Texas Capital Bancshares - 10-Q quarterly report FY

 

(Exact Name of Registrant as Specified in Its Charter)

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     Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

     On October 31, 2006, the number of shares set forth below was outstanding with respect to each of the issuer’s classes of common stock:

Texas Capital Bancshares, Inc.
Form 10-Q
Quarter Ended September 30, 2006

Index

See accompanying notes to consolidated financial statements.

(In thousands except share data)

See accompanying notes to consolidated financial statements.

(In thousands except share data)

See accompanying notes to consolidated financial statements.

(In thousands)

See accompanying notes to consolidated financial statements.

The accounting and reporting policies of Texas Capital Bancshares, Inc. conform to accounting principles generally accepted in the United States and to generally accepted practices within the banking industry. Our Consolidated Financial Statements include the accounts of Texas Capital Bancshares, Inc. and its subsidiary, Texas Capital Bank, National Association (the “Bank”). Certain prior period balances have been reclassified to conform with the current period presentation.

The consolidated interim financial statements have been prepared without audit. Certain information and footnote disclosures presented in accordance with accounting principles generally accepted in the United States have been condensed or omitted. In the opinion of management, the interim financial statements include all normal and recurring adjustments and the disclosures made are adequate to make interim financial information not misleading. The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q adopted by the Securities and Exchange Commission (SEC). Accordingly, the financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements and should be read in conjunction with our consolidated financial statements, and notes thereto, for the year ended December 31, 2005, included in our Annual Report on Form 10-K filed with the SEC on March 3, 2006 (the “2005 Form 10-K”).

On January 1, 2006, we changed our accounting policy related to stock-based compensation in connection with the adoption of Statement of Financial Accounting Standards (SFAS) No. 123, “Share-Based Payment (Revised 2004) (“SFAS 123R”). Prior to adoption, we accounted for stock plans under the recognition and measurement principles of APB Opinion 25, “Accounting for Stock Issued to Employees”, and related interpretations. No stock-based compensation was reflected in net income, as all option grants had an exercise price equal to the market value of the underlying common stock on the date of the grant. SFAS 123R eliminates the ability to account for stock-based compensation using APB 25 and requires that such transactions be recognized as compensation expense in the statement of operations based on their fair values on the measurement date, which is generally the date of the grant. We transitioned to fair value based accounting for stock-based compensation using a modified version of prospective application (“modified prospective application”). Under modified prospective application, as it is applicable to us, SFAS 123R applies to new awards and to awards modified, repurchased or cancelled after January 1, 2006. Additionally, compensation expense for the portion of awards for which the requisite period has not been rendered (generally referring to nonvested awards) that are outstanding as of January 1, 2006 will be recognized as the remaining requisite service is rendered during and after the period of adoption of SFAS 123R. The compensation expense for the earlier awards is based on the same method and on the same grant date fair values previously determined for the pro forma disclosures required for all companies that did not previously adopt the fair value accounting method for stock-based compensation.

The fair value of our stock option and stock appreciation right (SAR) grants are estimated at the date of grant using the Black-Scholes option pricing model. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide the best single measure of the fair value of its employee stock options.

As a result of applying the provisions of SFAS 123R during the three and nine months ended September 30, 2006, we recognized additional stock-based compensation expense of $742,000, or $489,000 net of tax, and $1.9 million, or $1.2 million net of tax. The increase in stock-based compensation expense related to stock options resulted in a $0.02 decrease and a $0.05 decrease in diluted earnings per share during the three and

nine months ended September 30, 2006. The amount for the three months ended September 30, 2006 is comprised of $391,000 related to unvested options issued prior to the adoption of SFAS 123R, $238,000 related to SARs issued in the third quarter of 2006, and $113,000 related to RSUs issued in the third quarter of 2006. The amount for the nine months ended September 30, 2006 is comprised of $1.2 million related to unvested options issued prior to the adoption of SFAS 123R, $458,000 related to SARs issued in 2006, and $219,000 related to RSUs issued in 2006. Cash flows from financing activities for the nine months ended September 30, 2006 included $3.8 million in cash inflows from excess tax benefits related to stock compensation. Such cash flows were previously reported as operating activities. Unrecognized stock-based compensation expense related to unvested options issued prior to adoption of SFAS 123R is $ 3.8 million, pre-tax. At September 30, 2006, the weighted average period over which this unrecognized expense is expected to be recognized was 2.0 years. Unrecognized stock-based compensation expense related to grants issued during 2006 is $5.9 million. At September 30, 2006, the weighted average period over which this unrecognized expense is expected to be recognized was 2.5 years.

