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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2003
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ___________ to __________
COMMISSION FILE NUMBER: 0-49771
MERCHANTS BANCORP, INC.
(Exact name of registrant as specified in its charter)
Ohio 31-1467303
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
100 North High Street, Hillsboro, Ohio 45133
(Address of principal executive offices) (Zip Code)
(937) 393-1993
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 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 Rule 12b-2 of the Exchange Act.) Yes [ ] No [X]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Common stock - 2,945,000 shares outstanding at November 13, 2003
1
PART I - FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
The accompanying information has not been audited by independent public
accountants; however, in the opinion of management such information reflects all
adjustments necessary for a fair presentation of the results for the interim
period. All such adjustments are of a normal and recurring nature.
The accompanying financial statements are presented in accordance with the
requirements of Form 10-Q and consequently do not include all of the disclosures
normally required by accounting principles generally accepted in the United
States of America or those made in the Registrant's Form 10-K. Accordingly, the
reader of the Form 10-Q should refer to the Registrant's Form 10-K for the year
ended December 31, 2002 for further information in this regard.
2
SEPTEMBER 30, 2003 AND DECEMBER 31, 2002 (IN THOUSANDS EXCEPT SHARE DATA)
SEPTEMBER 30, DECEMBER 31,
2003 2002
ASSETS (UNAUDITED)
CASH AND CASH EQUIVALENTS:
Cash and due from banks $ 11,822 $ 13,852
Federal funds sold 14,075 8,350
--------- ---------
Total cash and cash equivalents 25,897 22,202
--------- ---------
SECURITIES AVAILABLE FOR SALE
(amortized cost of $31,772 and $38,596 respectively) 32,920 40,012
--------- ---------
LOANS 286,188 248,270
Less allowance for loan losses (2,374) (2,106)
--------- ---------
Net loans 283,814 246,164
--------- ---------
OTHER ASSETS:
Bank premises and equipment, net 3,990 4,349
Accrued interest receivable 3,798 3,088
Deferred income tax 111
Other 3,631 2,873
--------- ---------
Total other assets 11,419 10,421
--------- ---------
TOTAL $ 354,050 $ 318,799
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES:
Deposits:
Noninterest bearing $ 29,865 $ 30,195
Interest bearing 242,667 232,521
--------- ---------
Total deposits 272,532 262,716
--------- ---------
Repurchase agreements 2,688 3,365
FHLB borrowings 44,018 17,470
Other liabilities 6,728 1,740
--------- ---------
Total liabilities 325,966 285,291
--------- ---------
SHAREHOLDERS' EQUITY:
Common stock - no par value; 4,500,000 shares authorized and
3,000,000 shares issued; outstanding shares of 2,945,000 and 2,000 2,000
3,000,000 at September 30, 2003 and December 31, 2002, respectively
Additional paid-in capital 2,000 2,000
Retained earnings 30,435 28,682
Accumulated other comprehensive income 649 826
Treasury stock - 55,000 shares (7,000)
--------- ---------
Total shareholders' equity 28,084 33,508
--------- ---------
TOTAL $ 354,050 $ 318,799
========= =========
See notes to condensed consolidated financial statements.
3
MERCHANTS BANCORP, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS EXCEPT PER SHARE DATA)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------- --------------------
2003 2002 2003 2002
(UNAUDITED) (UNAUDITED)
INTEREST INCOME:
Interest and fees on loans $ 4,804 $ 4,783 $ 14,266 $ 13,922
Interest and dividends on securities:
Taxable 154 346 547 1,121
Exempt from income taxes 258 248 757 681
Interest on federal funds sold and other short-term investments 21 1 123 91
-------- -------- -------- --------
Total interest income 5,237 5,378 15,693 15,815
-------- -------- -------- --------
INTEREST EXPENSE:
Interest on deposits 1,245 1,631 3,972 5,368
Interest on repurchase agreements and federal funds purchased 20 43 72 81
Interest on FHLB borrowings 402 221 994 661
-------- -------- -------- --------
Total interest expense 1,667 1,895 5,038 6,110
-------- -------- -------- --------
NET INTEREST INCOME 3,570 3,483 10,655 9,705
PROVISION FOR LOAN LOSSES (1,785) (138) (2,451) (367)
-------- -------- -------- --------
NET INTEREST INCOME AFTER PROVISION
FOR LOAN LOSSES 1,785 3,345 8,204 9,338
-------- -------- -------- --------
NONINTEREST INCOME - Service charges and fees 384 400 1,125 1,131
-------- -------- -------- --------
NONINTEREST EXPENSE:
Salaries and employee benefits 747 938 2,778 2,684
Occupancy 309 283 926 835
Legal and professional services 115 159 333 478
Franchise tax 52 68 196 220
Data processing 60 71 227 202
Advertising 70 92 160 186
Other 312 276 936 814
-------- -------- -------- --------
Total noninterest expense 1,665 1,887 5,556 5,419
-------- -------- -------- --------
INCOME BEFORE INCOME TAXES 504 1,858 3,773 5,050
INCOME TAXES (19) (603) (1,060) (1,622)
-------- -------- -------- --------
NET INCOME $ 485 $ 1,255 $ 2,713 $ 3,428
======== ======== ======== ========
BASIC AND DILUTED EARNINGS PER SHARE $ 0.16 $ 0.42 $ 0.91 $ 1.14
======== ======== ======== ========
See notes to condensed consolidated financial statements.
