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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934 FOR THE QUARTERLY PERIOD ENDED March 31, 2005
Commission file number 0-7818
INDEPENDENT BANK CORPORATION
- --------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
Michigan 38-2032782
- -------------------------------------- --------------------------------------
(State or jurisdiction of (I.R.S. Employer Identification
Incorporation or Organization) Number)
230 West Main Street, P.O. Box 491, Ionia, Michigan 48846
----------------------------------------------------------
(Address of principal executive offices)
(616) 527-9450
--------------
(Registrant's telephone number, including area code)
NONE
- --------------------------------------------------------------------------------
Former name, address and fiscal year, if changed since last report.
Indicate by check mark whether the registrant (1) has filed all documents
and reports required to be filed by Sections 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports), and (2) has been subject
to such filing requirements for the past 90 days. YES [X] NO [ ]
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes [X] No [ ]
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date.
Common stock, par value $1 21,146,359
- -------------------------------------- --------------------------------------
Class Outstanding at May 4, 2005
INDEPENDENT BANK CORPORATION AND SUBSIDIARIES
INDEX
Number(s)
---------
PART I - Financial Information
Item 1. Consolidated Statements of Financial Condition March 31, 2005 and December 31, 2004 2
Consolidated Statements of Operations Three-month periods ended March 31, 2005 and 2004 3
Consolidated Statements of Cash Flows Three-month periods ended March 31, 2005 and 2004 4
Consolidated Statements of Shareholders' Equity Three-month periods ended March 31, 2005 and 2004 5
Notes to Interim Consolidated Financial Statements 6-16
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 17-36
Item 3. Quantitative and Qualitative Disclosures about Market Risk 37
Item 4. Controls and Procedures 37
PART II - Other Information
Item 2. Changes in securities, use of proceeds and issuer purchases of equity securities 38
Item 6. Exhibits 38
Any statements in this document that are not historical facts are
forward-looking statements as defined in the Private Securities Litigation
Reform Act of 1995. Words such as "expect," "believe," "intend," "estimate,"
"project," "may" and similar expressions are intended to identify
forward-looking statements. These forward-looking statements are predicated on
management's beliefs and assumptions based on information known to Independent
Bank Corporation's management as of the date of this document and do not purport
to speak as of any other date. Forward-looking statements may include
descriptions of plans and objectives of Independent Bank Corporation's
management for future or past operations, products or services, and forecasts of
the Company's revenue, earnings or other measures of economic performance,
including statements of profitability, business segments and subsidiaries, and
estimates of credit quality trends. Such statements reflect the view of
Independent Bank Corporation's management as of this date with respect to future
events and are not guarantees of future performance; involve assumptions and are
subject to substantial risks and uncertainties, such as the changes in
Independent Bank Corporation's plans, objectives, expectations and intentions.
Should one or more of these risks materialize or should underlying beliefs or
assumptions prove incorrect, the Company's actual results could differ
materially from those discussed. Factors that could cause or contribute to such
differences are changes in interest rates, changes in the accounting treatment
of any particular item, the results of regulatory examinations, changes in
industries where the Company has a concentration of loans, changes in the level
of fee income, changes in general economic conditions and related credit and
market conditions, and the impact of regulatory responses to any of the
foregoing. Forward-looking statements speak only as of the date they are made.
Independent Bank Corporation does not undertake to update forward-looking
statements to reflect facts, circumstances, assumptions or events that occur
after the date the forward-looking statements are made. For any forward-looking
statements made in this document, Independent Bank Corporation claims the
protection of the safe harbor for forward-looking statements contained in the
Private Securities Litigation Reform Act of 1995.
Part I
Item 1.
INDEPENDENT BANK CORPORATION AND SUBSIDIARIES
Consolidated Statements of Financial Condition
March 31, December 31,
2005 2004
----------- -----------
(unaudited)
---------------------------
(in thousands)
Assets
Cash and due from banks $ 63,344 $ 72,815
Securities available for sale 549,162 550,908
Federal Home Loan Bank stock, at cost 17,322 17,322
Loans held for sale 41,657 38,756
Loans
Commercial 962,464 931,251
Real estate mortgage 788,448 773,609
Installment 265,735 266,042
Finance receivables 307,676 254,388
----------- -----------
Total Loans 2,324,323 2,225,290
Allowance for loan losses (24,628) (24,737)
----------- -----------
Net Loans 2,299,695 2,200,553
Property and equipment, net 57,659 56,569
Bank owned life insurance 38,307 38,337
Goodwill 53,656 53,354
Other intangibles 12,809 13,503
Accrued income and other assets 53,736 51,910
----------- -----------
Total Assets $ 3,187,347 $ 3,094,027
=========== ===========
Liabilities and Shareholders' Equity
Deposits
Non-interest bearing $ 274,099 $ 287,672
Savings and NOW 899,609 849,110
Time 1,174,349 1,040,165
----------- -----------
Total Deposits 2,348,057 2,176,947
Federal funds purchased 129,030 117,552
Other borrowings 314,641 405,386
Subordinated debentures 64,197 64,197
Financed premiums payable 41,121 48,160
Accrued expenses and other liabilities 51,177 51,493
----------- -----------
Total Liabilities 2,948,223 2,863,735
----------- -----------
Shareholders' Equity
Preferred stock, no par value -- 200,000 shares authorized; none
outstanding
Common stock, $1.00 par value -- 30,000,000 shares authorized;
issued and outstanding: 21,271,052 shares at March 31, 2005
and 21,194,651 shares at December 31, 2004 21,271 21,195
Capital surplus 159,932 158,797
Retained earnings 49,050 41,795
Accumulated other comprehensive income 8,871 8,505
----------- -----------
Total Shareholders' Equity 239,124 230,292
----------- -----------
Total Liabilities and Shareholders' Equity $ 3,187,347 $ 3,094,027
=========== ===========
See notes to interim consolidated financial statements
2
INDEPENDENT BANK CORPORATION AND SUBSIDIARIES
Consolidated Statements of Operations
Three Months Ended
March 31,
2005 2004
-------- --------
(unaudited)
------------------------
(in thousands,
except per share amounts)
Interest Income
Interest and fees on loans $ 41,185 $ 30,126
Securities available for sale
Taxable 3,692 3,094
Tax-exempt 2,568 2,229
Other investments 212 166
-------- --------
Total Interest Income 47,657 35,615
-------- --------
Interest Expense
Deposits 9,174 6,202
Other borrowings 4,962 4,038
-------- --------
Total Interest Expense 14,136 10,240
-------- --------
Net Interest Income 33,521 25,375
Provision for loan losses 1,606 801
-------- --------
Net Interest Income After Provision for Loan Losses 31,915 24,574
-------- --------
Non-interest Income
Service charges on deposit accounts 4,042 3,641
Net gains (losses) on asset sales
Real estate mortgage loans 1,388 1,059
Securities (32) 493
Title insurance fees 497 544
Manufactured home loan origination fees 274 289
VISA check card interchange income 622 416
Real estate mortgage loan servicing 1,064 (684)
Other income 1,870 1,679
-------- --------
Total Non-interest Income 9,725 7,437
-------- --------
Non-interest Expense
Compensation and employee benefits 13,479 11,099
Occupancy, net 2,238 1,823
Furniture and fixtures 1,798 1,390
Other expenses 8,511 6,346
-------- --------
Total Non-interest Expense 26,026 20,658
-------- --------
Income Before Income Tax 15,614 11,353
Income tax expense 4,313 2,910
-------- --------
Net Income $ 11,301 $ 8,443
======== ========
Net Income Per Share
Basic $ .53 $ .43
Diluted .52 .42
Dividends Per Common Share
Declared $ .19 $ .16
Paid .16 .16
See notes to interim consolidated financial statements
3
INDEPENDENT BANK CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Three months ended
March 31,
2005 2004
---------- ----------
(unaudited)
------------------------
(in thousands)
Net Income $ 11,301 $ 8,443
--------- ---------
Adjustments to Reconcile Net Income
to Net Cash from (used in) Operating Activities
Proceeds from sales of loans held for sale 89,306 69,793
Disbursements for loans held for sale (90,819) (89,876)
Provision for loan losses 1,606 801
Depreciation and amortization of premiums and accretion of
discounts on securities and loans (2,780) 2,435
Net gains on sales of real estate mortgage loans (1,388) (1,059)
Net (gains) losses on securities 32 (493)
Deferred loan fees (308) (208)
Increase in accrued income and other assets (288) (1,171)
Increase (decrease) in accrued expenses and other liabilities (7,006) 17,229
--------- ---------
(11,645) (2,549)
--------- ---------
Net Cash from (used in) Operating Activities (344) 5,894
--------- ---------
Cash Flow used in Investing Activities
Proceeds from the sale of securities available for sale 7,876 13,112
Proceeds from the maturity of securities available for sale 2,448 1,024
Principal payments received on securities available for sale 12,099 10,013
Purchases of securities available for sale (22,208) (18,377)
Principal payments on portfolio loans purchased 434 2,235
Portfolio loans originated, net of principal payments (96,139) (39,449)
Capital expenditures (2,787) (3,521)
--------- ---------
Net Cash used in Investing Activities (98,277) (34,963)
--------- ---------
Cash Flow from (used in) Financing Activities
Net increase in total deposits 171,110 9,407
Net increase (decrease) in short-term borrowings 43,221 (590)
Proceeds from Federal Home Loan Bank advances 49,000 146,400
Payments of Federal Home Loan Bank advances (171,488) (128,256)
Dividends paid (3,404) (2,934)
Proceeds from issuance of common stock 711 569
--------- ---------
Net Cash from Financing Activities 89,150 24,596
--------- ---------
Net Decrease in Cash and Cash Equivalents (9,471) (4,473)
Cash and Cash Equivalents at Beginning of Period 72,815 61,741
--------- ---------
Cash and Cash Equivalents at End of Period $ 63,344 $ 57,268
========= =========
Cash paid during the period for
Interest $ 13,215 $ 10,164
Income taxes 3,252
Transfer of loans to other real estate 892 1,043
See notes to interim consolidated financial statements
4
INDEPENDENT BANK CORPORATION AND SUBSIDIARIES
Consolidated Statements of Shareholders' Equity
Three months ended
March 31,
2005 2004
---------- ----------
(unaudited)
------------------------
(in thousands)
Balance at beginning of period $ 230,292 $ 162,216
Net income 11,301 8,443
Cash dividends declared (4,047) (3,151)
Issuance of common stock 1,212 1,610
Net change in accumulated other comprehensive
income, net of related tax effect (note 4) 366 3,418
--------- ---------
Balance at end of period $ 239,124 $ 172,536
========= =========
See notes to interim consolidated financial statements.
5
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
1. In our opinion, the accompanying unaudited consolidated financial statements
contain all the adjustments necessary to present fairly our consolidated
financial condition as of March 31, 2005 and December 31, 2004, and the results
of operations for the three-month periods ended March 31, 2005 and 2004. Certain
reclassifications have been made in the prior year financial statements to
conform to the current year presentation. Our critical accounting policies
include the assessment for other than temporary impairment on investment
securities, the determination of the allowance for loan losses, the valuation of
derivative financial instruments, the valuation of originated mortgage servicing
rights, the valuation of deferred tax assets and the valuation of goodwill.
