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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
X Quarterly Report Pursuant to Section 13 or 15(d) of the
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Securities and Exchange Act of 1934
For the quarterly period ended September 30, 2003, or
Transition Report Pursuant to Section 13 or 15(d) of the
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Securities Exchange Act of 1934
For the Transition Period from to
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Commission File No. 0-17000
COMMERCIAL NATIONAL FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
Michigan 38-2799780
(State of Incorporation) (IRS Employer Identification No.)
101 North Pine River Street, Ithaca, Michigan 48847
(address of principal executive offices) (ZIP Code)
Registrant's telephone number, including area code: (989) 875-4144
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
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Indicate by check mark whether the registrant is an accelerated filer (as
defined in rule 12b-2 of the Exchange Act).
YES NO X
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Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Class Outstanding at November 3, 2003
----- -------------------------------
Common Stock 3,860,282
No Par Value
INDEX
PART I FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of September 30, 2003 (Page 3)
(unaudited) and December 31, 2002
Consolidated Statements of Income and Other Comprehensive (Page 4)
Income (unaudited) for the three and nine months ended
September 30, 2003 and September 30, 2002
Consolidated Statements of Changes in Shareholders' Equity (Page 5)
(unaudited) for the nine months ended September 30, 2003 and
September 30, 2002
Consolidated Statements of Cash Flows (unaudited) for the (Page 6)
nine months ended September 30, 2003 and September 30, 2002
Notes to Consolidated Financial Statements (unaudited) (Page 7-9)
Item 2. Management's Discussion and Analysis of Financial Condition (Page 10-14)
and Results of Operations
Item 3. Quantitative and Qualitative Disclosures about Market Risk (Page 14-15)
Item 4. Controls and Procedures (Page 16)
PART II OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders (Page 17)
Item 6. Exhibits and Reports on Form 8-K (Page 17-24)
SIGNATURES (Page 18)
COMMERCIAL NATIONAL FINANCIAL CORPORATION
CONSOLIDATED BALANCE SHEETS
September 30, December 31,
2003 2002
------------- -------------
(Unaudited)
ASSETS
Cash and due from banks $ 5,569,806 $ 8,784,826
Federal funds sold 3,670,614 6,850,000
Other interest bearing deposits 822,043 3,634,988
------------- -------------
Total cash and cash equivalents 10,062,463 19,269,814
Securities available for sale 24,157,616 21,345,896
Securities held to maturity (fair value $3,306,631 -
September 30, 2003; $4,911,696 - December 31, 2002) 3,153,460 4,689,025
Federal Home Loan Bank stock, at cost 1,689,500 1,647,000
Gross loans receivable 188,226,893 184,448,296
Allowance for loan losses (2,710,505) (2,783,234)
------------- -------------
Net loans receivable 185,516,388 181,665,062
Bank owned life insurance 3,360,389 3,231,374
Premises and equipment, net 3,945,765 3,687,151
Accrued interest receivable and other assets 3,114,350 2,715,261
------------- -------------
Total assets $ 234,999,931 $ 238,250,583
============= =============
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities
Deposits
Noninterest-bearing demand $ 21,659,113 $ 21,495,410
Interest-bearing demand 28,969,092 29,872,655
Savings 62,581,345 59,432,935
Time 52,375,470 55,258,479
------------- -------------
Total deposits 165,585,020 166,059,479
Securities sold under agreements to repurchase 14,116,848 14,266,239
Other short-term borrowings 165,804 491,840
Federal Home Loan Bank advances 29,891,690 32,807,086
Accrued expenses and other liabilities 1,200,240 921,967
------------- -------------
Total liabilities 210,959,602 214,546,611
Shareholders' equity
Common stock and paid-in-capital, no par value: 5,000,000 shares
authorized; shares issued and outstanding
September 30, 2003 - 3,842,203 and December 31,
2002 - 3,801,421 23,736,347 23,255,499
Retained earnings (deficit) (17,987) 3,908
Accumulated other comprehensive income, net of tax 321,969 444,565
------------- -------------
Total shareholders' equity 24,040,329 23,703,972
------------- -------------
Total liabilities and shareholders' equity $ 234,999,931 $ 238,250,583
============= =============
See accompanying notes
3
COMMERCIAL NATIONAL FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (Unaudited)