4
2003 2002
(UNAUDITED)
OPERATING ACTIVITIES:
Net income $ 2,713 $ 3,428
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization 661 663
Provision for loan losses 2,451 367
Gain on sale of mortgage loans (148) (134)
Proceeds from sale of mortgage loans 11,159 8,755
Mortgage loans originated for sale (11,011) (8,621)
Changes in assets and liabilities:
Accrued interest receivable (710) (530)
Other assets (758) (392)
Accrued interest, taxes and other liabilities (654) 25
-------- --------
Net cash provided by operating activities 3,703 3,561
-------- --------
INVESTING ACTIVITIES:
Proceeds from sales and maturities of securities available for sale 9,554 11,345
Purchases of securities available for sale (2,830) (16,963)
Net increase in loans (40,101) (24,587)
Capital expenditures (203) (533)
-------- --------
Net cash used in investing activities (33,580) (30,738)
-------- --------
FINANCING ACTIVITIES:
Net (decrease) increase in deposits 9,816 (9,443)
Net (decrease) increase in repurchase agreements (677) 1,011
Net federal funds purchased 2,675
Net FHLB borrowings 26,548 8,483
Dividends paid to stockholders (960) (840)
Stock repurchase (1,155)
-------- --------
Net cash (used in) provided by financing activities 33,572 1,886
-------- --------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 3,695 (25,291)
CASH AND CASH EQUIVALENTS:
Beginning of year 22,202 34,788
-------- --------
End of period $ 25,897 $ 9,497
======== ========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the period for federal income taxes $ 1,800 $ 1,681
======== ========
Cash paid during the period for interest $ 5,071 $ 6,218
======== ========
SUPPLEMENTAL DISCLOSURE OF NONCASH FINANCING ACTIVITY:
In connection with the Redemption Agreement to purchase treasury stock, the
company recorded $5,845 in other liabilities.
See notes to condensed consolidated financial statements.
5
MERCHANTS BANCORP, INC. AND SUBSIDIARY
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002
- --------------------------------------------------------------------------------
1. SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING POLICIES
The unaudited condensed consolidated financial statements include the
accounts of Merchants Bancorp, Inc. and its wholly-owned subsidiary,
Merchants National Bank (collectively, the "Company"). All significant
intercompany balances and transactions have been eliminated in
consolidation.
In the opinion of management, these condensed consolidated financial
statements include all adjustments (which consist of normal recurring
accruals) necessary to present the condensed consolidated financial
position as of September 30, 2003, the results of operations for the
three and nine months ended September 30, 2003 and 2002, and of cash
flows for the nine-months ended September 30, 2003 and 2002. These
condensed consolidated financial statements have been prepared in
accordance with instructions to Form 10-Q, and therefore do not include
all information and footnote disclosures necessary for a fair
presentation of financial position, results of operations and cash flows
in conformity with accounting principles generally accepted in the United
States of America. Financial information as of December 31, 2002 has been
derived from the audited consolidated financial statements of Merchants
Bancorp, Inc. and subsidiary. The results of operations for the three and
nine months ended September 30, 2003 and 2002 and cash flows for the nine
months ended September 30, 2003 and 2002 are not necessarily indicative
of the results to be expected for the full year. For further information,
refer to the consolidated financial statements and footnotes thereto for
the year ended December 31, 2002, included in the Company's Form 10-K.
Earnings per Share -- Basic earnings per share is computed using the
weighted average number of shares of common stock outstanding during the
period. For the three and nine months ended September 30, 2003, the
weighted average number of shares outstanding were 2,985,054 shares and
2,994,963 shares, respectively. For the three and nine months ended
September 30, 2002, the weighted average number of shares outstanding
were 3,000,000. There were no common stock equivalents or potentially
diluted securities outstanding during the respective periods.
New Accounting Pronouncements -- In April 2003, the FASB issued SFAS No.
149, "Amendment of Statement 133 on Derivative Instruments and Hedging
Activities." This Statement amends and clarifies financial accounting and
reporting for derivative instruments, including certain embedded
derivatives, and for hedging activities under SFAS No. 133, "Accounting
for Derivative Instruments and Hedging Activities." This Statement amends
SFAS No. 133 to reflect the decisions made as part of the Derivatives
Implementation Group (DIG) and in other FASB projects or deliberations.
SFAS No. 149 is effective for contracts entered into or modified after
June 30, 2003, and for hedging relationships designated after June 30,
2003. Adoption of this standard is not expected to have a material effect
on the Company's Consolidated Financial Statements.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and
Equity." This Statement establishes standards for how an entity
classifies and measures certain financial instruments with
characteristics of both liabilities and equity. This Statement is
effective for financial instruments entered into or modified after May
31, 2003, and otherwise is effective at the beginning of the first
interim period beginning after June 15, 2003. Adoption of this standard
did not have a material effect on the Company's Consolidated Financial
Statements.
6
2. LOANS
Major classifications of loans are summarized as follows (in thousands):
September December 31,
2003 2002
(unaudited)
Commercial real estate $ 58,466 $ 53,104
Commercial and industrial 25,558 25,779
Agricultural 44,432 41,106
Residential real estate 126,717 99,610
Installment 29,828 27,178
Other 1,187 1,493
--------- ---------
Total 286,188 248,270
Less allowance for loan losses (2,374) (2,106)
--------- ---------
$ 283,814 $ 246,164
========= =========
The Company did not have any loans held for sale at September 30, 2003
or December 31, 2002.