Refer to our 2004 Annual Report on Form 10-K for a disclosure of our accounting
policies.
2. Our assessment of the allowance for loan losses is based on an evaluation of
the loan portfolio, recent loss experience, current economic conditions and
other pertinent factors. Loans on non-accrual status, past due more than 90
days, or restructured amounted to $18.0 million at March 31, 2005, and $15.1
million at December 31, 2004. (See Management's Discussion and Analysis of
Financial Condition and Results of Operations).
3. The provision for income taxes represents federal and state income tax
expense calculated using annualized rates on taxable income generated during the
respective periods.
4. Comprehensive income for the three-month periods ended March 31 follows:
Three months ended
March 31,
2005 2004
--------- ---------
(in thousands)
Net income $ 11,301 $ 8,443
Net change in unrealized gain on securities
available for sale, net of related tax effect (1,244) 3,921
Net change in unrealized gain (loss) on derivative
instruments, net of related tax effect 1,610 (503)
-------- --------
Comprehensive income $ 11,667 $ 11,861
======== ========
The net change in unrealized gain on securities available for sale reflect net
gains and losses reclassified into earnings as follows:
Three months ended
March 31,
2005 2004
---- ----
(in thousands)
Gain (loss) reclassified into earnings $(32) $493
Federal income tax expense (benefit) as a
result of the reclassification of these
amounts from comprehensive income (11) 173
5. Our reportable segments are based upon legal entities. We have five
reportable segments: Independent Bank ("IB"), Independent Bank West Michigan
("IBWM"), Independent Bank South Michigan ("IBSM"), Independent Bank East
Michigan ("IBEM") and Mepco Insurance Premium Financing, Inc. ("Mepco"). We
evaluate performance based principally on net income of the respective
reportable segments.
6
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
A summary of selected financial information for our reportable segments as of or
for the three-month periods ended March 31, follows:
As of or for the three months ended March 31,
IB IBWM IBSM IBEM Mepco Other(1) Elimination Total
--------------------------------------------------------------------------------------------
(in thousands)
2005
Total assets $1,194,082 $524,238 $436,554 $686,981 $335,351 $325,109 $314,968 $3,187,347
Interest income 17,123 7,558 5,837 9,377 7,771 5 14 47,657
Net interest income 12,266 5,727 3,940 7,108 5,891 (1,411) 33,521
Provision for loan losses (362) 94 1,280 318 276 1,606
Income (loss) before
income tax 7,400 3,522 1,071 2,628 3,439 (2,294) 152 15,614
Net income (loss) 5,356 2,510 951 1,980 2,047 (1,391) 152 11,301
2004
Total assets $1,021,575 $467,169 $371,337 $348,920 $193,728 $233,285 $221,749 $2,414,265
Interest income 14,807 6,810 4,839 4,861 4,299 4 5 35,615
Net interest income 10,333 5,269 3,379 3,646 3,818 (1,070) 25,375
Provision for loan losses 353 148 104 40 156 801
Income (loss) before
income tax 4,790 3,084 1,808 1,449 1,690 (1,273) 195 11,353
Net income (loss) 3,672 2,233 1,357 1,179 1,032 (835) 195 8,443
(1) Includes items relating to the Registrant and certain insignificant
operations.
7
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
6. A reconciliation of basic and diluted earnings per share for the three-month
periods ended March 31 follows:
Three months ended
March 31,
2005 2004
------- -------
(in thousands, except
per share amounts)
Net income $11,301 $ 8,443
======= =======
Shares outstanding 21,229 19,565
Effect of stock options 397 433
Stock units for deferred compensation plan for non-employee directors 45 46
------- -------
Shares outstanding for calculation of diluted earnings per share 21,671 20,044
======= =======
Net income per share
Basic $ .53 $ .43
Diluted .52 .42
7. Statement of Financial Accounting Standards No. 133, "Accounting for
Derivative Instruments and Hedging Activities," ("SFAS #133") which was
subsequently amended by SFAS #138, requires companies to record derivatives on
the balance sheet as assets and liabilities measured at their fair value. The
accounting for increases and decreases in the value of derivatives depends upon
the use of derivatives and whether the derivatives qualify for hedge accounting.
Our derivative financial instruments according to the type of hedge in which
they are designated under SFAS #133 follows:
March 31, 2005
Average
Notional Maturity Fair
Amount (years) Value
-----------------------------------
(dollars in thousands)
Fair Value Hedge - pay variable interest-rate swap agreements $270,659 3.5 $(3,329)
======== === =======
Cash Flow Hedge - pay fixed interest-rate swap agreements $348,000 1.4 $ 3,816
======== === =======
No hedge designation
Pay fixed interest-rate swap agreements $ 15,000 0.6 $ 100
Pay variable interest-rate swap agreements 55,000 0.6 (140)
Rate-lock real estate mortgage loan commitments 21,557 0.1 438
Mandatory commitments to sell real estate mortgage loans 62,650 0.1 176
-------- --- -------
Total $154,207 0.3 $ 574
======== === =======
We have established management objectives and strategies that include
interest-rate risk parameters for maximum fluctuations in net interest income
and market value of portfolio equity. We monitor our interest rate risk position
via simulation modeling reports (See "Asset/liability management"). The goal of
our asset/liability management efforts is to maintain profitable financial
leverage within established risk parameters.
8
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
We use variable rate and short-term fixed-rate (less than 12 months) debt
obligations to fund a portion of our balance sheet, which exposes us to
variability in interest rates. To meet our objectives, we may periodically enter
into derivative financial instruments to mitigate exposure to fluctuations in
cash flows resulting from changes in interest rates ("Cash Flow Hedges"). Cash
Flow Hedges currently include certain pay-fixed interest-rate swaps.
Pay-fixed interest-rate swaps convert the variable-rate cash flows on debt
obligations to fixed-rates. Under interest-rate collars, we will receive cash if
interest rates rise above a predetermined level while we will make cash payments
if interest rates fall below a predetermined level. As a result, we effectively
have variable rate debt with an established maximum and minimum rate.
We record the fair value of Cash Flow Hedges in accrued income and other assets
and accrued expenses and other liabilities. On an ongoing basis, we adjust our
balance sheet to reflect the then current fair value of Cash Flow Hedges. The
related gains or losses are reported in other comprehensive income and are
subsequently reclassified into earnings, as a yield adjustment in the same
period in which the related interest on the hedged items (primarily
variable-rate debt obligations) affect earnings. It is anticipated that
approximately $1.1 million, net of tax, of unrealized gains on Cash Flow Hedges
at March 31, 2005 will be reclassified to earnings over the next twelve months.
To the extent that the Cash Flow Hedges are not effective, the ineffective
portion of the Cash Flow Hedges are immediately recognized as interest expense.
The maximum term of any Cash Flow Hedge at March 31, 2005 is 4.4 years.
We also use long-term, fixed-rate brokered CDs to fund a portion of our balance
sheet. These instruments expose us to variability in fair value due to changes
in interest rates. To meet our objectives, we may enter into derivative
financial instruments to mitigate exposure to fluctuations in fair values of
such fixed-rate debt instruments ("Fair Value Hedges"). Fair Value Hedges
currently include pay-variable interest rate swaps.
Also, we record Fair Value Hedges at fair value in accrued income and other
assets and accrued expenses and other liabilities. The hedged items (primarily
fixed-rate debt obligations) are also recorded at fair value through the
statement of operations, which offsets the adjustment to Fair Value Hedges. On
an ongoing basis, we will adjust our balance sheet to reflect the then current
fair value of both the Fair Value Hedges and the respective hedged items. To the
extent that the change in value of the Fair Value Hedges do not offset the
change in the value of the hedged items, the ineffective portion is immediately
recognized as interest expense.
Certain derivative financial instruments are not designated as hedges. The fair
value of these derivative financial instruments have been recorded on our
balance sheet and are adjusted on an ongoing basis to reflect their then current
fair value. The changes in the fair value of derivative financial instruments
not designated as hedges, are recognized currently as interest expense.
In the ordinary course of business, we enter into rate-lock real estate mortgage
loan commitments with customers ("Rate Lock Commitments"). These commitments
expose us to interest rate risk. We also enter into mandatory commitments to
sell real estate mortgage loans ("Mandatory Commitments") to hedge price
fluctuations of mortgage loans held for sale and Rate Lock Commitments.
Mandatory Commitments help protect our loan sale profit margin from fluctuations
in interest rates. The changes in the fair value of Rate Lock Commitments and
Mandatory Commitments are recognized currently as part of gains on the sale of
real estate mortgage loans. We utilize an outside third party to assist us in
our valuation of Mandatory Commitments and Rate Lock Commitments. Interest
expense and net gains on the sale of real estate mortgage loans, as well as net
income may be more volatile as a result of derivative instruments, which are not
designated as hedges.
9
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
The impact of SFAS #133 on net income and other comprehensive income for the
three-month periods ended March 31, 2005 and 2004 is as follows:
Income (Expense)
----------------------------------------
Other
Comprehensive
Net Income Income Total
---------- -------------- -------
(in thousands)
Change in fair value during the three-
month period ended March 31, 2005
Interest-rate swap agreements
not designated as hedges $ (58) $ (58)
Rate Lock Commitments 346 346
Mandatory Commitments 236 236
Ineffectiveness of cash flow hedges (6) (6)
Cash flow hedges $ 2,776 2,776
Reclassification adjustment (299) (299)
------- ------- -------
Total 518 2,477 2,995
Income tax 181 867 1,048
------- ------- -------
Net $ 337 $ 1,610 $ 1,947
======= ======= =======
Income (Expense)
----------------------------------------
Other
Comprehensive
Net Income Income Total
---------- -------------- -------
(in thousands)
Change in fair value during the three-
month period ended March 31, 2004
Interest-rate swap agreements
not designated as hedges $ (48) $ (48)
Rate Lock Commitments 52 52
Mandatory Commitments 163 163
Ineffectiveness of cash flow hedges 15 15
Cash flow hedges $(2,163) (2,163)
Reclassification adjustment 1,390 1,390
------- ------- -------
Total 182 (773) (591)
Income tax 63 (270) (207)
------- ------- -------
Net $ 119 $ (503) $ (384)
======= ======= =======
10
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
8. Statement of Financial Accounting Standards No. 141, "Business Combinations,"
("SFAS #141") and Statement of Financial Accounting Standards No. 142, "Goodwill
and Other Intangible Assets," ("SFAS #142") effects how organizations account
for business combinations and for the goodwill and intangible assets that arise
from those combinations or are acquired otherwise.
Intangible assets, net of amortization, were comprised of the following at March
31, 2005 and December 31, 2004:
March 31, 2005 December 31, 2004
------------------------ -------------------------
Gross Gross
Carrying Accumulated Carrying Accumulated
Amount Amortization Amount Amortization
-------- ------------ -------- ------------
(dollars in thousands)
Amortized intangible assets
Core deposit $20,545 $10,191 $20,545 $ 9,685
Customer relationship 2,604 1,366 2,604 1,254
Covenants not to compete 1,520 303 1,520 227
------- ------- ------- -------
Total $24,669 $11,860 $24,669 $11,166
======= ======= ======= =======
Unamortized intangible assets -
Goodwill $53,656 $53,354
======= =======
Based on our review of goodwill recorded on the Statement of Financial
Condition, no impairment existed as of March 31, 2005.