Three Months Nine Months
Ended September 30, Ended September 30,
2003 2002 2003 2002
------------ ------------ ------------ ------------
Interest and dividend income
Loans, including fees $ 3,283,747 $ 3,203,445 $ 9,503,415 $ 9,506,875
Taxable securities 176,486 182,267 539,648 594,735
Nontaxable securities 90,415 112,770 297,219 361,862
Federal funds sold 10,207 27,670 77,236 68,242
Federal Home Loan Bank stock dividends 19,741 24,573 64,099 66,836
Interest on other deposits 2,315 6,369 12,730 14,945
------------ ------------ ------------ ------------
Total interest and dividend income 3,582,911 3,557,094 10,494,347 10,613,495
Interest expense
Deposits 560,532 838,541 1,901,464 2,614,279
Securities sold under agreements to repurchase 33,731 42,197 119,167 111,111
Federal Home Loan Bank advances 379,753 431,300 1,178,106 1,193,315
Other 640 1,454 2,059 4,761
------------ ------------ ------------ ------------
Total interest expense 974,656 1,313,492 3,200,796 3,923,466
Net interest income 2,608,255 2,243,602 7,293,551 6,690,029
Provision for loan losses 431,000 274,000 1,781,000 561,000
------------ ------------ ------------ ------------
Net interest income after provision for loan losses 2,177,255 1,969,602 5,512,551 6,129,029
Noninterest income
Service charges and fees 124,365 132,329 358,774 357,261
Net gains on loan sales 238,554 196,893 779,685 290,765
Receivable financing fees 36,840 39,196 121,266 122,934
Net security gains -- -- -- 27,565
Other 372,182 132,857 476,285 336,620
------------ ------------ ------------ ------------
Total noninterest income 771,941 501,275 1,736,010 1,135,145
Noninterest expense
Salaries and employee benefits 961,804 859,784 2,795,473 2,485,499
Occupancy and equipment 292,474 202,266 914,967 647,981
FDIC insurance 7,245 6,942 21,429 23,355
Printing, postage and supplies 67,639 65,686 205,570 204,523
Professional and outside services 118,053 91,548 310,312 285,909
Other 321,545 252,626 837,860 744,280
------------ ------------ ------------ ------------
Total noninterest expense 1,768,760 1,478,852 5,085,611 4,391,547
------------ ------------ ------------ ------------
Income before income tax expense 1,180,436 992,025 2,162,950 2,872,627
Income tax expense (benefit) 362,000 249,400 576,000 788,700
------------ ------------ ------------ ------------
Net income $ 818,436 $ 742,625 $ 1,586,950 $ 2,083,927
============ ============ ============ ============
Net change in unrealized gains on securities available for sale $ (265,940) $ 141,005 $ (185,751) $ 230,504
Reclassification adjustment for (gains) recognized in income -- -- -- (27,565)
Tax effects 90,419 (47,942) 63,155 (68,999)
------------ ------------ ------------ ------------
Total comprehensive income $ 642,915 $ 835,688 $ 1,464,354 $ 2,217,867
============ ============ ============ ============
Per share information
Basic earnings $ 0.21 $ 0.20 $ 0.41 $ 0.55
Diluted earnings $ 0.21 $ 0.19 $ 0.41 $ 0.55
Dividends declared $ 0.14 $ 0.13 $ 0.42 $ 0.40
See accompanying notes
4
COMMERCIAL NATIONAL FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
Nine Months ended September 30, 2003 and September 30, 2002 (Unaudited)
Accumulated
Shares Common Other
Issued Stock and Retained Comprehensive Total
and Paid in Earnings Income/(Loss), Shareholders'
Outstanding Capital (Deficit) Net of Tax Equity
- --------------------------------------------------------------------------------------------------------------------------------
Balance at January 1, 2002 3,725,085 $ 22,104,910 $ (416,257) $ 375,625 $ 22,064,278
Comprehensive income:
Net income 2,083,927 2,083,927
Net change in unrealized gains/(losses) on
securities available for sale 230,504 230,504
Reclassification adjustment for gains
recognized in income (27,565) (27,565)
Tax effects (68,999) (68,999)
------------
Total comprehensive income 2,217,867
Cash dividends declared, $.40 per share (1,508,691) (1,508,691)
Issued under dividend reinvestment program 63,538 611,727 611,727
Issued under stock option plans 6,939 47,691 47,691
Issued under employee benefit plan 4,404 46,576 46,576
Repurchase and retirement of shares (9,995) (122,787) (122,787)
------------ ------------ ------------ ------------ ------------
Balance at September 30, 2002 3,789,971 $ 22,688,117 $ 158,979 $ 509,565 $ 23,356,661
============ ============ ============ ============ ============
- --------------------------------------------------------------------------------------------------------------------------------
Balance at January 1, 2003 3,801,421 $ 23,255,499 $ 3,908 $ 444,565 $ 23,703,972
Comprehensive income:
Net income 1,586,950 1,586,950