7
3. FHLB BORROWINGS
All stock in the Federal Home Loan Bank ("FHLB") and qualifying first
mortgage residential loans are pledged as collateral on FHLB borrowings.
Maturities and interest rates of advances from the FHLB at September 30,
2003 are as follows (in thousands):
Interest
Maturity Rate Amount
April 10, 2008 5.4% $ 1,000
September 25, 2008 4.8% 3,000
March 15, 2010 6.3% 3,000
September 1, 2011 5.2% 179
January 3, 2012 4.6% 10,000
March 1, 2013 3.1% 475
April 1, 2013 2.9%-3.1% 1,196
May 1, 2013 3.0% 482
June 1, 2013 2.8% 243
March 1, 2018 3.6% 728
April 1, 2018 3.3% 1,217
May 1, 2018 3.4%-3.6% 3,686
June 1, 2018 3.0%-3.2% 1,473
July 1, 2018 2.8% 987
October 1, 2018 3.7% to 4.0% 2,500
March 1, 2023 3.8% 735
April 1, 2023 3.5%-3.7% 2,702
May 1, 2023 3.6%-3.8% 3,442
June 1, 2023 3.1%-3.4% 1,482
July 1, 2023 3.0% 991
October 1, 2023 3.7%-4.2% 4,500
-------
Total $44,018
=======
The maximum amount available to the Company under FHLB borrowings was
approximately $75.7 million and $57.8 million as of September 30, 2003 and
December 31, 2002, respectively.
4. TREASURY STOCK
On August 28, 2003 Merchants Bancorp entered into a stock redemption
agreement with 3 shareholders of the Company. Collectively the three
shareholders owned 351,349.994 common shares of the Company
8
or 11.71% of outstanding shares. They desired to sell 333,349.994 of such
shares (referred to herein as the "shares") to the Company. The Company
retained Austin Associates, LLC to determine a "fair value" and issued a
"fairness opinion" to the Company dated July 30, 2003. The purchase is to
be made in two separate settlements. The first settlement was for 55,000
shares and a total of $1,155,000 and occurred on September 5, 2003. The
second settlement will occur on January 5, 2004 for the 278,349.994
remaining shares. The dollar value of this settlement is $5,845,349.87 and
is recorded in other liabilities on the September 30, 2003 financial
statements. The total value of the transaction is $7,000,349.87.
9
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
Merchants Bancorp, Inc. (the "Company") is a bank holding company and sole
shareholder of Merchants National Bank (the "Bank"), headquartered in Hillsboro,
Ohio. At September 30, 2003, the Company had total assets of approximately
$354.0 million and total shareholders' equity of approximately $28.1 million.
The Company, through its banking affiliate, offers a broad range of banking
services to the commercial, industrial and consumer market segments which it
serves. The primary business of the Bank consists of accepting deposits through
various consumer and commercial deposit products, and using such deposits to
fund various loan products. The Bank's primary loan products are as follows: (1)
loans secured by residential real estate, including loans for the purchase of
one to four family residences which are secured by 1st and 2nd mortgages and
home equity loans; (2) consumer loans, including new and used automobile loans,
loans for the purchase of mobile homes and debt consolidation loans; (3)
agricultural loans, including loans for the purchase of real estate used in
connection with agricultural purposes, operating loans and loans for the
purchase of equipment; and (4) commercial loans, including loans for the
purchase of real estate used in connection with office or retail activities,
loans for the purchase of equipment and loans for the purchase of inventory.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires the appropriate
application of certain accounting policies, many of which require us to make
estimates and assumptions about future events and their impact on amounts
reported in our financial statements and related notes. Since future events and
their impact cannot be determined with certainty, the actual results will
inevitably differ from our estimates. Such differences could be material to the
financial statements.
The Company believes the application of accounting policies and the estimates
required therein are reasonable. These accounting policies and estimates are
constantly reevaluated, and adjustments are made when facts and circumstances
dictate a change. Historically, the Company has found its application of
accounting policies to be appropriate, and actual results have not differed
materially from those determined using necessary estimates.
The Company's accounting policies are more fully described in Note 1 to the
condensed consolidated financial statements.
Management believes that the determination of the allowance for loan losses
represents a critical accounting policy. The Company maintains an allowance for
loan losses to absorb probable loan losses inherent in the portfolio. The
allowance for loan losses is maintained at a level management considers to be
adequate to absorb probable loan losses inherent in the portfolio, based on
evaluations of the collectibility and historical loss experience of loans.
Credit losses are charged and recoveries are credited to the allowance.
Provisions for loan losses are based on management's review of the historical
loan loss experience and such factors which, in management's judgment, deserve
consideration under existing economic conditions in estimating probable credit
losses. The allowance is based on ongoing assessments of the probable estimated
losses inherent in the loan portfolio. The Company's methodology for assessing
the appropriate allowance level consists of several key elements, as described
below.
10
Larger commercial loans that exhibit probable or observed credit weaknesses are
subject to individual review. Where appropriate, reserves are allocated to
individual loans based on management's estimate of the borrower's ability to
repay the loan given the availability of collateral, other sources of cash flow
and available legal options. Included in the review of individual loans are
those that are impaired as provided in Statement of Financial Accounting
Standards No. 114, "Accounting by Creditors for Impairment of a Loan," as
amended. Any specific reserves for impaired loans are measured based on the fair
value of the underlying collateral. The Company evaluates the collectibility of
both principal and interest when assessing the need for a specific reserve.
Historical loss rates are applied to other commercial loans not subject to
specific reserve allocations.