Amortization of intangibles, has been estimated through 2010 and thereafter in
the following table, and does not take into consideration any potential future
acquisitions or branch purchases.
(dollars in thousands)
Nine months ended December 31, 2005 $ 2,080
Year ending December 31:
2006 2,572
2007 2,382
2008 2,061
2009 966
2010 and thereafter 2,748
-------
Total $12,809
=======
11
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
Changes in the carrying amount of goodwill and amortizing intangibles by
reporting segment for the three months ended March 31, 2005 were as follows:
IB IBWM IBSM IBEM Mepco Other(1) Total
-- ---- ---- ---- ----- -------- -----
(dollars in thousands)
Goodwill
Balance, December 31, 2004 $ 9,702 $ 32 $ 23,205 $ 20,035 $ 380 $ 53,354
Goodwill adjustment during period (142)(2) 481(4) (37)(3) 302
-------- -------- -------- -------- -------- -------- --------
Balance, March 31, 2005 $ 9,560 $ 32 $ 23,205 $ 20,516 $ 343 $ 53,656
======== ======== ======== ======== ======== ======== ========
Core Deposit Intangible, net
Balance, December 31, 2004 $ 2,556 $ 69 $ 451 $ 7,727 $ 57 $ 10,860
Amortization (119) (5) (35) (343) (4) (506)
-------- -------- -------- -------- -------- -------- --------
Balance, March 31, 2005 $ 2,437 $ 64 $ 416 $ 7,384 $ 53 $ 10,354
======== ======== ======== ======== ======== ======== ========
Customer Relationship Intangible, net
Balance, December 31, 2004 $ 1,350 $ 1,350
Amortization (112) (112)
-------- -------- -------- -------- -------- -------- --------
Balance, March 31, 2005 $ 1,238 $ 1,238
======== ======== ======== ======== ======== ======== ========
Covenants not to compete, net
Balance, December 31, 2004 $ 1,148 $ 145 $ 1,293
Amortization (65) (11) (76)
-------- -------- -------- -------- -------- -------- --------
Balance, March 31, 2005 $ 1,083 $ 134 $ 1,217
======== ======== ======== ======== ======== ======== ========
(1)Includes items relating to the Registrant and certain insignificant
operations.
(2)Goodwill associated with the acquisition of North. See footnote #10.
(3)Goodwill associated with the acquisition of Midwest. See footnote #10.
(4)Goodwill associated with contingent consideration accrued pursuant to an
earnout.
12
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
9. We maintain stock option plans for our non-employee directors as well as
certain of our officers and those of our Banks and their subsidiaries. Options
that were granted under these plans were granted with vesting periods of up to
one year, at a price equal to the fair market value of the common stock on the
date of grant, and expire not more than ten years after the date of grant.
The per share weighted-average fair value of stock options was obtained using
the Black-Scholes options pricing model. The following table summarizes the
assumptions used and values obtained:
Three months ended
March 31,
2005 2004
------ -------
Expected dividend yield 2.27% 2.36%
Risk-free interest rate 4.14% 4.24%
Expected life (in years) 9.68 9.76
Expected volatility 31.97% 32.56%
Per share weighted-average fair value $11.80 $10.67
The following table summarizes the impact on our net income had compensation
cost included the fair value of options at the grant date:
Three months ended
March 31,
2005 2004
------- -------
(in thousands except
per share amounts)
Net income - as reported $11,301 $8,443
Stock based compensation expense determined under
fair value based method, net of related tax effect (662) (504)
------- ------
Pro-forma net income $10,639 $7,939
======= ======
Income per share
Basic
As reported $ .53 $ .43
Pro-forma .50 .41
Diluted
As reported $ .52 $ .42
Pro-forma .49 .40
10. On May 31, 2004, we completed our acquisition of Midwest Guaranty Bancorp,
Inc. ("Midwest")with the purpose of expanding our presence in southeastern
Michigan. Midwest was a closely held bank holding company primarily doing
business as a commercial bank. As a result of the closing of this transaction,
we issued 997,700 shares of common stock and paid $16.6 million in cash to the
Midwest shareholders. Our results include Midwest's operations subsequent to May
31, 2004. At the time of acquisition, Midwest had total assets of $238.0
million, total loans of $205.0 million, total deposits of $198.9 million and
total stockholders' equity of $18.7 million. We recorded purchase accounting
adjustments related to the Midwest acquisition including recording goodwill of
$23.0 million, establishing a core deposit intangible of $4.9 million, and a
covenant not to compete of $1.3 million. The core deposit intangible is being
amortized on an accelerated basis over ten years and the covenant not to compete
on a straight-line basis over five years.
13
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
The following is a condensed balance sheet of Midwest at our date of acquisition
adjusted for updated information related to the fair value of assets acquired
and liabilities assumed:
(in thousands)
Cash and equivalents $ 8,390
Securities 19,557
Loans, net 201,476
Property and equipment 5,674
Intangible assets 6,219
Goodwill 23,037
Other assets 1,861
--------
Total assets acquired 266,214
--------
Deposits 199,123
Borrowings 12,314
Other liabilities 10,663
--------
Total liabilities assumed 222,100
--------
Net assets acquired $ 44,114
========
On July 1, 2004, we completed our acquisition of North Bancorp, Inc. ("North"),
with the purpose of expanding our presence in northern Michigan. North was a
publicly held bank holding company primarily doing business as a commercial
bank. As a result of the closing of this transaction, we issued 345,391 shares
of common stock to the North shareholders. Our results include North's
operations subsequent to July 1, 2004. At the time of acquisition, North had
total assets of $155.1 million, total loans of $103.6 million, total deposits of
$123.8 million and total stockholders' equity of $3.3 million. We recorded
purchase accounting adjustments related to the North acquisition including
recording goodwill of $2.8 million, and establishing a core deposit intangible
of $2.2 million. The core deposit intangible is being amortized on an
accelerated basis over eight years.
The following is a condensed balance sheet of North at our date of acquisition
adjusted for updated information related to the fair value of assets acquired
and liabilities assumed:
(in thousands)
Cash and equivalents $ 21,505
Securities 26,418
Loans, net 97,573
Property and equipment 2,318
Intangible assets 2,240
Goodwill 2,807
Other assets 9,440
--------
Total assets acquired 162,301
--------
Deposits 124,088
Borrowings 22,039
Other liabilities 7,401
--------
Total liabilities assumed 153,528
--------
Net assets acquired $ 8,773
========
14
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
11. In December 2004, the FASB issued Statement of Financial Accounting
Standards No. 123 (revised 2004), "Share Based Payment," ("SFAS #123R") which is
a revision of Statement of Financial Accounting Standards No. 123, "Accounting
for Stock-Based Compensation," ("SFAS #123"). SFAS #123R supersedes Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees,"
("APB #25") and amends Statement of Financial Accounting Standards No. 95,
"Statement of Cash Flows," ("SFAS #95"). Generally the requirements of SFAS
#123R are similar to the requirements described in SFAS #123. However, SFAS
#123R requires all share-based payments to employees, including grants of
employee stock options, to be recognized in the statement of operations based on
their fair values. Pro forma disclosure is no longer an alternative. Statement
#123R originally was to be effective at the beginning of the first interim or
annual period beginning after June 15, 2005. However, on April 21, 2005 the
Securities and Exchange Commission issued an amendment to Rule 4-01(a) of
Regulation S-X that delayed the effective date for SFAS #123R to the first
interim or annual reporting period of the registrant's first fiscal year
beginning on or after June 15, 2005. Early adoption is permitted in periods in
which financial statements have not yet been issued. We expect to adopt SFAS
#123R on January 1, 2006.
SFAS #123R permits companies to adopt its requirements using one of two methods.
First, a "modified prospective" method in which compensation cost is recognized
beginning with the effective date (a) based on the requirements of SFAS #123R
for all share-based payments granted after the effective date and (b) based on
the requirements of SFAS #123 for all awards granted to employees prior to the
effective date of SFAS #123R that remain unvested on the effective date. Second,
a "modified retrospective" method which includes the requirements of the
modified prospective method described above, but also permits entities to
restate based on the amounts previously recognized under SFAS #123 for purposes
of pro forma disclosures either (a) all prior period presented or (b) prior
interim periods of the year of adoption. We plan to adopt SFAS #123R using the
modified prospective method described above.
As permitted by SFAS #123, we currently account for share-based payments to
employees using APB #25's intrinsic value method and, as such, generally
recognize no compensation cost for employee stock options. Accordingly, the
adoption of SFAS 123R's fair value method will have a significant impact on our
results of operations, although it will have no impact on our overall financial
position. The impact of SFAS #123R cannot be predicted at this time because it
will depend on the level and type of share-based payments granted in the future.
However, had we adopted SFAS #123R in prior periods, the impact of that standard
would have approximated the impact of SFAS #123 as described in the disclosure
of pro forma net income and earnings per share in Note #9 to above.
In March 2004, the Securities and Exchange Commission ("SEC") issued Staff
Accounting Bulletin No. 105, "Application of Accounting Principles to Loan
Commitments," ("SAB #105") which provides guidance about the measurement of loan
commitments required to be accounted for as derivative instruments and
recognized at fair value under SFAS #133. SAB #105 also requires companies to
disclose their accounting policy for those loan commitments including methods
and assumptions used to estimate fair value and associated hedging strategies.
SAB #105 is effective for all loan commitments accounted for as derivatives that
are entered into after March 31, 2004. Our current policies are consistent with
the guidance issued in SAB #105.
15
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
In 2003, the Emerging Issues Task Force ("EITF") issued Issue No. 03-1, "The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments." The recognition and measurement guidance in EITF 03-1 should be
applied in other-than-temporary impairment evaluations performed in reporting
periods beginning after June 15, 2004. Disclosures were effective in annual
financial statements for fiscal years ending after December 15, 2003, for
investments accounted for under FASB Statement of Financial Accounting Standards
No. 115, "Accounting in Certain Investments in Debt and Equity Securities, and
No. 124, Accounting for Certain Investments Held by Not-for-Profit
Organizations". The disclosure requirements for all other investments are
effective in annual financial statements for fiscal years ending after June 15,
2004. Comparative information for periods prior to initial application is not
required. On September 15, 2004, the FASB staff proposed two FASB Staff
Positions ("FSP"). The first, proposed FSP EITF Issue 03-1-a, "Implementation
Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1, `The
Meaning of Other-Than-Temporary Impairment and its Application to Certain
Investments,'" would provide guidance for the application of paragraph 16 of
EITF 03-1 to debt securities that are impaired because of interest rate and/or
sector spread increases. The second, proposed FSP EITF Issue 03-1-b, "Effective
Date of Paragraph 16 of EITF Issue No. 03-1, `The Meaning of
Other-Than-Temporary Impairment and its Application to Certain Investments,"
would delay the effective date of EITF 03-1 for debt securities that are
impaired because of interest rate and/or sector spread increases. Other
investments within the scope of EITF 03-1 remain subject to its recognition and
measurement provisions for interim and annual periods beginning after June 15,
2004. The disclosure provisions of EITF 03-1 also would not be affected by the
two proposed FSPs.