Net change in unrealized gains/(losses) on
securities available for sale (185,751) (185,751)
Tax effects 63,155 63,155
------------
Total comprehensive income 1,464,354
Cash dividends declared, $.42 per share (1,608,845) (1,608,845)
Issued under dividend reinvestment program 53,086 629,371 629,371
Issued under stock option plans 48 318 318
Issued under employee benefit plan 3,982 48,643 48,643
Repurchase and retirement of shares (16,334) (197,484) (197,484)
------------ ------------ ------------ ------------ ------------
Balance at September 30, 2003 3,842,203 $ 23,736,347 $ (17,987) $ 321,969 $ 24,040,329
============ ============ ============ ============ ============
See accompanying notes
5
COMMERCIAL NATIONAL FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
Nine Months Ended
September 30,
2003 2002
---- ----
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 1,586,950 $ 2,083,927
Adjustments to reconcile net income to net
cash from operating activities
Provision for loan losses 1,781,000 561,000
Net gains on loan sales (779,685) (290,765)
Originations of loans held for sale (31,849,988) (15,080,652)
Proceeds from sales of loans held for sale 32,629,673 15,371,417
Gain on sales of securities available for sale -- (27,565)
Depreciation, amortization and accretion 522,945 363,433
Net change in accrued interest receivable and other assets 1,035,050 797,448
Net change in accrued expenses and other liabilities 272,405 566,704
------------ ------------
Net cash from operating activities 5,198,350 4,344,947
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of securities available for sale (15,779,027) (4,189,284)
Purchases of FHLB stock (42,500) (224,900)
Proceeds from maturities of securities available for sale 12,612,198 5,675,000
Proceeds from maturities of securities held to maturity 1,530,000 2,723,900
Net change in loans (7,136,830) (15,359,224)
Purchases of premises and equipment (602,131) (954,451)
------------ ------------
Net cash from investing activities (9,418,290) (12,328,959)
CASH FLOW FROM FINANCING ACTIVITIES
Net change in deposits (474,459) (1,443,800)
Net change in securities sold under agreements to repurchase (149,391) 3,835,212
Net change in other short term borrowings (326,036) 344,745
Proceeds from Federal Home Loan Bank advances 3,000,000 13,000,000
Repayment of Federal Home Loan Bank advances (5,915,396) (7,153,269)
Repurchase and retirement of shares of common stock (197,484) (122,787)
Dividends paid (1,602,977) (1,499,629)
Proceeds from sale of common stock and fractional shares paid 678,332 705,994
------------ ------------
Net cash from financing activities (4,987,411) 7,666,466
------------ ------------
Net change in cash and cash equivalents (9,207,351) (317,546)
Cash and cash equivalents, at beginning of period 19,269,814 14,347,325
------------ ------------
CASH AND CASH EQUIVALENTS, AT END OF PERIOD $ 10,062,463 $ 14,029,779
============ ============
Cash paid during the period for
Interest $ 3,247,715 $ 4,001,622
Federal income taxes 684,000 1,010,000
See accompanying notes
6
COMMERCIAL NATIONAL FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
Note 1-Summary of Significant Accounting Policies
Basic Presentation
The accompanying unaudited consolidated financial statements were prepared in
accordance with Rule 10-01 of regulation S-X and the instructions for Form 10-Q
and, therefore, do not include all disclosures required by accounting principles
generally accepted in the United States of America for complete presentation of
financial statements. In management's opinion, the condensed consolidated
financial statements contain all adjustments (consisting of normal recurring
accruals) necessary to present fairly the financial condition of Commercial
National Financial Corporation as of September 30, 2003 and December 31, 2002
and the results of its operations for the three and nine months ending September
30, 2003 and September 30, 2002. The results for the three and nine months ended
September 30, 2003 are not necessarily indicative of the results expected for
the full year.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of
Commercial National Financial Corporation (CNFC), Commercial Bank (Bank), CNFC
Financial Services, Inc. and CNFC Mortgage Corporation, both wholly owned
subsidiaries of the Bank. All material intercompany accounts and transactions
have been eliminated in consolidation.
Nature of Operations, Industry Segments and Concentrations of Credit Risk
CNFC is a one-bank holding company, which conducts limited business activities.
The Bank performs the majority of business activities.