Homogenous loans, such as consumer installment and residential mortgage loans,
are not individually reviewed by management. Reserves are established for each
pool of loans based on the expected net charge-offs. Loss rates are based on the
average five-year net charge-off history by loan category.
Historical loss rates for commercial and consumer loans may be adjusted for
significant factors that, in management's judgment, reflect the impact of any
current conditions on loss recognition. Factors which management considers in
the analysis include the effects of the local economy, trends in the nature and
volume of loans (delinquencies, charge-offs, nonaccrual and problem loans),
changes in the internal lending policies and credit standards, collection
practices, and examination results from bank regulatory agencies and the
Company's internal credit review function.
An unallocated reserve is maintained to recognize the imprecision in estimating
and measuring loss when evaluating reserves for individual loans or pools of
loans.
Specific reserves on individual loans and historical loss rates are reviewed
throughout the year and adjusted as necessary based on changing borrower and/or
collateral conditions and actual collection and charge-off experience.
The Company has not substantively changed any aspect of its overall approach in
the determination of the allowance for loan losses since January 1, 2003. There
have been no material changes in assumptions or estimation techniques as
compared to prior years that impacted the determination of the current year
allowance.
COMPARISON OF OPERATING RESULTS FOR THE THREE MONTHS ENDED, SEPTEMBER 2003
AND 2002
The Company reported net income of $485,000 and $1,255,000 for the three months
ended September 30, 2003 and 2002, respectively. During the same periods, basic
and diluted earnings per share were $.16 and $.42, respectively. On an
annualized basis, return on average assets was .57% and return on average equity
was 5.93% for the three months ended September 30, 2003, compared to 1.63% and
15.76%, respectively, for the comparable period in 2002. The income was
substantially less for the three quarters in 2003 due to an accrual of $1.5
million to the loan loss reserve. The provision was made when management became
aware of a probable credit loss to a large borrower. The credit loss is
discussed further in the "Loans and Allowance for Loan Losses" section of this
report.
Net interest income for the three months ended September 30, 2003, was
$3,570,000, an increase of $87,000, or 2.50%, compared to net interest income of
$3,483,000 for the comparable period in 2002. Net interest margin was 4.44% for
the three months ended September 30, 2003, compared to 4.83% for the comparable
period in 2002. The average annualized yield on earning assets decreased to
6.52% for the three months ended September 30, 2003, from 7.45% for the
comparable period in 2002. The average cost of interest-bearing funds was 2.40%
for the three months ended September 30, 2003, a decrease from 3.10% for the
comparable period in 2002. Management attributes the decrease in net interest
margin to the contractual
11
repricing of one, three and five year adjustable rate mortgages in the loan
portfolio. Management has also implemented a fixed rate 1-4 family lending
program to maintain and grow the loan portfolio. The loans are funded by FHLB
borrowings and are priced to net approximately 2% spread over borrowings. This
spread is slightly lower than our usual spread to cost of funds but is necessary
due to competition.
The provision for loan losses was $1,785,000 and $138,000 for the three months
ended September 30, 2003 and 2002, respectively, representing an increase of
1,193.5%. Net charge-offs for the three months ended September 30, 2003 were
$1,706,000, compared to $38,000 experienced during the three months ended
September 30, 2002. Management increased the provision for loan losses during
the three month period ending September 30, 2003 to reflect the increased
estimate of probable loan losses in 2003, primarily related to a certain
commercial borrower, which was identified by management on July 23, 2003. The
Company assessed the collateral situation and believes the collateral to be
inadequate. In July 2003, the Company provided $1.5 million in the loan loss
reserve to cover the estimated losses. In September 2003, the company charged
off $1.5 million against the loan loss reserve relating to this credit loss.
Upon further review of the borrower's loans, the company estimated additional
loss potential and made an additional allowance in the loan loss reserve for
$80,000 in September 2003. The remaining collateral will be liquidated over time
to cover the remaining balance of the loans. The collateral to be liquidated
includes 4 residential properties, a commercial property, chattels and rolling
stock.
Additionally, throughout the year, the Company has made additional provisions to
the loan loss reserve for certain agricultural credits. Drought conditions,
reduced government program payments, and average to below-average grain prices
have affected the repayment opportunities for borrowers. Management has
conducted a review of its agricultural lending approval process and made
modifications where necessary to strengthen its underwriting process of
agricultural operating loans. Management believes its review process has
adequately identified problem loans within its portfolio.
Total noninterest income was $384,000 for the three months ended September 30,
2003, a decrease of $16,000, or 4.0%, from $400,000 for the comparable period in
2002. The decrease is due to a recording of a gain on sale of Other Real Estate
Owned in third quarter 2002 for $22,000.
Total noninterest expense was $1,665,000 for the three months ended September
30, 2003, a decrease of $222,000, or 11.8%, from $1,887,000 for the comparable
period in 2002. Salaries and benefits expense comprises the largest component of
noninterest expense, with totals of $747,000 and $938,000 for the three months
ended September 30, 2003 and 2002, respectively. The net decrease in salaries
and benefits expense is primarily attributable to the reduction in profit
sharing bonus accrual which is based on return on equity. For the three months
ended September 2003 the expense was negative $100,000 as a result of the
reversal of the accrual compared to $150,000 expense for three months ended
September 2002. The reduction in expense is a result of the large credit loss
recorded during July 2003 as described above. This decrease is offset by an
increase in salaries and benefits expense primarily attributable to the
additional employees at the new branch opened during 2002 and the hiring of an
additional mortgage loan officer.