In December 2003, the American Institute of Certified Public Accountants
("AICPA") issued Statement of Position ("SOP") 03-03, "Accounting for Certain
Loans or Debt Securities Acquired in a Transfer". This SOP addresses accounting
for differences between contractual cash flows and cash flows expected to be
collected from an investor's initial investment in loans or debt securities
(loans) acquired in a transfer if those differences are attributable, at least
in part, to credit quality. It includes loans acquired in purchase business
combinations. This SOP does not apply to loans originated by us and is effective
for loans acquired in fiscal years beginning after December 15, 2004. This SOP
is expected to have a significant impact on our future acquisitions as it will
require the allocation of the acquired entity's allowance for loan losses to
individual loans.
In December 2003, the FASB issued Interpretation No. 46 (revised December 2003),
"Consolidation of Variable Interest Entities," ("FIN 46R"), which addresses how
a business enterprise should evaluate whether it has a controlling financial
interest in an entity through means other than voting rights and accordingly
should consolidate the entity. FIN 46R replaces FIN 46. Under the general
transition provisions of FIN 46R all public entities are required to fully
implement FIN 46R no later than the end of the first reporting period ending
after March 15, 2004. The adoption of FIN 46R during the quarter ended March 31,
2004 did not have a material impact on our financial condition or results of
operations.
12. The results of operations for the three-month periods ended March 31, 2005,
are not necessarily indicative of the results to be expected for the full year.
16
Item 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following section presents additional information that may be necessary to
assess our financial condition and results of operations. This section should be
read in conjunction with our consolidated financial statements contained
elsewhere in this report as well as our 2004 Annual Report on Form 10-K.
FINANCIAL CONDITION
SUMMARY Our total assets increased by $93.3 million during the first three
months of 2005. Loans, excluding loans held for sale ("Portfolio Loans"),
totaled $2.324 billion at March 31, 2005, an increase of $99.0 million from
December 31, 2004. This was principally driven by increases in commercial loans
and finance receivables. (See "Portfolio loans and asset quality.") Loans held
for sale increased by $2.9 million, as the volume of new originations of such
loans exceeded loan sales in the first quarter of 2005.
Deposits totaled $2.348 billion at March 31, 2005, compared to $2.177 billion at
December 31, 2004. The $171.1 million increase in total deposits during the
period principally reflects an increase in savings and NOW accounts and time
deposits partially offset by a decline in non-interest bearing deposits. Other
borrowings totaled $314.6 million at March 31, 2005, a decrease of $90.7 million
from December 31, 2004. This was primarily attributable to the payoff of
maturing borrowings with funds from brokered certificates of deposit ("Brokered
CD's").
SECURITIES We maintain diversified securities portfolios, which may include
obligations of the U.S. Treasury and government-sponsored agencies as well as
securities issued by states and political subdivisions, corporate securities,
mortgage-backed securities and asset-backed securities. We also invest in
capital securities, which include preferred stocks and trust preferred
securities. We regularly evaluate asset/liability management needs and attempt
to maintain a portfolio structure that provides sufficient liquidity and cash
flow. We believe that the unrealized losses on securities available for sale are
temporary in nature and due primarily to changes in interest rates and are
expected to be recovered within a reasonable time period. We also believe that
we have the ability to hold securities with unrealized losses to maturity or
until such time as the unrealized losses reverse. (See "Asset/liability
management.")
SECURITIES
Unrealized
----------
Amortized Fair
Cost Gains Losses Value
--------- ------- ------ --------
(in thousands)
Securities available for sale
March 31, 2005 $539,330 $13,983 $4,151 $549,162
December 31, 2004 539,162 13,448 1,702 550,908
Securities available for sale remained relatively unchanged during the first
quarter of 2005 because strong loan growth supplanted the need for any
significant purchases of new investment
17
securities. Generally we cannot earn the same interest-rate spread on securities
as we can on loans. As a result, offsetting slow loan growth with purchases of
securities will tend to erode some of our profitability measures, including our
return on assets.
At March 31, 2005 and December 31, 2004, we had $22.2 million and $23.6 million,
respectively, of asset-backed securities included in securities available for
sale. Approximately 83% of our asset-backed securities at March 31, 2005 are
backed by mobile home loans (compared to 87% at December 31, 2004). All of our
asset-backed securities are rated as investment grade (by the major rating
agencies) except for one mobile home loan asset-backed security with a book
value of $2.5 million at March 31, 2005 that was down graded during 2004 to a
below investment grade rating. During the first quarter of 2005 we recorded an
impairment charge of $0.2 million on this security due primarily to some further
credit related deterioration on the underlying mobile home loan collateral (we
also recorded impairment charges on this security totaling $0.2 million in
2004). We continue to closely monitor this particular security as well as our
entire mobile home loan asset-backed securities portfolio. We do not foresee, at
the present time, any significant risk of loss (related to credit issues) with
respect to any of our other asset-backed securities. During the first quarter we
recorded an additional $0.1 million impairment charge on Fannie Mae and Freddie
Mac preferred securities (we also recorded a $1.4 million impairment charge on
Fannie Mae and Freddie Mac preferred securities during 2004). At March 31, 2005,
we had a remaining book balance of $26.6 million in Fannie Mae and Freddie Mac
preferred securities. Currently the FASB is considering certain changes or
clarifications related to the assessment of other than temporary impairment on
investment securities as well as other related accounting matters (See note #11
of Notes to Interim Consolidated Financial Statements).
Sales of securities available for sale were as follows (See "Non-interest
income."):
Three months ended
March 31,
2005 2004
------- -------
(in thousands)
Proceeds $ 7,876 $13,112
======= =======
Gross gains $ 499 $ 619
Gross losses 279 126
Impairment charges 252
------- -------
Net gains (losses) $ (32) $ 493
======= =======
PORTFOLIO LOANS AND ASSET QUALITY We believe that our decentralized loan
origination structure provides important advantages in serving the credit needs
of our principal lending markets. In addition to the communities served by our
bank branch networks, principal lending markets include nearby communities and
metropolitan areas. Subject to established underwriting criteria, we also
participate in commercial lending transactions with certain non-affiliated banks
and may also purchase real estate mortgage loans from third-party originators.
Our April 2003 acquisition of Mepco added the financing of insurance premiums
and extended automobile warranties to our lending activities. These are
relatively new lines of business for us and expose us to new risks. Mepco
conducts its lending activities across the United States.
18
Mepco generally does not evaluate the creditworthiness of the individual
borrower but instead primarily relies on the loan collateral (the unearned
insurance premium or automobile warranty contract) in the event of default. As a
result, we have established and monitor insurance carrier concentration limits
in order to manage our collateral exposure. The insurance carrier concentration
limits are primarily based on the insurance company's AM Best rating and
statutory surplus level. Mepco also has established procedures for loan
servicing and collections, including the timely cancellation of the insurance
policy or automobile warranty contract in order to protect our collateral
position in the event of default. Mepco also has established procedures to
attempt to prevent and detect fraud since the loan origination activities and
initial borrower contact is entirely done through unrelated third parties
(primarily insurance agents and automobile warranty administrators or automobile
dealerships). There can be no assurance that the aforementioned risk management
policies and procedures will prevent us from the possibility of incurring
significant credit or fraud related losses in this business segment.
Although the management and board of directors of each of our banks retain
authority and responsibility for credit decisions, we have adopted uniform
underwriting standards. Further, our loan committee structure as well as the
centralization of commercial loan credit services and the loan review process,
provides requisite controls and promotes compliance with such established
underwriting standards. Such centralized functions also facilitate compliance
with consumer protection laws and regulations. There can be no assurance that
the aforementioned centralization of certain lending procedures and the use of
uniform underwriting standards will prevent us from the possibility of incurring
significant credit losses in our lending activities.
We generally retain loans that may be profitably funded within established risk
parameters. (See "Asset/liability management.") As a result, we may hold
adjustable-rate and balloon real estate mortgage loans as Portfolio Loans, while
15- and 30-year, fixed-rate obligations are generally sold to mitigate exposure
to changes in interest rates. (See "Non-interest income.") During the first
three months of 2005 our balance of real estate mortgage loans held in portfolio
increased by $14.8 million.
The $31.2 million increase in commercial loans during the three months ended
March 31, 2005, principally reflects our emphasis on lending opportunities
within this category of loans and an increase in commercial lending staff. Loans
secured by real estate comprise the majority of new commercial loans.
The $307.7 million of finance receivables at March 31, 2005 are comprised
principally of loans to businesses to finance insurance premiums and payment
plans offered to individuals to finance extended automobile warranties. The
finance receivables are a result of our acquisition of Mepco. The growth in this
category of loans is primarily due to the geographic expansion of Mepco's
lending activities and the addition of sales staff to call on insurance agencies
and automobile warranty administrators.
Future growth of overall Portfolio Loans is dependent upon a number of
competitive and economic factors. Declines in Portfolio Loans or competition
leading to lower relative pricing on new Portfolio Loans could adversely impact
our future operating results. We continue to view loan growth consistent with
prevailing quality standards as a major short and long-term challenge.
19
NON-PERFORMING ASSETS
March 31, December 31,
2005 2004
--------- ------------
(dollars in thousands)
Non-accrual loans $15,165 $11,804
Loans 90 days or more past due and
still accruing interest 2,556 3,123
Restructured loans 305 218
------- -------
Total non-performing loans 18,026 15,145
Other real estate 2,645 2,113
------- -------
Total non-performing assets $20,671 $17,258
======= =======
As a percent of Portfolio Loans
Non-performing loans 0.78% 0.68%
Allowance for loan losses 1.06 1.11
Non-performing assets to total assets 0.65 0.56
Allowance for loan losses as a percent of
non-performing loans 137 163
The increase in the overall level of non-performing loans in the first quarter
of 2005 is primarily due to increases in non-performing real estate mortgage
loans and finance receivables and to a lesser degree, commercial loans. We
believe that the increase in non-performing real estate mortgage loans (to $5.8
million at March 31, 2005 from $4.6 million at December 31, 2004) reflects
weakened economic conditions in the State of Michigan which currently has one of
the highest unemployment rates in the United States. The increase in
non-performing finance receivables (to $3.1 million at March 31, 2005 from $2.1
million at December 31, 2004) is due primarily to the growth of this loan
portfolio and the timing of the receipt of return premiums from insurance
carriers.
Other real estate and repossessed assets totaled $2.6 million and $2.1 million
at March 31, 2005 and December 31, 2004, respectively. This increase is
primarily a result of a rise in the level of residential homes acquired through
foreclosure.
We will place a loan that is 90 days or more past due on non-accrual, unless we
believe the loan is both well secured and in the process of collection.
Accordingly, we have determined that the collection of the accrued and unpaid
interest on any loans that are 90 days or more past due and still accruing
interest is probable.
The ratio of net charge-offs to average loans was 0.30% on an annualized basis
in the first quarter of 2005 compared to 0.19% in the first quarter of 2004. The
increase in net charge-offs is primarily due to a charge-off (based on an
updated collateral analysis) on a real estate mortgage and commercial loan
relationship with one borrower who recently declared bankruptcy.
Despite the increases in net loan charge-offs and non-performing loans in the
first quarter of 2005, the allowance for loan losses declined slightly due
primarily to a decline in other adversely rated loans. At March 31, 2005, the
allowance for loan losses totaled $24.6 million, or 1.06% of portfolio loans
compared to $24.7 million, or 1.11% of portfolio loans at December 31, 2004.