The Bank provides a full range of banking services to individuals, agricultural
businesses, commercial businesses and light industries located in its service
area. It maintains a diversified loan portfolio, including loans to individuals
for home mortgages, automobiles and personal expenditures, and loans to business
enterprises for current operations and expansion. The Bank offers a variety of
deposit products, including checking, savings, money market, individual
retirement accounts and certificates of deposit. While CNFC's chief
decision-makers monitor the revenue stream of various products and services,
operations are managed and financial performance is evaluated on a
corporation-wide basis. Accordingly, management considers all of the CNFC's
banking operations to be aggregated into one operating segment.
The principal markets for the Bank's financial services are the Michigan
communities in which the Bank is located and the areas surrounding these
communities. The Bank serves these markets through nine offices located in
Gratiot, Isabella and Montcalm Counties in Michigan.
Use of Estimates
To prepare financial statements in conformity with accounting principles
generally accepted in the United States of America, management makes estimates
and assumptions based on available information. These estimates and assumptions
affect the amounts reported in the financial statements and the disclosures
provided. The allowance for loan losses and fair values of securities and other
financial instruments are particularly subject to change.
STOCK COMPENSATION Employee compensation expense under stock options is reported
using the intrinsic value method. No stock-based compensation cost is reflected
in net income as all options granted had an exercise price equal to or greater
than the market price of the underlying common stock at date of grant. The
following table illustrates the effect on net income and earnings per share if
expense was measured using the fair value recognition provisions of SFAS No.
123, Accounting for Stock-Based Compensation Expense.
7
COMMERCIAL NATIONAL FINANCIAL CORPORATION
Quarter to Date Year to Date
September 30, 2003 September 30, 2002 September 30, 2003 September 30, 2002
- --------------------------------------------------------------------------------------------------------------------------
Net income as reported $ 818,436 $ 742,625 $ 1,586,950 $ 2,083,927
Stock-based compensation expense (34,860) (46,968) (88,221) (75,890)
- --------------------------------------------------------------------------------------------------------------------------
Proforma net income $ 783,576 $ 695,657 $ 1,498,729 $ 2,008,037
==========================================================================================================================
Basic earnings per share as reported $ .21 $ .20 $ .41 $ .55
Proforma basic earnings per share $ .20 $ .18 $ .39 $ .53
Diluted earnings per share as reported $ .21 $ .19 $ .41 $ .55
Proforma diluted earnings per share $ .20 $ .18 $ .39 $ .53
The pro forma effects are computed using option pricing models, using the
following weighted-average assumptions as of the grant date.
Quarter to Date Year to Date
September 30, 2003 September 30, 2002 September 30, 2003 September 30, 2002
- --------------------------------------------------------------------------------------------------------------------------
Risk-free interest rate 3.57% 4.08% 3.57% 4.08%
Expected option life 10.00 9.45 10.00 9.45
Expected stock price volatility 21.10 40.83 21.10 40.83
Dividend yield 4.31% 4.70% 4.31% 4.70%
Cash Flow Reporting
Cash and cash equivalents include cash on hand, demand deposits with other
financial institutions and federal funds sold. Cash flows are reported net for
customer loan and deposit transactions, securities sold under agreements to
repurchase with original maturity of 90 days or less and U.S. Treasury demand
notes.
Earnings and Dividends Per Share
Basic earnings per common share is based on net income divided by the weighted
average number of common shares outstanding during the period. Diluted earnings
per common share shows the diluted effect of any additional potential common
shares. Earnings and dividends per common share are restated for all stock
splits and stock dividends.
Comprehensive Income
Comprehensive income consists of net income and other comprehensive income
(loss). Other comprehensive income (loss) includes the change in unrealized
appreciation and depreciation on securities available for sale, net of tax,
which is also recognized as a separate component of shareholders' equity.
Reclassifications
Some items in the prior year financial statements have been reclassified to
conform with the current year presentation.
Newly Issued But Not Yet Effective Accounting Standards
New accounting standards on asset retirement obligations, restructuring
activities and exit costs, operating leases, and early extinguishment of debt
were issued in 2002. The new accounting standards were adopted in 2003, and did
not have a material impact on Commercial's financial position or results of
operations.
8
COMMERCIAL NATIONAL FINANCIAL CORPORATION
Note 2 - Earnings Per Share
A reconciliation of the numerators and denominators of the basic earnings per
share and diluted earnings per share computations for the periods ended is
presented below. Stock options representing 73,984 and 162,438 shares of common
stock were not considered in computing diluted earnings per share for the three
and nine month periods in 2002 and 2003 because they were antidilutive.