The following pro forma information presents net income and earnings per share for the three and nine months ended September 30, 2005 as if the fair value method of SFAS 123R had been used to measure compensation expense for stock-based compensation.

The following table presents the computation of basic and diluted earnings per share (dollars in thousands except per share data):

The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit which involve varying degrees of credit risk in excess of the amount recognized in the consolidated balance sheets. Our exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. We use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet instruments. The amount of collateral obtained, if deemed necessary, is based on management’s credit evaluation of the borrower.

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 may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s credit-worthiness on a case-by-case basis.

Standby letters of credit are conditional commitments we issue to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.

On October 16, 2006, the Bank completed the sale of its residential mortgage lending division (RML) to Transnational Financial Network, Inc. (TFN). The sale was effective as of September 30, 2006, and is, accordingly, reported as discontinued operations. Under the terms of the agreement, the Bank will initially receive 1.13 million shares of TFN common stock with an additional 866,355 shares of TFN common stock subject to earn-out provisions. All accounts associated with this transaction have been reflected as discontinued operations. The Bank’s mortgage warehouse operations were not part of the sale, and are included in the results from continuing operations. Except as otherwise noted, all amounts and disclosures throughout this document reflect only the Company’s continuing operations.

On September 29, 2006, Texas Capital Statutory Trust V issued $41,238,000 of its Floating Rate Capital Securities (the “2006 Trust Preferred Securities”) in a private offering. Proceeds of the 2006 Trust Preferred Securities were invested in Floating Rate Junior Subordinated Deferrable Interest Debenture (the “2006 Subordinated Debentures”) of the Company due 2036, After deducting underwriter’s compensation and other expenses of the offering, the net proceeds were available to the Company to increase capital and for general corporate purposes, including use in investment and lending activities. Interest payments on the 2006 Subordinated Debentures are deductible for federal income tax purposes.

Interest rate on the 2006 Subordinated Debentures is a floating rate that resets quarterly to 1.71% above the three-month LIBOR rate. Interest payments on the 2006 Subordinated Debentures are deductible for federal income tax purposes. The payment by us of the principal and interest on the 2006 Subordinated Debentures is subordinated and junior in light of payment to the prior payment in full of all of our senior indebtedness, whether outstanding at this time or incurred in the future.

The 2006 Trust Preferred Securities and the 2006 Subordinated Debentures each mature in September 2036, however, the 2006 Trust Preferred Securities and the 2006 Subordinated Debentures may be redeemed at the option of the Company on fixed quarterly dates beginning on December 31, 2011.

In July 2006, the FASB issued FASB Interpretation (FIN) No. 48, “Accounting for Uncertainty in Income Taxes-An Interpretation of FASB Statement No. 109” (FIN 48). This Interpretation clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements. FIN 48 requires companies to determine whether it is “more likely than not” that a tax position will be sustained upon examination by the appropriate taxing authorities before any part of the benefit can be recorded in the financial statements. It also provides guidance on the recognition, measurement and classification of income tax uncertainties, along with any related interest and penalties. FIN 48 will also require significant additional disclosures. This Interpretation will be effective for fiscal years beginning after December 15, 2006. We will implement this Interpretation in the first quarter of 2007 on a prospective basis. We are currently evaluating the potential impact this Interpretation will have on our financial position and results of operations.

Consolidated Daily Average Balances, Average Yields and Rates

(Dollars in thousands)

QUARTERLY FINANCIAL SUMMARY — UNAUDITED
Consolidated Daily Average Balances, Average Yields and Rates
(Dollars in thousands)

Statements and financial analysis contained in this document 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. Forward looking statements describe our future plans, strategies and expectations and are based on certain assumptions. As a result, these forward looking statements involve substantial risks and uncertainties, many of which are beyond our control. The important factors that could cause actual results to differ materially from the forward looking statements include the following:

We have no obligation to update or revise any forward looking statements as a result of new information or future events. In light of these assumptions, risks and uncertainties, the events discussed in any forward looking statements in this quarterly report might not occur.

We reported net income of $7.9 million, or $.30 per diluted common share, for the third quarter of 2006 compared to $7.6 million, or $.28 per diluted common share, for the third quarter of 2005. We reported net income from continuing operations of $8.0 million, or $.30 per diluted common share, for the third quarter of 2006 compared to $7.4 million, or $.28 per diluted common share, for the third quarter of 2005. Return on average equity was 13.54% and return on average assets was .91% for the third quarter of 2006, compared to 14.41% and 1.04%, respectively, for the third quarter of 2005. From continuing operations, return on average equity was 13.83% and return on average assets was .94% for the third quarter of 2006, compared to 14.14% and 1.03%, respectively, for the third quarter of 2005.