COMPARISON OF OPERATING RESULTS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2003
AND 2002
The Company reported net income of $2,713,000 and $3,428,000 for the nine months
ended September 30, 2003 and 2002, respectively. During each of the same
periods, basic and diluted earnings per share were $.90 and $1.14, respectively.
On an annualized basis, return on average assets was 1.08% and return on average
equity was 10.83% for the nine months ended September 30, 2003, compared to
1.50% and 14.36%, respectively, for the comparable period in 2002.
Net interest income for the nine months ended September 30, 2003, was
$10,655,000, an increase of $950,000, or 9.8%, compared to net interest income
of $9,705,000 for the comparable period in 2002. Net interest margin was 4.45%
for the nine months ended September 30, 2003, compared to 4.48% for the
12
comparable period in 2002. The average annualized yield on earning assets
decreased to 6.55% for the nine months ended September 30, 2003, from 7.29% for
the comparable period in 2002. The average cost of interest-bearing funds was
2.48% for the nine months ended September 30, 2003, a decrease from 3.34% for
the comparable period in 2002. The net interest margin has remained relatively
consistent over the comparable time periods due to the correlation of the
decreasing yield on interest earning assets and decreasing cost of funds.
The provision for loan losses was $2,451,000 and $367,000 for the nine months
ended September 30, 2003 and 2002, respectively, representing an increase of
567.9%. Net charge-offs for the nine months ended September 30, 2003 were
$2,183,000, compared to $165,000 experienced during the nine months ended
September 30, 2002. Management increased the provision for loan losses during
the nine month period ending September 30, 2003 to reflect the increased
estimate of probable loan losses in 2003, primarily related to a certain
commercial borrower, which was identified by management on July 23, 2003. The
Company assessed the collateral situation and believes the collateral to be
inadequate. In July 2003, the Company provided $1.5 million in the loan loss
reserve to cover the estimated losses. In September 2003, the company charged
off $1.5 million against the loan loss reserve relating to this credit loss.
Upon further review of the borrower's loans, the company estimated additional
loss potential and made an additional allowance in the loan loss reserve for
$80,000 in September 2003. The remaining collateral will be liquidated over time
to cover the remaining balance of the loans. The collateral to be liquidated
includes 4 residential properties, a commercial property, chattels and rolling
stock.
The additional charge offs in the first nine months of 2003 were primarily
within the agricultural portfolio. Drought conditions, reduced government
program payments, and average to below-average grain prices have affected the
repayment opportunities for these certain borrowers. Management has conducted a
review of its agricultural lending approval process and made modifications where
necessary to strengthen its underwriting process of agricultural operating
loans. Management believes its review process has adequately identified problem
loans within its portfolio on a timely basis.
Total noninterest income was $1,125,000 for the nine months ended September 30,
2003, a decrease of $6,000, or .53%, from $1,131,000 for the comparable period
in 2002. The increase is due to service charges on customers' deposit account
transactions.
Total noninterest expense was $5,556,000 for the nine months ended September 30,
2003, an increase of $137,000, or 2.5%, from $5,419,000 for the comparable
period in 2002. Salaries and benefits expense comprises the largest component of
noninterest expense, with totals of $2,778,000 and $2,684,000 for the nine
months ended September 30, 2003 and 2002, respectively. The net increase in
salaries and benefits expense is primarily attributable to the additional
employees at the new branch opened during 2002 and the hiring of an additional
mortgage loan officer offset by the reduction in profit sharing bonus accrual
totaling $197,000 during the nine months ended September 30, 2003 compared to
$440,000 for the nine months ended 2002. The reduction is expense is a result of
the large credit loss recorded during July 2003 as described above.
FINANCIAL CONDITION
The Company's total assets increased to $354.0 million as of September 30, 2003
from $318.8 million as of December 31, 2002, an increase of 11.0%. The majority
of the asset growth came from $37.9 million in loan growth. The loan growth was
funded by an increase of $26.5 million in FHLB borrowings and an increase of
$9.8 million is deposits. The loan growth was partially driven by increases in
the residential mortgage portfolio due to the continued historically low
interest rates.
LOANS AND ALLOWANCE FOR LOAN LOSSES
13
The Company reported total loans of $286.2 million as of September 30, 2003 and
$248.3 million as of December 31, 2002, an increase of $37.9 million, or 15.3%.
The portfolio composition has remained consistent during the period.
Federal regulations and generally accepted accounting principles require the
Company establish prudent allowances for loan losses. The Company maintains an
allowance for loan losses to absorb probable loan losses inherent in the
portfolio, based on evaluations of the collectability and historical loss
experience of loans. Loan losses are charged and recoveries are credited to the
allowance. Provisions for loan losses are based on management's review of the
historical loan loss experience and such factors which, in management's
judgment, deserve consideration under existing economic conditions in estimating
probable loan losses. The allowance is based on ongoing assessments of the
probable estimated losses inherent in the loan portfolio. The Company has not
substantively changed any aspect of its overall approach in the determination of
the allowance for loan losses during 2003. There have been no material changes
in assumptions or estimation techniques as compared to prior years that impacted
the determination of the current year allowance.
The allowance for loan losses was 0.83% of total loans as of September 30, 2003
and 0.85% as of December 31, 2002.
As a percentage of the allowance for loan losses, total nonaccrual loans and
loans past due 90 days or more were 173.7% as of September 30, 2003, 145.8% as
of June 30, 2003, and 76.4% as of December 31, 2002.