20
Impaired loans totaled approximately $15.3 million and $14.6 million at March
31, 2005 and 2004, respectively. At those same dates, certain impaired loans
with balances of approximately $13.8 million and $7.7 million, respectively had
specific allocations of the allowance for loan losses, which totaled
approximately $4.0 million and $1.5 million, respectively. Our average
investment in impaired loans was approximately $14.9 million and $14.0 million
for the three-month periods ended March 31, 2005 and 2004, respectively. Cash
receipts on impaired loans on non-accrual status are generally applied to the
principal balance. Interest recognized on impaired loans during the first
quarter of 2005 and 2004 was approximately $0.14 million.
ALLOWANCE FOR CREDIT LOSSES
Three months ended
March 31,
2005 2004
---------------------------- -----------------------------
Loan Unfunded Loan Unfunded
Losses Commitments Losses Commitments
------- ----------- ------- -----------
(in thousands)
Balance at beginning of period $24,737 $1,846 $16,836 $892
Additions (deduction)
Provision charged to operating expense 1,613 (7) 773 28
Recoveries credited to allowance 419 258
Loans charged against the allowance (2,141) (1,061)
------- ------ ------- ----
Balance at end of period $24,628 $1,839 $16,806 $920
======= ====== ======= ====
Net loans charged against the allowance to
average Portfolio Loans (annualized) 0.30% 0.19%
In determining the allowance and the related provision for loan losses, we
consider four principal elements: (i) specific allocations based upon probable
losses identified during the review of the loan portfolio, (ii) allocations
established for other adversely rated loans, (iii) allocations based principally
on historical loan loss experience, and (iv) additional allowances based on
subjective factors, including local and general economic business factors and
trends, portfolio concentrations and changes in the size, mix and/or the general
terms of the loan portfolios.
The first element reflects our estimate of probable losses based upon our
systematic review of specific loans. These estimates are based upon a number of
objective factors, such as payment history, financial condition of the borrower,
and discounted collateral exposure.
The second element reflects the application of our loan rating system. This
rating system is similar to those employed by state and federal banking
regulators. Loans that are rated below a certain predetermined classification
are assigned a loss allocation factor for each loan classification category that
is based upon a historical analysis of losses incurred. The lower the rating
assigned to a loan or category, the greater the allocation percentage that is
applied.
The third element is determined by assigning allocations based principally upon
the ten-year average of loss experience for each type of loan. Recent years are
weighted more heavily in this average. Average losses may be further adjusted
based on the current delinquency rate. Loss analyses are conducted at least
annually.
21
The fourth element is based on factors that cannot be associated with a specific
credit or loan category and reflects our attempt to ensure that the overall
allowance for loan losses appropriately reflects a margin for the imprecision
necessarily inherent in the estimates of expected credit losses. We consider a
number of subjective factors when determining the unallocated portion, including
local and general economic business factors and trends, portfolio concentrations
and changes in the size, mix and the general terms of the loan portfolios. (See
"Provision for credit losses.")
Mepco's allowance for loan losses is determined in a similar manner as discussed
above and takes into account delinquency levels, net charge-offs, unsecured
exposure and other subjective factors deemed relevant to their lending
activities.
ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES
March 31, December 31,
2005 2004
--------- ------------
(in thousands)
Specific allocations $ 3,985 $ 2,874
Other adversely rated loans 8,115 9,395
Historical loss allocations 6,141 6,092
Additional allocations based on subjective factors 6,387 6,376
------- -------
$24,628 $24,737
======= =======
DEPOSITS AND BORROWINGS Our competitive position within many of the markets
served by our bank branch networks limits the ability to materially increase
deposits without adversely impacting the weighted-average cost of core deposits.
Accordingly, we compete principally on the basis of convenience and personal
service, while employing pricing tactics that are intended to enhance the value
of core deposits.
To attract new core deposits, we have implemented a high-performance checking
program that utilizes a combination of direct mail solicitations, in-branch
merchandising, gifts for customers opening new checking accounts or referring
business to our banks and branch staff sales training. This program has
generated increases in customer relationships as well as deposit service
charges. We believe that the new relationships that result from these marketing
and sales efforts provide valuable opportunities to cross sell related financial
products and services.
We have implemented strategies that incorporate federal funds purchased, other
borrowings and Brokered CDs to fund a portion of our increases in interest
earning assets. The use of such alternate sources of funds supplements our core
deposits and is also an integral part of our asset/liability management efforts.
22
ALTERNATE SOURCES OF FUNDS
March 31, December 31,
2005 2004
----------------------------------------- -------------------------------------
Average Average
Amount Maturity Rate Amount Maturity Rate
---------- --------- ---- ---------- --------- ----
(dollars in thousands)
Brokered CDs(1) $ 710,896 2.0 years 2.90% $ 576,944 1.9 years 2.56%
Fixed rate FHLB advances(1,2) 58,414 6.2 years 5.55 59,902 6.4 years 5.55
Variable rate FHLB advances(1) 43,000 0.3 years 2.98 164,000 0.4 years 2.32
Securities sold under agreements to
Repurchase(1) 201,549 0.1 years 2.73 169,810 0.2 years 2.27
Federal funds purchased 129,030 1 day 3.02 117,552 1 day 2.44
---------- --------- ---- ---------- --------- ----
Total $1,142,889 1.6 years 3.02% $1,088,208 1.4 years 2.63%
========== ========= ==== ========== ========= ====
(1) Certain of these items have had their average maturity and rate altered
through the use of derivative instruments, including pay-fixed and pay-variable
interest rate swaps.
(2) Advances totaling $10.0 million at both March 31, 2005 and December 31,
2004, respectively, have provisions that allow the FHLB to convert fixed-rate
advances to adjustable rates prior to stated maturity.
Other borrowed funds, principally advances from the Federal Home Loan Bank (the
"FHLB") and securities sold under agreements to repurchase ("Repurchase
Agreements"), totaled $314.6 million at March 31, 2005, compared to $405.4
million at December 31, 2004. The $90.7 million decrease in other borrowed funds
principally reflects the payoff of maturing variable rate FHLB advances with
funds from Brokered CD's.
Derivative financial instruments are employed to manage our exposure to changes
in interest rates. (See "Asset/liability management.") At March 31, 2005, we
employed interest-rate swaps with an aggregate notional amount of $688.7
million. (See note #7 of Notes to Interim Consolidated Financial Statements.)
LIQUIDITY AND CAPITAL RESOURCES Liquidity risk is the risk of being unable to
timely meet obligations as they come due at a reasonable funding cost or without
incurring unacceptable losses. Our liquidity management involves the measurement
and monitoring of a variety of sources and uses of funds. Our Consolidated
Statements of Cash Flows categorize these sources and uses into operating,
investing and financing activities. We primarily focus our liquidity management
on developing access to a variety of borrowing sources to supplement our deposit
gathering activities and provide funds for growing our investment and loan
portfolios as well as to be able to respond to unforeseen liquidity needs.
Our sources of funds include a stable deposit base, secured advances from the
Federal Home Loan Bank of Indianapolis, both secured and unsecured federal funds
purchased borrowing facilities with other commercial banks, an unsecured holding
company credit facility and access to the capital markets (for trust preferred
securities and Brokered CD's).
At March 31, 2005 we had $677.2 million of time deposits that mature in the next
twelve months. Historically, a majority of these maturing time deposits are
renewed by our customers or are Brokered CD's that we expect to replace.
Additionally $1.174 billion of our deposits at March 31, 2005 were in account
types from which the customer could withdraw the funds on demand. Changes in the
balances of deposits that can be withdrawn upon demand are usually predictable
and the total balances of these accounts have generally grown over time as a
result of our marketing and promotional activities. There can be no assurance
that historical patterns of renewing time deposits or overall growth in deposits
will continue in the future.
23
We have developed contingency funding plans that stress tests our liquidity
needs that may arise from certain events such as an adverse credit event, rapid
loan growth or a disaster recovery situation. Our liquidity management also
includes periodic monitoring of each bank that segregates assets between liquid
and illiquid and classifies liabilities as core and non-core. This analysis
compares our total level of illiquid assets to our core funding. It is our goal
to have core funding sufficient to finance illiquid assets.
Over the past several years our Portfolio Loans have grown more rapidly than our
core deposits. In addition much of this growth has been in loan categories that
cannot generally be used as collateral for FHLB advances (such as commercial
loans and finance receivables). As a result, we have become more dependent on
wholesale funding sources (such as brokered CD's and Repurchase Agreements). In
order to reduce this greater reliance on wholesale funding we intend to explore
the potential securitization of both commercial loans and finance receivables
during 2005. It is likely that a securitization facility would have a higher
total cost than our current wholesale funding sources, which would adversely
impact our future net interest income. However, we believe that the improved
liquidity will likely outweigh the adverse impact on our net interest income.
Effective management of capital resources is critical to our mission to create
value for our shareholders. The cost of capital is an important factor in
creating shareholder value and, accordingly, our capital structure includes
unsecured debt and cumulative trust preferred securities.
We also believe that a diversified portfolio of quality loans will provide
superior risk-adjusted returns. Accordingly, we have implemented balance sheet
management strategies that combine efforts to originate Portfolio Loans with
disciplined funding strategies. Acquisitions have also been an integral
component of our capital management strategies. (See "Acquisitions.")
In March 2003, a special purpose entity, IBC Capital Finance II (the "trust")
issued $1.6 million of common securities to Independent Bank Corporation and
$50.6 million of trust preferred securities to the public. Independent Bank
Corporation issued $52.2 million of subordinated debentures to the trust in
exchange for the proceeds from the public offering. These subordinated
debentures represent the sole asset of the trust. Both the common securities and
subordinated debentures are included in our Consolidated Statements of Financial
Condition at March 31, 2005, and December 31, 2004.
In connection with our acquisition of Midwest, we assumed all of the duties,
warranties and obligations of Midwest as the sponsor and sole holder of the
common securities of Midwest Guaranty Trust I ("MGT"). In 2002, MGT, a special
purpose entity, issued $0.2 million of common securities to Midwest and $7.5
million of trust preferred securities as part of a pooled offering. Midwest
issued $7.7 million of subordinated debentures to the trust in exchange for the
proceeds of the offering, which debentures represent the sole asset of MGT. Both
the common securities and subordinated debentures are included in our
Consolidated Statements of Financial Condition at March 31, 2005, and December
31, 2004.
In connection with our acquisition of North, we assumed all of the duties,
warranties and obligations of North as the sole general partner of Gaylord
Partners, Limited Partnership ("GPLP"), a special purpose entity. In 2002, North
contributed an aggregate of $0.1 million to the capital of GPLP and GPLP issued
$5.0 million of floating rate cumulative preferred securities
24
as part of a private placement offering. North issued $5.1 million of
subordinated debentures to GPLP in exchange for the proceeds of the offering,
which debentures represent the sole asset of GPLP. Independent Bank purchased
$0.8 million of the GPLP floating rate cumulative preferred securities during
the private placement offering. This investment security at Independent Bank and
a corresponding amount of subordinated debentures are eliminated in
consolidation. The remaining subordinated debentures as well as our capital
investment in GPLP are included in our Consolidated Statements of Financial
Condition at March 31, 2005 and December 31, 2004.