Net interest income for the third quarter of 2006 increased by $5.2 million, or 21%, from $24.9 million to $30.1 million over the third quarter of 2005. The increase in net interest income was due to an increase in average earning assets of $487.5 million, or 18%, with an 8 basis point improvement in net interest margin.

Non-interest income increased $1.8 million, or 52%, compared to the third quarter of 2005. The increase is primarily related to a $943,000 increase in insurance commission income from $114,000 to $1.1 million due to increased focus on the insurance business. Rental income on leased equipment increased $1.1 million related to expansion of our operating lease portfolio. Additionally, trust fee income increased $230,000 due to continued growth of trust assets.

Non-interest expense increased $5.4 million, or 32%, compared to the third quarter of 2005. The increase is primarily related to a $2.9 million increase in salaries and employee benefits to $13.1 million from $10.2 million, of which $742,000 relates to FAS 123R. The increase in salaries and employee benefits resulted from increases in commissions and incentives for insurance lines of business, the total number of employees related to the addition of the premium finance business and general business growth. Leased equipment depreciation increased $883,000 from $45,000 to $928,000 in the third quarter of 2006 related to expansion of our operating lease portfolio. Net occupancy expense increased $440,000 from $1.5 million to $2.0 million in the third quarter of 2006 relating to our general business growth.

Net interest income was $30.1 million for the third quarter of 2006, compared to $24.9 million for the third quarter of 2005. The increase was due to an increase in average earning assets of $487.5 million as compared to the third quarter of 2005 and an 8 basis point improvement in net interest margin, reflecting rising market interest rates. The increase in average earning assets included a $594.9 million increase in average loans held for investment and an increase of $65.0 million in loans held for sale, offset by a $136.2 million decrease in average securities. For the quarter ended September 30, 2006, average net loans and securities represented 82% and 18%, respectively, of average earning assets compared to 73% and 26% in the same quarter of 2005.

Average interest bearing liabilities increased $448.2 million from the third quarter of 2005, which included a $634.7 million increase in interest bearing deposits offset by a $238.9 million decrease in other borrowings. The average cost of interest bearing liabilities increased from 3.21% for the quarter ended September 30, 2005 to 4.86% for the same period of 2006, reflecting rising market interest rates and change in funding mix.

Net interest income was $86.0 million for the first nine months of 2006, compared to $67.8 million for the same period of 2005. The increase was due to an increase in average earning assets of $464.4 million as compared to 2005 and a 36 basis point increase in net interest margin. The increase in average earning assets included a $592.7 million increase in average loans held for investment and an increase of $42.2 million in loans held for sale, offset by a $148.5 million decrease in average securities. For the nine months ended September 30, 2006, average net loans and securities represented 81% and 19%, respectively, of average earning assets compared to 71% and 29% in the same period of 2005.

Average interest bearing liabilities increased $416.4 million compared to the first nine months of 2005, which included a $542.4 million increase in interest bearing deposits offset by a $166.8 million decrease in other borrowings. The average cost of interest bearing liabilities increased from 2.84% for the nine months ended September 30, 2005 to 4.50% for the same period of 2006, reflecting the rising market interest rates and change in funding mix.

TABLE 1 — VOLUME/RATE ANALYSIS
(In thousands)

Net interest margin from continuing operations, the ratio of net interest income to average earning assets from continuing operations, was 3.80% for the third quarter of 2006 compared to 3.72% for the third quarter of 2005. The improvement in net interest margin resulted primarily from a 153 basis point increase in the yield on earning assets while interest expense as a percentage of earning assets increased by only 145 basis points.

Non-interest income increased $1.8 million compared to the same quarter of 2005. The increase is related to a $943,000 increase in insurance commission income from $114,000 to $1.1 million due to increased focus on the insurance business. Rental income on leased equipment increased $1.1 million related to expansion of our operating lease portfolio. Additionally, trust fee income increased $230,000 due to continued growth of trust assets.

Non-interest income increased $5.8 million during the nine months ended September 30, 2006 to $14.5 million compared to $8.7 million during the same period of 2005. The increase is primarily related to a $2.2 million increase in insurance commission income from $399,000 to $2.6 million due to increased focus on the insurance business. Rental income on leased equipment increased $2.4 million related to expansion of our operating lease portfolio. Additionally, trust fee income increased $738,000 due to continued growth of trust assets.

While management expects continued growth in non-interest income, the future rate of growth could be affected by increased competition from nationwide and regional financial institutions. In order to achieve continued growth in non-interest income, we may need to introduce new products or enter into new markets. Any new product introduction or new market entry would likely place additional demands on capital and managerial resources.

TABLE 2 — NON-INTEREST INCOME
(In thousands)