FBIZ: Reducing Recommendation to Neutral from Outperform

We are reducing our recommendation on First Business Financial Services, Inc. (FBIZ) to Neutral from Outperform, as the stock has exceeded our previous target price. At the same time, we are increasing our new six-month price target to $12.75 to reflect the rolling over of estimates to the new year. When combined with the Company's current dividend yield, our new target price for FBIZ represents a total return of approximately 5%, in line with our expectations for broader U.S. equity market gains during this period. Therefore, we recommend a Neutral on FBIZ shares.

In other news, the Company recently announced amendments to its annual incentive bonus plan, beginning in 2011, to reflect changing priorities for its business units and enhance profitability. From a practical perspective, we do not expect these changes to have a significant impact on compensation expense going forward. All entities are affected by changes in criteria at the holding company, with the new Companywide equally-weighted criteria including:
1.    Return on Assets (ROA), defined as net income divided by average total assets;
2.    Core Earnings, defined as preprovision, pretax earnings; and
3.    Core Deposit/Total Deposits, with core deposits defined as nonbroker deposits.

 These, of course, are different than the former Companywide criteria, which included:
1.    Return on Equity (ROE), defined as net income divided by average common equity;
2.    Adjusted Net Income, defined as preprovision, pretax earnings less net charge-offs for the year; and
3.    Net Income.

The shift to ROA from ROE reflects the Company's belief that ROA produces a more consistent measure of profitability over time because it is not affected by capital structure. At the subsidiary level, ROA is used as each subsidiary's capital structure is promulgated by and managed at the holding company. Moreover, any increase in equity relative to risk-adjusted assets would depress future bonus payouts, which would not occur using ROA.

The modification in the definition of earnings to Core Earnings from Adjusted Net Income is not a significant one, in our opinion. However, the addition of the third item, Core Deposits/Total Deposits, represents an important change in operating philosophy.

To date, FBIZ has relied to a great extent on brokered deposits to fund its lending operations, at a higher level than is typical for a bank of its size. FBIZ found the brokered deposit market to be a lower-cost and more efficient method to raise funds than the regular nonbrokered retail deposit market. However, reliance on confidence-sensitive brokered deposits is also a more risky funding strategy, and one to which investors are not particularly partial. Given this, we believe this change is a positive one and will gradually reduce the Company's risk profile over time.
 
We note that FBIZ paid on January 15, 2011 its $0.07 regular quarterly dividend that it had declared on December 16, 2010.

First Business Financial Services, Inc. is a bank holding company headquartered in Madison, Wisconsin, with $1.1 billion in total assets at September 30, 2010. FBIZ specializes in business lending for small-medium-sized companies with sales ranging from $2-50 million. As an adjunct to these services, FBIZ also offers banking services to business owners, executives, professionals, and high net worth individuals, though this is a less significant part of its business.