In March 2005, the Federal Reserve Board issued a final rule that retains trust
preferred securities in the Tier 1 capital of bank holding companies. After a
transition period ending March 31, 2009, the aggregate amount of trust preferred
securities and certain other capital elements will be limited to 25 percent of
Tier 1 capital elements, net of goodwill (net of any associated deferred tax
liability). The amount of trust preferred securities and certain other elements
in excess of the limit could be included in the Tier 2 capital, subject to
restrictions. Based upon our existing levels of Tier 1 capital, trust preferred
securities and goodwill, this final Federal Reserve Board rule would have
reduced our Tier 1 capital to average assets ratio by approximately 25 basis
points at March 31, 2005, (this calculation assumes no transition period).
To supplement our balance sheet and capital management activities, we
periodically repurchase our common stock. The level of share repurchases in a
given year generally reflects changes in our need for capital associated with
our balance sheet growth. In February 2005 we announced that our board of
directors had authorized the repurchase of up to 0.8 million shares. This
authorization expires on December 31, 2005.
CAPITALIZATION
March 31, December 31,
2005 2004
--------- ------------
(in thousands)
Unsecured debt $ 8,500 $ 9,000
--------- ---------
Subordinated debentures 64,197 64,197
Amount not qualifying as regulatory capital (1,847) (1,847)
--------- ---------
Amount qualifying as regulatory capital 62,350 62,350
--------- ---------
Shareholders' Equity
Preferred stock, no par value
Common stock, par value $1.00 per share 21,271 21,195
Capital surplus 159,932 158,797
Retained earnings 49,050 41,795
Accumulated other comprehensive income 8,871 8,505
--------- ---------
Total shareholders' equity 239,124 230,292
--------- ---------
Total capitalization $ 309,974 $ 301,642
========= =========
Total shareholders' equity at March 31, 2005 increased $8.8 million from
December 31, 2004, due primarily to the retention of earnings, an increase in
accumulated other comprehensive income and the issuance of common stock pursuant
to certain compensation plans, partially offset by cash dividends that we
declared. Shareholders' equity totaled $239.1 million, equal to 7.50% of total
assets at March 31, 2005. At December 31, 2004, shareholders' equity totaled
$230.3 million, which was equal to 7.44% of assets.
25
CAPITAL RATIOS
March 31, 2005 December 31, 2004
-------------- -----------------
Equity capital 7.50% 7.44%
Tier 1 leverage (tangible equity capital) 7.40 7.36
Tier 1 risk-based capital 9.38 9.39
Total risk-based capital 10.50 10.53
ASSET/LIABILITY MANAGEMENT Interest-rate risk is created by differences in the
cash flow characteristics of our assets and liabilities. Options embedded in
certain financial instruments, including caps on adjustable-rate loans as well
as borrowers' rights to prepay fixed-rate loans also create interest-rate risk.
Our asset/liability management efforts identify and evaluate opportunities to
structure the balance sheet in a manner that is consistent with our mission to
maintain profitable financial leverage within established risk parameters. We
evaluate various opportunities and alternate balance-sheet strategies carefully
and consider the likely impact on our risk profile as well as the anticipated
contribution to earnings. The marginal cost of funds is a principal
consideration in the implementation of our balance-sheet management strategies,
but such evaluations further consider interest-rate and liquidity risk as well
as other pertinent factors. We have established parameters for interest-rate
risk. We regularly monitor our interest-rate risk and report quarterly to our
respective banks' boards of directors.
We employ simulation analyses to monitor each bank's interest-rate risk profiles
and evaluate potential changes in each banks' net interest income and market
value of portfolio equity that result from changes in interest rates. The
purpose of these simulations is to identify sources of interest-rate risk
inherent in our balance sheets. The simulations do not anticipate any actions
that we might initiate in response to changes in interest rates and,
accordingly, the simulations do not provide a reliable forecast of anticipated
results. The simulations are predicated on immediate, permanent and parallel
shifts in interest rates and generally assume that current loan and deposit
pricing relationships remain constant. The simulations further incorporate
assumptions relating to changes in customer behavior, including changes in
prepayment rates on certain assets and liabilities.
RESULTS OF OPERATIONS
SUMMARY Net income totaled $11.3 million during the three months ended March 31,
2005, compared to $8.4 million during the comparable period in 2004. The
increase in net income is primarily a result of increases in net interest
income, service charges on deposit accounts and gains on real estate mortgage
loan sales, as well as the recovery of a previously recorded impairment charge
on real estate mortgage loan servicing. These items were partially offset by
increases in non-interest expenses and income taxes as well as a decline in
securities gains. 2005 results include the operations of Midwest Guaranty
Bancorp, Inc. since our May 31, 2004 date of acquisition and include the
operations of North Bancorp, Inc. since our July 1, 2004 date of acquisition.
26
KEY PERFORMANCE RATIOS
Three months
ended March 31,
2005 2004
------ ------
Net income (annualized) to
Average assets 1.47% 1.44%
Average equity 19.38 20.34
Earnings per common share
Basic $ 0.53 $ 0.43
Diluted 0.52 0.42
We believe that our earnings per share growth rate over a long period of time
(five years or longer) is the best single measure of our performance. We strive
to achieve an average annual long term earnings per share growth rate of
approximately 10% to 15%. Consequently, we emphasize long-term performance over
short-term results. Certain components of our revenues are cyclical in nature
(such as mortgage-banking) which can cause fluctuations in our earnings per
share from one period to another. Our primary strategies for achieving long-term
growth in earnings per share include: earning asset growth (both organic and
through acquisitions), diversification of revenues (within the financial
services industry), effective capital management (efficient use of our
shareholders' equity) and sound risk management (credit, interest rate,
liquidity and regulatory risks).
NET INTEREST INCOME Net interest income is the most important source of our
earnings and thus is critical in evaluating our results of operations. Changes
in our tax equivalent net interest income are primarily influenced by our level
of interest-earning assets and the income or yield that we earn on those assets
and the manner by which we fund (and the related cost of funding) such
interest-earning assets. Certain macro-economic factors can also influence our
net interest income such as the level and direction of interest rates, the
difference between short-term and long-term interest rates (the steepness of the
yield curve) and the general strength of the economies in which we are doing
business. Finally, risk management plays an important role in our level of net
interest income. The ineffective management of credit risk and interest-rate
risk in particular can adversely impact our net interest income.
Tax equivalent net interest income totaled $35.0 million during the first
quarter of 2005, which represents an $8.3 million or 31.1% increase from the
comparable quarter one year earlier. We review yields on certain asset
categories and our net interest margin on a fully taxable equivalent basis. This
presentation is not in accordance with generally accepted accounting principles
("GAAP") but is customary in the banking industry. In this non-GAAP
presentation, net interest income is adjusted to reflect tax-exempt interest
income on an equivalent before-tax basis. This measure ensures comparability of
net interest income arising from both taxable and tax-exempt sources. The
adjustments to determine tax equivalent net interest income were $1.5 million
and $1.3 million for the first quarters of 2005 and 2004, respectively, and were
computed using a 35% tax rate.
The increase in tax equivalent net interest income in 2005 compared to 2004
reflects a $680.2 million increase in average interest-earning assets and a 3
basis point increase in our tax equivalent net interest income as a percent of
average interest-earning assets ("Net Yield"). The increase in average
interest-earning assets is due to our Midwest and North acquisitions as well
27
as growth in commercial loans, finance receivables and investment securities.
The Net Yield was equal to 4.92% in 2005 compared to 4.89% in 2004. This
increase was due to a rise in the tax equivalent yield on average
interest-earning assets to 6.92% in the first quarter of 2005 from 6.77% in the
first quarter of 2004. This increase primarily reflects the recent rise in
short-term interest rates that has resulted in variable rate loans re-pricing at
higher rates. The increase in the tax equivalent yield on average
interest-earning assets was partially offset by a 12 basis point rise in the
Company's interest expense as a percentage of average interest-earning assets
(the "cost of funds") to 2.00% during the first quarter of 2005 from 1.88%
during the first quarter of 2004. The increase in the Company's cost of funds
also primarily reflects the recent rise in short-term interest rates that has
resulted in higher rates on certain short-term and variable rate borrowings and
somewhat higher rates on deposits.
AVERAGE BALANCES AND TAX EQUIVALENT RATES
Three Months Ended
March 31,
2005 2004
--------------------------------- ---------------------------------
Average Average
Balance Interest Rate Balance Interest Rate
----------- ---------- ---- ----------- --------- ----
(dollars in thousands)
Assets
Taxable loans (1) $ 2,298,934 $ 41,106 7.22% $ 1,718,396 $ 30,043 7.02%
Tax-exempt loans (1,2) 6,569 122 7.53 6,867 128 7.50
Taxable securities 304,285 3,692 4.92 253,165 3,094 4.92
Tax-exempt securities (2) 244,331 4,026 6.68 198,908 3,527 7.13
Other investments 17,384 212 4.95 13,940 166 4.79
----------- ---------- ----------- ---------
Interest Earning Assets 2,871,503 49,158 6.92 2,191,276 36,958 6.77
---------- ---------
Cash and due from banks 62,876 45,700
Other assets, net 189,128 127,016
----------- -----------
Total Assets $ 3,123,507 $ 2,363,992
=========== ===========
Liabilities
Savings and NOW $ 881,454 1,674 0.77 $ 720,065 972 0.54
Time deposits 1,093,119 7,500 2.78 792,186 5,230 2.66
Long-term debt 6,994 80 4.56
Other borrowings 541,637 4,882 3.66 438,137 4,038 3.71
----------- ---------- ----------- ---------
Interest Bearing Liabilities 2,523,204 14,136 2.27 1,950,388 10,240 2.11
---------- ---------
Demand deposits 275,130 183,908
Other liabilities 88,623 62,736
Shareholders' equity 236,550 166,960
----------- -----------
Total liabilities and shareholders' equity $ 3,123,507 $ 2,363,992
=========== ===========
Tax Equivalent Net Interest Income $ 35,022 $ 26,718
========== =========
Tax Equivalent Net Interest Income
as a Percent of Earning Assets 4.92% 4.89%
==== ====
(1) All domestic
(2) Interest on tax-exempt loans and securities is presented on a fully tax
equivalent basis assuming a marginal tax rate of 35%
28
PROVISION FOR LOAN LOSSES The provision for loan losses was $1.6 million during
the three months ended March 31, 2005, compared to $0.8 million during the
three-month period in 2004. The increase in the provision reflects our
assessment of the allowance for loan losses taking into consideration factors
such as loan mix, levels of non-performing and classified loans and net
charge-offs. (See "Portfolio loans and asset quality.")
NON-INTEREST INCOME . Non-interest income is a significant element in assessing
our results of operations. On a long-term basis we are attempting to grow
non-interest income in order to diversity our revenues within the financial
services industry. We regard net gains on real estate mortgage loan sales as a
core recurring source of revenue but they are quite cyclical and volatile. We
regard net gains (losses) on securities as a "non-operating" component of
non-interest income. As a result, we believe it is best to evaluate our success
in growing non-interest income and diversifying our revenues by also comparing
non-interest income when excluding net gains (losses) on assets (real estate
mortgage loans and securities).