The amount of nonaccrual loans increased to $1,309,000 as of September 30, 2003,
compared to $573,000 as of June 30, 2003, and $476,000 at December 31, 2002. As
a percentage of total loans, nonaccrual loans represented 0.46% as of September
30, 2003, 0.21% as of June 30, 2003, and 0.19% as of December 31, 2002. The
increase in nonaccrual loans is due to a single commercial borrower whose
nonaccrual borrowings total $933,000. These loans are secured with 4 residences,
a commercial property, chattels, and rolling stock, all of which will be
liquidated to repay these borrowings. Management will closely monitor the
liquidation of collateral to assure adequate proceeds are available to fully
repay the associated loans.
The category of accruing loans which are past due 90 days or more was $2,814,000
as of September 30, 2003, $2,772,000 as of June 30, 2003, and $1,133,000 as of
December 31, 2002. As a percentage of total loans, loans past due 90 days and
still accruing interest represented .98% as of September 30, 2003, 1.00% as of
June 30, 2003, and 0.46% as of December 31, 2002. Nine borrowers represent
approximately $2 million of the past due loans 90 days or over. A commercial
borrower representing $539,000 is expected to be liquidating the business and
inventories in November 2003. The loan may need to be restructured after the
sale but no loss is anticipated. Two customers with balances of approximately
$303,000 have 90% FSA loan guarantees. The bank expects to receive full payment
on both loans through either regular payments or liquidation. No losses are
anticipated on these loans. A customer with an approximate loan balance of
$150,000 has filed chapter 7 bankruptcy. The Company is receiving sporadic
payments from the bankruptcy plan. Management believes liquidation of the
underlying collateral will be sufficient to mitigate any significant losses on
the loan should foreclosure become necessary. The bank believes it has
sufficient collateral of the remaining 5 customers to cover the balance of the
loans if forced to liquidate. Of the five remaining loans, one loan with a loan
balance of $150,000 paid off their loan in October 2003.
As a percentage of the allowance for loan losses, total nonaccrual loans and
loans past due 90 days or more were 173.7% as of September 30, 2003, 145.8% as
of June 30, 2003, and 76.4% as of December 31, 2002.
DEPOSITS
Deposits totaled $272.5 million as of September 30, 2003, an increase of $9.8
million, or 3.7%, from $262.7 million as of December 31, 2002. Deposit areas
showing the most significant growth are in savings, insured
14
money markets, and supernow accounts. Certificate of Deposit balances remain
flat from December 31, 2002. .
FHLB BORROWINGS
Federal Home Loan Bank borrowings increased $26.5 million to $44.0 million as of
September 30, 2003 from $17.5 million as of December 31, 2002. The additional
borrowings were primarily used to fund the lending of 1-4 family fixed rate
loans made and held by the bank for additional loan funding.
LIQUIDITY AND CAPITAL RESOURCES
The declaration and payment of dividends by the Company are subject to the
discretion of the Board of Directors and to the earnings and financial condition
of the Company and applicable laws and regulations. The Company paid $960,000
and $840,000 in dividends during the nine months ended September 30, 2003 and
2002, respectively.
At September 30, 2003, consolidated Tier 1 risk based capital was 10.30%, and
total risk-based capital was 11.19%. The minimum Tier 1 and total risk-based
capital ratios required by the Board of Governors of the Federal Reserve are 4%
and 8%, respectively.
Effective liquidity management ensures that the cash flow requirements of
depositors and borrowers, as well as company cash needs, are met. The Company
manages liquidity on both the asset and liability sides of the balance sheet.
Community bank liquidity management currently involves the challenge of
attracting deposits while maintaining positive loan growth at a reasonable
interest rate spread. The loan to deposit ratio at September 30, 2003 was 105.0%
compared to 94.5% as of December 31, 2002. Loans to total assets were 80.8% at
September 30, 2003 compared to 77.9% at the end of 2002. The securities
portfolio is available for sale and consists of securities that are readily
marketable. Approximately 73% of the available for sale portfolio is pledged to
secure public deposits, short-term and long-term borrowings and for other
purposes as required by law. The balance of the available for sale securities
could be sold if necessary for liquidity purposes. Also, a stable deposit base,
consisting of 88.1% core deposits, makes the Company less susceptible to large
fluctuations in funding needs. The Company also has both short- and long-term
borrowings capacity available through FHLB with unused available credit of
approximately $12.7 million as of September 30, 2003. The Company has the
ability to obtain deposits in the brokered certificate of deposit market to help
provide liquidity to fund loan growth, if necessary. Generally, the Company uses
short-term borrowings to fund overnight and short-term funding needs in the
Company's balance sheet. Longer-term borrowings have been primarily used to fund
mortgage-loan originations. This has occurred when FHLB longer-term rates are a
more economical source of funding than traditional deposit gathering activities.
Additionally, the Company occasionally uses FHLB borrowings to fund larger
commercial loans.
As of September 30, 2003, management is not aware of any current recommendations
by banking regulatory authorities which, if they were to be implemented, would
have, or would be reasonably likely to have, a material adverse impact on the
Company's liquidity, capital resources, or operations.
On August 28, 2003 Merchants Bancorp entered into a stock redemption agreement
with 3 shareholders of the Company. Collectively the three shareholders owned
351,349.994 common shares of the Company or 11.71% of outstanding shares. They
desired to sell 333,349.994 of such shares (referred to herein as the "shares")
to the Company. The Company retained Austin Associates, LLC to determine a "fair
value" and issued a "fairness opinion" to the Company dated July 30, 2003
confirming that the payment of $21.00 per share is fair to both the Company and
remaining shareholders. The purchase is to be made in two separate settlements.
