1st Source: Navigating Macro Headwinds With A Specialty Finance Edge (SRCE)

Executive Summary / Key Takeaways

  • 1st Source Corporation (NASDAQ: SRCE) is a well-capitalized Midwest regional bank with a significant national specialty finance division, offering a differentiated niche in areas like aircraft and construction equipment lending.
  • The company delivered strong first quarter 2025 results, with net income available to common shareholders increasing 27.3% year-over-year to $37.52 million, driven by improved net interest income and higher noninterest income, alongside a lower provision for credit losses.
  • Despite positive recent performance, management maintains a cautious outlook for the next two years, citing weakened domestic growth expectations, uncertainty from proposed trade policies, elevated inflation and interest rates, and geopolitical instability, which are expected to adversely impact the loan portfolio.
  • SRCE's competitive positioning leverages its community banking relationships and specialized lending expertise, although it faces pressure from larger regional banks with greater scale and more advanced digital capabilities, necessitating continued investment in technology.
  • Credit quality metrics show modest increases in non-performing assets and delinquency, prompting an accretive adjustment to the allowance for credit losses forecast assumption to reflect increased downside economic risks.

Setting the Scene: A Midwest Anchor with National Reach

1st Source Corporation stands as a prominent regional bank holding company rooted in South Bend, Indiana, extending its financial services across Indiana, Michigan, and into Florida. Through its subsidiaries, the company operates a diversified commercial banking model, encompassing traditional consumer and commercial banking, trust and wealth advisory services, and insurance. This regional strength is complemented by a significant national footprint via its Specialty Finance Group, which focuses on niche lending markets across the continental United States.

The banking industry landscape is marked by intense competition, particularly in the Midwest, where SRCE contends with larger regional players like First Merchants Corporation (FRME), Huntington Bancshares Incorporated (HBAN), Fifth Third Bancorp (FITB), and Old National Bancorp (ONB). These competitors often possess greater scale, broader geographic reach, and more extensive digital infrastructure. Beyond traditional banks, the competitive environment is increasingly shaped by fintech firms offering alternative, often lower-cost, digital-first solutions that can challenge established banking models, especially in payment processing and consumer lending.

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SRCE's strategic response to this competitive pressure centers on leveraging its deep community ties and cultivating specialized expertise. The company aims to differentiate itself through personalized service and a focus on specific lending verticals where it has built considerable knowledge and relationships. This dual strategy of maintaining a strong regional community bank presence while pursuing national niche opportunities forms the core of its business model.

Technology as a Differentiator and Area for Investment

While SRCE operates within a traditional banking framework, technology plays a crucial role in its operations and competitive standing. The company invests in technology projects, as evidenced by the increase in data processing expense, which grew during the first quarter of 2025 due to higher computer processing charges and software maintenance costs. This indicates an ongoing commitment to maintaining and upgrading its technological infrastructure.

A specific area where technology provides a tangible benefit is within its Specialty Finance Group, particularly in aircraft leasing. The company's processes in this niche enable faster approval times, estimated to be 15-20% quicker than some competitors. This operational efficiency in a specialized market contributes to its competitive edge and supports its ability to capture market share in this vertical.

However, the competitive analysis highlights that SRCE faces "digital lags" compared to larger rivals like HBAN and FITB, whose digital platforms offer faster transaction processing speeds (25-30% quicker for some functions). This suggests that while SRCE is investing in technology, there may be areas where its digital capabilities trail those of larger, more technologically aggressive competitors. Addressing these gaps through continued investment in digital transformation is crucial for maintaining competitiveness and improving operational efficiency.

Financial Performance: A Strong Start to 2025

1st Source reported a robust financial performance for the first quarter of 2025, demonstrating significant growth in key metrics compared to the same period in 2024. Net income available to common shareholders rose to $37.52 million, a substantial increase from $29.46 million in the prior year's first quarter. This translated to diluted net income per common share of $1.52, up from $1.19.

The improvement was primarily driven by a significant increase in net interest income, which grew by $9.02 million to $80.94 million. This expansion was a result of a higher net interest margin, which stood at 3.90% on a fully taxable-equivalent basis for Q1 2025, compared to 3.54% in Q1 2024. The yield on average earning assets increased by 21 basis points to 5.94%, benefiting from higher average loan and lease balances and improved rates on investment securities. Concurrently, the total cost of average interest-bearing liabilities decreased by 20 basis points to 2.90%, reflecting lower rates on interest-bearing deposits and other short-term borrowings.

Noninterest income also contributed positively, increasing by $0.95 million to $23.10 million. This growth was fueled by a notable 37.4% increase in insurance commissions, primarily due to higher contingent commissions, and a 19.6% rise in other income, driven by gains on the sale of renewable energy tax equity investments, customer interest rate swap fees, and higher brokerage and commission fees. These gains were partially offset by declines in equipment rental income (down 46.2% due to reduced leasing volume and competitive pressures) and mortgage banking income (down 10.2% from lower secondary market production and servicing fees).

Operating expenses saw an increase of $4.37 million, or 9.0%, totaling $53.08 million for the quarter. This rise was mainly attributable to higher salaries and employee benefits (up 8.6% due to merit increases, incentive compensation, and group insurance costs), increased data processing expenses (up 12.2% on technology projects), and higher professional fees (up 24.0% from audit and legal fees). Despite the increase in expenses, the growth in revenue outpaced costs, contributing to the improved profitability.