Non-interest income totaled $9.7 million during the first three months of 2005
compared to $7.4 million in 2004. Excluding net gains and losses on asset sales,
non-interest income grew by 42.2% to $8.4 million during the first three months
of 2005 compared to 2004.
NON-INTEREST INCOME
Three months ended
March 31,
2005 2004
------- -------
(in thousands)
Service charges on deposit
accounts $ 4,042 $ 3,641
Net gains (losses) on assets sales
Real estate mortgage loans 1,388 1,059
Securities (32) 493
Title insurance fees 497 544
VISA check card interchange income 622 416
Bank owned life insurance 389 345
Manufactured home loan origination fees
and commissions 274 289
Mutual fund and annuity commissions 292 347
Real estate mortgage loan servicing 1,064 (684)
Other 1,189 987
------- -------
Total non-interest income $ 9,725 $ 7,437
======= =======
Service charges on deposits totaled $4.0 million in the first quarter of 2005, a
$0.4 million or 11.0% increase from the comparable period in 2004. The increase
in such service charges principally relates to growth in checking accounts as a
result of deposit account promotions, including direct mail solicitations as
well as two bank acquisitions completed in mid-2004. Partially as a result of a
leveling off in our growth rate of new checking accounts, we would expect the
growth rate of service charges on deposits to moderate in future periods.
Gains on the sale of real estate mortgage loans were $1.4 million and $1.1
million in the first quarters of 2005 and 2004, respectively. Real estate
mortgage loan sales totaled $87.9 million in the first quarter of 2005 compared
to $68.7 million in the first quarter of 2004. Real estate
29
mortgage loans originated totaled $147.0 million in the first quarter of 2005
compared to $159.4 million in the comparable quarter of 2004. Loans held for
sale were $41.7 million at March 31, 2005 compared to $38.8 million at December
31, 2004. Based on current interest rates, we would expect the level of mortgage
loan refinance activity in 2005 to be below 2004 levels and would therefore also
anticipate somewhat lower levels of gains on loan sales during the balance of
2005 compared to the same period in 2004.
NET GAINS ON THE SALE OF REAL ESTATE MORTGAGE LOANS
Three months ended
March 31,
2005 2004
-------- --------
(in thousands)
Real estate mortgage loans originated $146,962 $159,419
Real estate mortgage loans sold 87,918 68,734
Real estate mortgage loans sold with servicing rights released 10,298 7,681
Net gains on the sale of real estate mortgage loans 1,388 1,059
Net gains as a percent of real estate mortgage loans sold
("Loans Sale Margin") 1.58% 1.54%
SFAS #133 adjustments included in the Loan Sale Margin 0.06 0.06
The volume of loans sold is dependent upon our ability to originate real estate
mortgage loans as well as the demand for fixed-rate obligations and other loans
that we cannot profitably fund within established interest-rate risk parameters.
(See "Portfolio loans and asset quality.") Net gains on real estate mortgage
loans are also dependent upon economic and competitive factors as well as our
ability to effectively manage exposure to changes in interest rates. As a
result, this category of revenue can be quite cyclical and volatile.
We incurred a loss of $32,000 on securities in the first quarter of 2005
compared to a gain of $0.5 million in the first quarter of 2004. The 2005 loss
is due primarily to the aforementioned $0.3 million of impairment charges (see
"Securities" above) partially offset by approximately $0.2 million in net gains
on the sale of certain corporate and municipal securities. The 2004 gains are
due primarily to the sale of certain corporate securities.
VISA check card interchange income increased to $0.6 million in the first
quarter of 2005 compared to $0.4 million in the first quarter of 2004. These
results can be primarily attributed to an increase in the size of our card base
due to growth in checking accounts as well as the two acquisitions completed in
2004. In addition, the frequency of use of our VISA check card product by our
customer base has increased.
Title insurance fees decreased slightly during the first quarter of 2005
compared to the first quarter of 2004 as a result of a decline in real estate
mortgage lending origination volume.
Manufactured home loan origination fees and commissions declined slightly during
the first quarter of 2005 compared to the first quarter of 2004. This industry
has faced a challenging environment as several buyers of this type of loan have
exited the market or materially altered the guidelines under which they will
purchase such loans. Further, regulatory changes have reduced the opportunity to
generate revenues on the sale of insurance related to this type of lending. As a
result, the lower level of revenue recorded in the first quarter of 2005 from
this activity is likely to be fairly reflective of ensuing quarters, at least in
the short-term.
30
Mutual fund and annuity commissions declined during the first quarter of 2005
due principally to decreased sales of these products, generally reflecting a
weaker market for equity based products.
Real estate mortgage loan servicing generated revenue of $1.1 million in the
first quarter of 2005, compared to expense of $0.7 million in the first quarter
of 2004. This increase is primarily due to changes in the impairment reserve on
capitalized real estate mortgage loan servicing rights. The period end
impairment reserve is based on a third-party valuation of our real estate
mortgage loan servicing portfolio and the amortization is primarily impacted by
prepayment activity. Activity related to capitalized mortgage loan servicing
rights is as follows:
CAPITALIZED REAL ESTATE MORTGAGE LOAN SERVICING RIGHTS
Three months ended
March 31,
2005 2004
-------- --------
(in thousands)
Balance at beginning of period $ 11,360 $ 8,873
Originated servicing rights capitalized 755 690
Amortization (479) (436)
(Increase)/decrease in impairment reserve 619 (1,045)
-------- --------
Balance at end of period $ 12,255 $ 8,082
======== ========
Impairment reserve at end of period $ 147 $ 1,767
======== ========
At March 31, 2005 we were servicing approximately $1.4 billion in real estate
mortgage loans for others on which servicing rights have been capitalized. This
servicing portfolio had a weighted average coupon rate of approximately 5.86%
and a weighted average service fee of 25.9 basis points. Remaining capitalized
real estate mortgage loan servicing rights at March 31, 2005 totaled $12.3
million, representing approximately 87 basis points on the related amount of
real estate mortgage loans serviced for others.
Other non-interest income rose to $1.2 million in the first quarter of 2005 from
$1.0 million in 2004. Increases in ATM fees, insurance commissions and check
printing charges have accounted for the majority of this growth. The growth is
generally reflective of the overall expansion of the organization in terms of
numbers of customers and accounts.
NON-INTEREST EXPENSE Non-interest expense is an important component of our
results of operations. However, we primarily focus on revenue growth, and while
we strive to efficiently manage our cost structure, our non-interest expenses
will generally increase from year to year because we are expanding our
operations through acquisitions and by opening new branches and loan production
offices.
Non-interest expense totaled $26.0 million during the three months ended March
31, 2005, compared to $20.7 million during the first three months of 2004. The
aforementioned two bank acquisitions in mid-2004 as well as growth associated
with new branch offices and loan production offices account for much of the
increases in non-interest expense.
31
NON-INTEREST EXPENSE
Three months ended
March 31,
2005 2004
------- -------
(in thousands)
Salaries $ 8,379 $ 7,595
Performance-based compensation and benefits 2,120 1,270
Other benefits 2,980 2,234
------- -------
Compensation and employee benefits 13,479 11,099
Occupancy, net 2,238 1,823
Furniture and fixtures 1,798 1,390
Data processing 1,143 1,053
Communications 1,076 806
Advertising 979 670
Loan and collection 956 747
Legal and professional 791 289
Amortization of intangible assets 693 452
Supplies 610 444
Other 2,263 1,885
------- -------
Total non-interest expense $26,026 $20,658
======= =======
The increase in compensation and benefits in 2005 compared to 2004 is primarily
attributable to an increased number of employees resulting from acquisitions and
the addition of new branch and loan production offices as well as to merit pay
increases and increases in certain employee benefit costs such as health care
insurance. Performance based compensation and benefits increased in 2005
compared to 2004 due primarily to an increased funding level for our employee
stock ownership plan and higher incentive compensation.
We maintain performance-based compensation plans. In addition to commissions and
cash incentive awards, such plans include employee stock ownership and employee
stock option plans. In December 2004 the Financial Accounting Standards Board
("FASB") issued FASB Statement No. 123 (revised 2004), "Share-Based Payment"
("SFAS #123R) (See note #11 of Notes to Interim Consolidated Financial
Statements). In general this accounting pronouncement requires that all
share-based payments to employees, including grants of employee stock options,
to be recognized in the financial statements based on their fair values.
Originally this new requirement would have applied to us beginning on July 1,
2005, however the Securities and Exchange Commission recently extended the date
to January 1, 2006.
Occupancy, furniture and fixtures, data processing, communications and supplies
expenses all generally increased in 2005 compared to 2004 as a result of the
growth of the organization through acquisitions and the opening of new branch
and loan production offices. The increase in amortization of intangible assets
is also a result of acquisitions.
The increases in loan and collection expense reflects costs associated with
holding or disposal of other real estate and collection costs associated with
increases in the level of non-performing loans.
32
Legal and professional expenses in 2005 include a $0.1 million increase in audit
related costs and $0.2 million in costs related to the Mepco investigation (see
"Litigation Matters" below).
INCOME TAX EXPENSE Our federal income tax expense has generally increased
commensurate with our increase in pre-tax earnings. Our actual federal income
tax expense is lower than the amount computed by applying our statutory federal
income tax rate to our pre-tax earnings primarily due to tax-exempt interest
income. Our effective tax rate was 27.6% and 25.6% during the first three months
of 2005 and 2004, respectively.
ACQUISITIONS
On July 1, 2004, we completed the acquisition of North. We issued 345,391 shares
of common stock to the North shareholders. 2005 includes the results of North's
operations. At the time of acquisition, North had total assets of $155.1
million, total loans of $103.6 million, total deposits of $123.8 million and
total stockholders' equity of $3.3 million. We recorded purchase accounting
adjustments related to the North acquisition including recording goodwill of
$2.8 million and establishing a core deposit intangible of $2.2 million.
On May 31, 2004, we completed the acquisition of Midwest. We issued 997,700
shares of common stock and paid $16.6 million in cash to the Midwest
shareholders. 2005 includes the results of Midwest's operations. At the time of
acquisition, Midwest had total assets of $238.0 million, total loans of $205.0
million, total deposits of $198.9 million and total stockholders' equity of
$18.7 million. We recorded purchase accounting adjustments related to the
Midwest acquisition including recording goodwill of $23.0 million, establishing
a core deposit intangible of $4.9 million, and a covenant not to compete of $1.3
million.
On April 15, 2003, we completed the acquisition of Mepco, a 40-year old
Chicago-based company, that specializes in financing insurance premiums for
businesses and providing payment plans to consumers for the purchase of vehicle
service contracts.
CRITICAL ACCOUNTING POLICIES
Our accounting and reporting policies are in accordance with accounting
principles generally accepted within the United States of America and conform to
general practices within the banking industry. Accounting and reporting policies
for other than temporary impairment of investment securities, the allowance for
loan losses, originated real estate mortgage servicing rights, derivative
financial instruments, income taxes and goodwill are deemed critical since they
involve the use of estimates and require significant management judgments.
Application of assumptions different than those that we have used could result
in material changes in our financial position or results of operations.
