equivalents totaled $221.6 million at Mar. 31, 2013, versus $179.8 million at Dec. 31, 2012. Securities available for sale totaled $283.9 million at Mar. 31, 2013, versus $208.4 million at Dec. 31, 2012.  This $75.5 million increase is primarily due to the purchase of residential mortgage-backed securities and municipal securities during the first quarter of 2013.

Total shareholders’ equity was $144.1 million at Mar. 31, 2013, or 6.84% of total assets.  Tangible common equity totaled $55.0 million at Mar. 31, 2013, or $5.81 per share.  The Company’s wholly owned subsidiary, Independent Bank, remains “well capitalized” for regulatory purposes with the following ratios:

Regulatory Capital Ratios                                  3/31/2013     12/31/2012     Well Capitalized Minimum

Tier 1 capital to average total assets

                                                                            9.55%               8.26%                                         5.00           %

Tier 1 capital to risk-weighted assets

                                                                          14.39%            13.67%                   6.00           %

Total capital to risk-weighted assets

                                                                          15.67%              14.95%                                        10.00           %

Shareholders’ equity applicable to common stock increased to $58.8 million at March 31, 2013 from $50.8 million at December 31, 2012 due primarily to our net income during the first quarter of 2013 as well as the issuance of common stock and a reduction in our accumulated other comprehensive loss. Our tangible common equity (“TCE”) totaled $55.0 million and $46.8 million, respectively, at those same dates. Our ratio of TCE to tangible assets was 2.62% at March 31, 2013 compared to 2.32% at December 31, 2012.

TARP Background:

In December 2008, we issued 72,000 shares of Series A, Fixed Rate Cumulative Perpetual Preferred Stock, with an original liquidation preference of $1,000 per share (“Series A Preferred Stock”), and a warrant to purchase 346,154 shares (at $31.20 per share) of our common stock (“Original Warrant”) to the UST in return for $72.0 million under the TARP Capital Purchase Program. Of the total proceeds, $68.4 million was originally allocated to the Series A Preferred Stock and $3.6 million was allocated to the Original Warrant (included in capital surplus) based on the relative fair value of each. The $3.6 million discount on the Series A Preferred Stock was being accreted using an effective yield method over five years. The accretion had been recorded as part of the Series A Preferred Stock dividend.

On April 16, 2010, we exchanged the Series A Preferred Stock (including accumulated but unpaid dividends) for 74,426 shares of our Series B Fixed Rate Cumulative Mandatorily Convertible Preferred Stock, with an original liquidation preference of $1,000 per share (“Series B Preferred Stock”). As part of the terms of the exchange agreement, we also agreed to amend and restate the terms of the Original Warrant and issued an Amended and Restated Warrant to purchase 346,154 shares of our common stock at an exercise price of $7.234 per share and expiring on December 12, 2018 (the “Amended Warrant”). The Series B Preferred Stock and the Amended Warrant were issued in a private placement exempt from registration pursuant to Section 4(2) of the Securities Act of 1933. We did not receive any cash proceeds from the issuance of the Series B Preferred Stock or the Amended Warrant. In general, the terms of the Series B Preferred Stock are substantially similar to the terms of the Series A Preferred Stock that was held by the UST, except that the Series B Preferred Stock is convertible into our common stock.