The first settlement was for 55,000 shares and a total of $1,155,000 and
occurred on September 5, 2003. The second settlement will occur on January 5,
2004 for the 278,349.994 remaining shares. The dollar value of this settlement
is $5,845,349.87 and is recorded in other liabilities on the September 30, 2003
15
financial statements. The total value of the transaction will be $7,000,349.87.
The Company and its subsidiary bank Merchants National Bank will be "well
capitalized" both before and after consummation of the stock transaction.
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
The Company has certain obligations and commitments to make future
payments under contracts. At September 30, 2003, the aggregate
contractual obligations and commercial commitments are:
Contractual Obligations Payments Due by Period
($ IN THOUSANDS) Less than 1-3 3-5 After 5
Total One Year Years Years Years
- ----------------------------------------------------------------------------------------------------------------------------
Total Deposits $272,532 $229,393 $ 42,972 $ 155 $ 12
FHLB Borrowings 44,018 3,813 6,301 4,850 29,054
Repurchase Agreements 2,688 2,688
Stock Redemption Commitment 5,845 5,845 $ - $ - $ -
-------- -------- -------- -------- --------
Total $325,083 $241,739 $ 49,273 $ 5,005 $ 29,066
OTHER COMMERCIAL COMMITMENTS Amount of Unused Commitments - Expirations by Period
Less than 1-3 3-5 After 5
(in thousands) Total One Year Years Years Years
- ----------------------------------------------------------------------------------------------------------------------------
Commitments to Extend Credit $ 25,558 $ 3,131 $ 11,472 $ 1,779 $ 9,176
Letters of Credit 39 34 5
-------- -------- -------- -------- --------
Total $ 25,597 $ 3,165 $ 11,477 $ 1,779 $ 9,176
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of loss arising from adverse changes in the fair value
of financial instruments due to variations in interest rates, exchange rates,
equity price risk and commodity prices. The Company does not maintain a trading
account for any class of financial instrument, and is not currently subject to
currency exchange rate risk, equity price risk or commodity price risk. The
Company's market risk is composed primarily of interest rate risk.
The major source of the Company's interest rate risk is the difference in the
maturity and repricing characteristics between the Company's core banking assets
and liabilities -- loans and deposits. This difference, or mismatch, poses a
risk to net interest income. Most significantly, the Company's core banking
assets and liabilities are mismatched with respect to repricing frequency,
maturity and/or index. Most of the Company's commercial loans, for example,
reprice rapidly in response to changes in short-term interest rates. In
contrast, many of the Company's consumer deposits reprice slowly, if at all, in
response to changes in market interest rates.
The Company's Senior Management is responsible for reviewing the interest rate
sensitivity position of the Company and establishing policies to monitor and
limit exposure to interest rate risk. The guidelines established by senior
management are approved by the Company's Board of Directors. The primary goal of
the asset/liability management function is to maximize net interest income
within the interest rate risk limits set by approved guidelines. Techniques used
include both interest rate gap management and simulation
16
modeling that measures the effect of rate changes on net interest income and
market value of equity under different rate scenarios.
In the Company's simulation models, each asset and liability balance is
projected over a time horizon. Net interest income is then projected based on
expected cash flows and projected interest rates under a stable rate scenario
and analyzed. The results of this analysis are factored into decisions made
concerning pricing strategies for loan and deposits, balance sheet mix,
securities portfolio strategies, liquidity and capital adequacy.
Simulation models are also performed under an instantaneous parallel 200 basis
point increase or decrease in interest rates. The model includes assumptions as
to repricing and expected prepayments, anticipated calls, and expected decay
rates of transaction accounts under the different rate scenarios. The results of
these simulations include changes in both net interest income and market value
of equity.
The Company's rate shock simulation models provide results in extreme interest
rate environments and results are used accordingly. Reacting to changes in
economic conditions, interest rates and market forces, the Company has been able
to alter the mix of short and long-term loans and investments, and increase or
decrease the emphasis on fixed and variable rate products in response to
changing market conditions. By managing the interest rate sensitivity of its
asset composition in this manner, the Company has been able to maintain a fairly
stable flow of net interest income.
Complicating management's efforts to control non-trading exposure to interest
rate risk is the fundamental uncertainty of the maturity, repricing, and/or
runoff characteristics of some of the Company's core banking assets and
liabilities. This uncertainty often reflects options embedded in these financial
instruments. The most important embedded options are contained in consumer
deposits and loans.
For example, many of the Company's interest bearing retail deposit products
(e.g., interest checking, savings and money market deposits) have no contractual
maturity. Customers have the right to withdraw funds from these deposit accounts
freely. Deposit balances may therefore run off unexpectedly due to changes in
competitive or market conditions. To forestall such runoff, rates on interest
bearing deposits may have to be increased more (or reduced less) than expected.
Such repricing may not be highly correlated with the repricing of prime
rate-based or U.S. Treasury-based loans. Finally, balances that leave the
banking franchise may have to be replaced with other more expensive retail or
wholesale deposits. Given the uncertainties surrounding deposit runoff and
repricing, the interest rate sensitivity of core bank liabilities cannot be
determined precisely.
Management believes as of September 30, 2003, there have been no material
changes in the Company's interest rate sensitive instruments which would cause a
material change in the market risk exposures which affect the quantitative and
qualitative risk disclosures as presented in the Company's Form 10-K filed for
the period ended December 31, 2002.