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Loan Portfolio Dynamics and Credit Quality

The total loan and lease portfolio saw modest growth, increasing by $8.59 million to $6.86 billion at March 31, 2025, compared to December 31, 2024. Growth was observed in renewable energy, commercial real estate, residential real estate, home equity, and auto and light truck portfolios, partially offset by decreases in construction equipment, consumer, and aircraft portfolios. The company's specialty finance portfolios, including auto and light truck ($955.9 million), medium and heavy duty truck ($289.8 million), aircraft ($1.12 billion), and construction equipment ($1.17 billion), represent a significant portion of the total portfolio.

Credit quality metrics showed some signs of deterioration, with nonperforming assets increasing to $43.07 million at March 31, 2025, up from $31.33 million at December 31, 2024, and $22.43 million a year prior. This increase was primarily driven by higher nonaccrual loans and repossessions, notably in the auto and light truck portfolio due to a large account transfer, alongside modest increases in aircraft and commercial and agricultural nonaccruals. Delinquency (30 days or more past due) as a percentage of total loans was 0.09% at March 31, 2025, slightly higher than 0.08% a year ago.

In response to the evolving economic landscape and the uptick in nonperforming assets, the provision for credit losses decreased to $3.27 million in Q1 2025 from $7.48 million in Q1 2024. However, the allowance for loan and lease losses increased to $157.47 million, representing 2.29% of outstanding loans and leases, up from 2.26% a year prior. This increase reflects an accretive adjustment to the forecast assumption, driven by a more cautious outlook on economic growth and increased uncertainty, particularly concerning domestic trade policies and their potential impact on loan portfolios.

Liquidity and Capital Strength

SRCE maintains a strong and conservative capital position, with ratios well above minimum regulatory requirements. As of March 31, 2025, the Total Capital to Risk-Weighted Assets ratio for the corporation was 17.46%, significantly exceeding the 10.50% minimum required to be well-capitalized with the capital buffer. Similarly, the Common Equity Tier 1 Capital to Risk-Weighted Assets ratio was 14.71%, comfortably above the 7.00% minimum. Total shareholders equity increased to $1.16 billion, contributing to an improved shareholders equity-to-assets ratio of 12.96%. Book value per common share also increased to $47.29.

Liquidity remains robust, supported by a diversified funding base including core deposits, access to brokered and listing service certificates of deposit, FHLB advances, and FRB borrowings. Total net available liquidity stood at $3.44 billion at March 31, 2025, representing approximately 50% of total deposits (net of brokered and listing services CDs). Cash and cash equivalents increased significantly to $222.82 million, primarily due to deposit growth and expected investment security redemptions. The company also paid off $100 million in borrowings from the Federal Reserve's Bank Term Funding Program during the quarter, reducing short-term borrowings.

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Outlook and Risks

Management's outlook is characterized by caution regarding the forward economic environment. The forecast assumption has been adjusted to reflect expectations of weaker economic growth over the next two years and continued uncertainty. Key concerns include the potential impact of proposed wide-ranging tariffs on various industries that directly affect the company's loan portfolios, heightened geopolitical instability, persistent elevated inflation and interest rates, and increasing consumer stress.

While the company's current loss estimates incorporate these risks, management acknowledges that future loss estimates could vary considerably due to the complex and unpredictable nature of the current environment. Specific portfolio risks highlighted include softening asset valuations in auto and light truck, construction equipment, and medium and heavy duty portfolios, which could be exacerbated by restrictive trade policies. The commercial real estate market is also impacted by higher rates and shifting demand, although SRCE's exposure is primarily in the owner-occupied segment with minimal office property risk.

The Aircraft portfolio, with its $299 million foreign exposure primarily in Mexico and Brazil, remains subject to collateral volatility and political/economic risks in those regions. Despite minimal recent losses, the company has historically experienced volatile losses in this segment. Management employs ongoing monitoring and tiered advance rates to mitigate this risk.

Despite these headwinds, analyst consensus estimates project 2025 EPS of $5.93, representing approximately 8% growth from 2024. This suggests an expectation that the company can continue to grow earnings, albeit within a challenging macro backdrop. The company's history of 37 consecutive years of dividend expansion and its recent inclusion in the KBW Bank Honor Roll and S&P Global's Top 50 Community Banks list underscore a track record of consistent performance and shareholder value creation.

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Conclusion

1st Source Corporation is a fundamentally sound regional bank with a valuable specialty finance segment that provides a distinct competitive advantage. The company's first quarter 2025 results demonstrate solid operational execution and profitability growth, supported by an expanding net interest margin and diversified noninterest income streams. Its capital and liquidity positions remain strong, providing a stable foundation.

However, the investment thesis is tempered by a cautious forward outlook and increasing credit quality concerns in specific portfolios, driven by macro-economic uncertainty, potential trade policy impacts, and asset valuation softening. While SRCE's niche expertise and community focus offer resilience against larger competitors, continued investment in digital capabilities is necessary to address competitive lags. The company's ability to navigate these macro headwinds while leveraging its specialized lending strengths will be key to sustaining its track record of earnings growth and delivering value to shareholders.

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