We are required to assess our investment securities for "other than temporary
impairment" on a periodic basis. The determination of other than temporary
impairment for an investment security requires judgment as to the cause of the
impairment, the likelihood of recovery and the projected timing of the recovery.
Our assessment process during the first quarter of 2005 resulted in recording a
$0.3 million impairment charge for other than temporary impairment on various
investment securities within our portfolio (we had no such impairment charge
during the first quarter of 2004). Currently the accounting profession (FASB) is
considering the meaning of other than temporary impairment with respect to debt
securities and has delayed the effective
33
date of certain portions of a recent accounting pronouncement (see note #11 of
Notes to Interim Consolidated Financial Statements). We believe that our
assumptions and judgments in assessing other than temporary impairment for our
investment securities are reasonable and conform to general industry practices.
Our methodology for determining the allowance and related provision for loan
losses is described above in "Financial Condition - Portfolio Loans and asset
quality." In particular, this area of accounting requires a significant amount
of judgment because a multitude of factors can influence the ultimate collection
of a loan or other type of credit. It is extremely difficult to precisely
measure the amount of losses that are probable in our loan portfolio. We use a
rigorous process to attempt to accurately quantify the necessary allowance and
related provision for loan losses, but there can be no assurance that our
modeling process will successfully identify all of the losses that are probable
in our loan portfolio. As a result, we could record future provisions for loan
losses that may be significantly different than the levels that we have recorded
in the most recent quarter.
At March 31, 2005 we had approximately $12.3 million of real estate mortgage
loan servicing rights capitalized on our balance sheet. There are several
critical assumptions involved in establishing the value of this asset including
estimated future prepayment speeds on the underlying real estate mortgage loans,
the interest rate used to discount the net cash flows from the real estate
mortgage loan servicing, the estimated amount of ancillary income that will be
received in the future (such as late fees) and the estimated cost to service the
real estate mortgage loans. We utilize an outside third party (with expertise in
the valuation of real estate mortgage loan servicing rights) to assist us in our
valuation process. We believe the assumptions that we utilize in our valuation
are reasonable based upon accepted industry practices for valuing mortgage
servicing rights and represent neither the most conservative or aggressive
assumptions.
We use a variety of derivative instruments to manage our interest rate risk.
These derivative instruments include interest rate swaps, collars, floors and
caps and mandatory forward commitments to sell real estate mortgage loans. Under
SFAS #133 the accounting for increases or decreases in the value of derivatives
depends upon the use of the derivatives and whether the derivatives qualify for
hedge accounting. In particular, we use pay fixed interest-rate swaps to convert
the variable rate cash flows on short-term or variable rate debt obligations to
fixed rates. At March 31, 2005 we had approximately $348 million in fixed pay
interest rate swaps being accounted for as cash flow hedges, thus permitting us
to report the related unrealized gains or losses in the fair market value of
these derivatives in other comprehensive income and subsequently reclassify such
gains or losses into earnings as yield adjustments in the same period in which
the related interest on the hedged item (primarily short-term or variable rate
debt obligations) affect earnings. The fair market value of our fixed pay
interest-rate swaps being accounted for as cash flow hedges is approximately
$3.8 million at March 31, 2005.
Our accounting for income taxes involves the valuation of deferred tax assets
and liabilities primarily associated with differences in the timing of the
recognition of revenues and expenses for financial reporting and tax purposes.
At December 31, 2004 we had recorded a net deferred tax asset of $8.7 million,
which included a net operating loss carryforward of $6.8 million. We have
recorded no valuation allowance on our net deferred tax asset because we believe
that the tax benefits associated with this asset will more likely than not, be
realized. However, changes in tax laws, changes in tax rates and our future
level of earnings can adversely impact the ultimate realization of our net
deferred tax asset.
34
At March 31, 2005 we had recorded $53.7 million of goodwill. Under SFAS #142,
amortization of goodwill ceased, and instead this asset must be periodically
tested for impairment. Our goodwill primarily arose from the 2004 acquisitions
of Midwest and North, the 2003 acquisition of Mepco and the past acquisitions of
other banks and a mobile home loan origination company. We test our goodwill for
impairment utilizing the methodology and guidelines established in SFAS #142.
This methodology involves assumptions regarding the valuation of the business
segments that contain the acquired entities. We believe that the assumptions we
utilize are reasonable. However, we may incur impairment charges related to our
goodwill in the future due to changes in business prospects or other matters
that could affect our valuation assumptions.
LITIGATION MATTERS
In May 2004, we received an unsolicited anonymous letter regarding certain
business practices at Mepco, which was acquired in April 2003 and is now a
wholly-owned subsidiary of Independent Bank. We processed this letter in
compliance with our Policy Regarding the Resolution of Reports on the Company's
Accounting, Internal Controls and Other Business Practices. Under the direction
of our Audit Committee, special legal counsel was engaged to investigate the
matters raised in the anonymous letter. This investigation was completed during
the first quarter of 2005 and we have determined that any amounts or issues
relating to the period after our April 2003 acquisition of Mepco were not
significant.
The potential amount of liability related to periods prior to our April 2003
acquisition date has been determined to not exceed approximately $5 million.
This potential liability primarily encompasses funds that may be due to former
customers of Mepco related to loan overpayments or unclaimed funds that may be
subject to escheatment. Prior to our acquisition, Mepco had erroneously recorded
these amounts as revenue over a period of several years. The final liability
may, however, be less, depending on the facts related to each loan account, the
application of the law to those facts and the applicable state escheatment
requirements for unclaimed funds. In the second quarter of 2004 we recorded a
liability of $2.7 million with a corresponding charge to earnings (included in
non-interest expenses) for potential amounts due to third parties (either former
loan customers or to states for the escheatment of unclaimed funds).
On September 30, 2004 we entered into an escrow agreement with the primary
former shareholders of Mepco. This escrow agreement was entered into for the
sole purpose of funding any obligations beyond the $2.7 million amount that we
already had accrued. The escrow agreement gives us the right to have all or a
portion of the escrow account distributed to us from time to time if the
aggregate amount that we (together with any of our affiliates including Mepco)
are required to pay to any third parties as a result of the matters being
investigated exceeds $2.7 million. At March 31, 2005, the escrow account
contained 90,766 shares of Independent Bank Corporation common stock (deposited
by the primary former shareholders of Mepco) having an aggregate market value at
that date of approximately $2.6 million. The escrow agreement contains
provisions that require the addition or distribution of shares of Independent
Bank Corporation common stock if the total market value of such stock in the
escrow account falls below $2.25 million or rises above $2.75 million. As a
result of the aforementioned escrow agreement as well as the $2.7 million
accrual established in the second quarter of 2004, we do not expect any future
liabilities (other than ongoing litigation costs) related to the Mepco
investigation.
35
The terms of the agreement under which we acquired Mepco, obligates the former
shareholders of Mepco to indemnify us for existing and resulting damages and
liabilities from pre-acquisition activities at Mepco. On April 12, 2005, we
filed a Notice of Indemnification Claims with the former shareholders of Mepco.
In the notice, we requested the payment of all accrued and incurred costs,
liabilities and damages, and as permitted by the Agreement, reimbursement of all
potential contingent claims. Our indemnification claims include approximately
$1.0 million in costs that we have incurred to date for the above described
investigation. There can be no assurance that we will successfully prevail with
respect to these claims.
On March 23, 2005 Edward M. Walder and Paul M. Walder (collectively the
"Walders") filed suit against Independent Bank Corporation and Mepco in the
Circuit Court of Cook County, Illinois. In general, the suit alleges various
breaches of the merger agreement between Independent Bank Corporation and Mepco,
the employment agreements with the Walders and the above mentioned escrow
agreement. The suit seeks unspecified damages and rescission of the merger
agreement, covenants not to compete and the escrow agreement. We believe that
the suit filed by the Walders is without merit and intend to vigorously defend
this matter.
We are also involved in various other litigation matters in the ordinary course
of business and at the present time, we do not believe that any of these matters
will have a significant impact on our financial condition or results of
operations.
36
Item 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
No material changes in the market risk faced by the Registrant have occurred
since December 31, 2004.
Item 4.
CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures.
With the participation of management, our chief executive officer and
chief financial officer, after evaluating the effectiveness of our
disclosure controls and procedures (as defined in Exchange Act Rules 13a -
15(e) and 15d - 15(e)) for the period ended March 31, 2005, have concluded
that, as of such date, our disclosure controls and procedures were
effective.
(b) Changes in Internal Controls.
During the quarter ended March 31, 2005, there were no changes in our
internal control over financial reporting that materially affected, or are
reasonably likely to materially affect, our internal control over
financial reporting.
37
Part II
Item 2. Changes in securities, use of proceeds and issuer purchases of equity
securities
The following table shows certain information relating to purchases of
common stock for the three-months ended March 31, 2005, pursuant to our
share repurchase plan:
Remaining
Total Number of Number of
Shares Purchased Shares
as Part of a Authorized for
Total Number of Average Price Publicly Purchase Under
Period Shares Purchased(1) Paid Per Share Announced Plan(2) the Plan
- ------------- ------------------- -------------- ----------------- --------------
January 2005 260 $30.77
February 2005
March 2005 975 28.77
----- ------ -------
Total 1,235 $29.19 748,765
===== ====== =======
(1)Represents shares purchased to fund our Deferred Compensation and Stock
Purchase Plan for Non-employee Directors.
(2)Our current stock repurchase plan authorizes the purchase up to 750,000
shares of our common stock. The repurchase plan expires on December 31,
2005.
Item 6. Exhibits
(a) The following exhibits (listed by number corresponding to the Exhibit
Table as Item 601 in Regulation S-K) are filed with this report:
11. Computation of Earnings Per Share.
31.1 Certificate of the Chief Executive Officer of Independent Bank
Corporation pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 (18 U.S.C. 1350).
31.2 Certificate of the Chief Financial Officer of Independent Bank
Corporation pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 (18 U.S.C. 1350).
32.1 Certificate of the Chief Executive Officer of Independent Bank
Corporation pursuant to Section 906 of the Sarbanes-Oxley Act of
2002 (18 U.S.C. 1350).
32.2 Certificate of the Chief Financial Officer of Independent Bank
Corporation pursuant to Section 906 of the Sarbanes-Oxley Act of
2002 (18 U.S.C. 1350).
38
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Date May 4, 2005 By /s/ Robert N. Shuster
--------------------------------------
Robert N. Shuster, Principal Financial
Officer
Date May 4, 2005 By /s/ James J. Twarozynski
----------------------------------------
James J. Twarozynski, Principal
Accounting Officer
39
EXHIBIT INDEX
EXHIBIT NO. EXHIBIT DESCRIPTION
- ----------- -------------------
11. Computation of Earnings Per Share.
31.1 Certificate of the Chief Executive Officer of Independent Bank
Corporation pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 (18 U.S.C. 1350).
31.2 Certificate of the Chief Financial Officer of Independent Bank
Corporation pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 (18 U.S.C. 1350).
32.1 Certificate of the Chief Executive Officer of Independent Bank
Corporation pursuant to Section 906 of the Sarbanes-Oxley Act of
2002 (18 U.S.C. 1350).
32.2 Certificate of the Chief Financial Officer of Independent Bank
Corporation pursuant to Section 906 of the Sarbanes-Oxley Act of
2002 (18 U.S.C. 1350).