ITEM 4. CONTROLS AND PROCEDURES
The Company carried out an evaluation, under the supervision and with the
participation of the Company's management, including the Company's Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the
design and operation of the Company's disclosure controls and procedures as of
September 30, 2003, pursuant to Exchange Act Rule 13a-15. Based upon that
evaluation, the Chief Executive Officer and Chief Financial Officer concluded
that the Company's disclosure controls and procedures were effective as of
September 30, 2003, in timely alerting them to material information relating to
the Company (including its consolidated subsidiaries) required to be included in
the Company's periodic SEC filings.
17
There was no change in the Company's internal control over financial reporting
that occurred during the Company's fiscal quarter ended September 30, 2003, that
has materially affected, or is reasonably likely to materially affect, the
Company's internal control over financial reporting.
FORWARD-LOOKING STATEMENTS
Certain of the statements contained herein that are not historical facts are
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act. Economic circumstances, the Company's operation and the
Company's actual results could differ significantly from those discussed in the
forward-looking statements. Forward-looking statements are typically identified
by words or phrases such as "believe," "expect," "anticipate," "intend,"
"estimate," "may increase," "may fluctuate," and similar expressions or future
or conditional verbs such as "will," "should," "would" and "could." These
forward-looking statements involve risks and uncertainties including, but not
limited to, economic conditions, portfolio growth, the credit performance of the
portfolios, including bankruptcies, and seasonal factors; changes in general
economic conditions including the performance of financial markets, the prices
of crops, prevailing inflation and interest rates, and losses on lending
activities; results of various investment activities; the effects of
competitors' pricing policies, of changes in laws and regulations on competition
and of demographic changes on target market populations' savings and financial
planning needs; industry changes in information technology systems on which we
are dependent; and the resolution of legal proceedings and related matters. In
addition, the policies and regulations of the various regulatory authorities
could affect the Company's results. These statements are representative only on
the date hereof, and the Company undertakes no obligation to update any
forward-looking statements made.
PART II - OTHER INFORMATION
ITEM 5. OTHER INFORMATION
On August 28, 2003 Merchants Bancorp entered into a stock redemption agreement
with 3 shareholders of the Company. Collectively the three shareholders owned
351,349.994 common shares of the Company or 11.71% of outstanding shares. They
desired to sell 333,349.994 of such shares (referred to herein as the "shares")
to the Company. The Company retained Austin Associates, LLC to determine a "fair
value" and issued a "fairness opinion" to the Company dated July 30, 2003. The
purchase is to be made in 2 separate settlements. The first settlement was for
55,000 shares and a total of $1,155,000 and occurred on September 5, 2003. The
second settlement will occur on January 5, 2004 for the 278,349.994 remaining
shares. The dollar value of this settlement is $5,845,349.87. The total value of
the transaction will be $7,000,349.87. The Company and its subsidiary bank
Merchants National Bank will be "well capitalized" both before and after
consummation of the stock transaction.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) EXHIBITS - The following exhibits are filed as a part of this report:
Exhibit No. Exhibit
3.1 Amended and Restated Articles of Incorporation of
Merchants Bancorp, Inc. (Incorporated by reference to
the Registration Statement on Form 10 filed on April
30, 2002.)
3.2 Code of Regulations of Merchants Bancorp, Inc.
(Incorporated by reference to the Registration
Statement on Form 10 filed on April 30, 2002.)
18
4. Instruments Defining the Rights of Security Holders.
(See Exhibit 3.)
10. Stock Redemption Agreement entered into August 28,
2003 (Incorporated by reference to Exhibit 10 to the
current report on Form 8-K filed with the Commission
by the Registrant on September 5, 2003).
31.1 Certification of Principal Executive and Financial
Officer Pursuant to Section 302 of the Sarbanes-
Oxley Act of 2002.
32.1 Certification pursuant to 18 U.S.C. section 1350, as
enacted pursuant to section 906 of the Sarbanes-
Oxley Act of 2002.
(b) REPORTS ON FORM 8-K DURING THE QUARTER ENDED SEPTEMBER 30, 2003:
o The Registrant filed a report on Form 8-K on September 5, 2003
announcing the stock redemption agreement dated as of August 28, 2003
executed by and among the Registrant and Janet F. Daniel, Mary Jane
Mallory and Sara Fling West.
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.
MERCHANTS BANCORP, INC.
Date: November 14, 2003 By: /s/ Paul W. Pence, Jr.
-----------------------
Paul W. Pence, Jr., President and
Principal Financial Officer
19
EXHIBIT INDEX
Exhibit No. Description
- ----------- -----------
3.1 Amended and Restated Articles of Incorporation of Merchants
Bancorp, Inc. (Incorporated by reference to the Registration
Statement on Form 10 filed on April 30, 2002.)
3.2 Code of Regulations of Merchants Bancorp, Inc.
(Incorporated by reference to the Registration Statement
on Form 10 filed on April 30, 2002.)
4. Instruments Defining the Rights of Security Holders.
(See Exhibit 3.)
10. Stock Redemption Agreement entered into August 28, 2003
(Incorporated by reference to Exhibit 10 to the current
report on Form 8-K filed with the Commission by the
Registrant on September 5, 2003).
31.1 Certification of Principal Executive and Financial Officer
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification pursuant to 18 U.S.C. section 1350, as enacted
pursuant to section 906 of the Sarbanes-Oxley Act of 2002.
20