Three Months Ended Nine Months Ended
SEPTEMBER 30, September 30, SEPTEMBER 30, September 30,
2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------------------------------
BASIC EARNINGS PER SHARE:
Net income available to common shareholders $ 818,436 $ 742,625 $1,586,950 $2,083,927
Weighted-average common shares outstanding for
basic earnings per share 3,833,826 3,775,613 3,833,826 3,775,613
-------------------------------------------------------
BASIC EARNINGS PER SHARE $ .21 $ .20 $ .41 $ .55
=======================================================
DILUTED EARNINGS PER SHARE:
Net income available to common shareholders $ 818,436 $ 742,625 $1,586,950 $2,083,927
Weighted-average common shares outstanding for basic
earnings per share 3,833,826 3,775,613 3,833,826 3,775,613
Add:
Dilutive effect of assumed exercise of stock options 42,316 38,646 42,316 38,646
-------------------------------------------------------
Weighted-average common and dilutive additional potential
common shares outstanding 3,876,142 3,814,259 3,876,142 3,814,259
=======================================================
DILUTED EARNINGS PER SHARE $ .21 $ .19 $ .41 $ .55
=======================================================
9
COMMERCIAL NATIONAL FINANCIAL CORPORATION
ITEM 2: MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
FINANCIAL CONDITION
Summary
Total assets decreased from $238.2 million at December 31, 2002 to $235.0
million at September 30, 2003. Management classifies the economic environment as
having weak business loan demand offset by strong residential real estate
activity. The interest rate environment provides few reasonably priced
investment alternatives to place excess liquidity. Since December 31, 2002
management has been attempting to reduce the excess cash and fed funds position
of the Bank through a combination of measures. These include: repayment of FHLB
borrowings as they mature, holding fixed rate residential mortgage loans in
situations where management believes the interest rate risk is acceptable and
pricing other funding sources, such as network certificate of deposits, below
prevailing market rates.
At September 30, 2003 cash and cash equivalents was $9.2 million less than at
December 31, 2002. At September 31, 2003 FHLB advances were $2.9 million less
than at December 31, 2002. Loan totals increased by $3.8 million by a decision
of management to retain a portion of purchase money and refinanced residential
real estate loans. This increase occurred despite the $2.0 million in year to
date loan charge-offs.
Liquidity
Management defines liquidity as the ability to fund appropriate levels of credit
worthy loans, meet the immediate cash withdrawal requirements of depositors, and
maintain access to sufficient resources to meet unexpected contingencies at a
reasonable cost, with minimal losses.
Management believes that the combination of available FHLB advances, Federal
funds lines of credit, the available for sale investment portfolio, and our
ability to sell mortgage loans provides adequate short and medium term sources
of liquidity. At a minimum the Bank has the following available to meet
short-term liquidity needs: $10,508,000 in available FHLB advances based on
available collateral and $9,000,000 in short term federal funds lines of credit
with correspondent banks.
CNFC also needs cash to pay dividends to its shareholders. The primary source of
cash is the dividends paid to CNFC by the Bank. Management believes that cash
from operations is sufficient to supply the cash needed to continue paying a
reasonable dividend.
Asset Quality
At September 30, 2003 CNFC has identified $3,711,000 of loans as non-performing.
This compares to $6,025,000 at December 31, 2002. The $3,711,000 in non-accrual
loans represents four business relationships and their related entities. All
non-accrual loans are considered impaired and the allowance for loan loss
allocated to these loans is $1,229,000. During the quarter, management was able
to dispose of $1.5 million in other real estate owned.
10
COMMERCIAL NATIONAL FINANCIAL CORPORATION
September 30, 2003 December 31, 2002
------------------ -----------------
Total loans $188,226,893 $184,448,296
Non-accrual loans $ 3,493,385 $ 5,676,390
Accruing loans past due 90 days or more 217,329 --
Restructured Loans (non accrual) -- 348,520
--------------------------------
Total non-performing loans 3,710,714 6,024,910
Repossessed assets and other real estate 29,298 120,970
--------------------------------
Total non-performing assets $ 3,740,012 $ 6,145,880
================================
Total non-performing loans as a
percentage of total loans 1.97% 3.26%
================================
Allowance for loan loss as a percentage of
non-performing loans 73.05% 46.20%
================================
Total non-performing assets as a percentage of
total assets 1.59% 2.58%
================================
Allowance for Loan Loss
Three Months Ended Three Months Ended Nine Months Ended Nine Months Ended
September 30, 2003 September 30, 2002 September 30, 2003 September 30, 2002
- -------------------------------------------------------------------------------------------------------------------------
Beginning balance $ 2,271,715 $ 2,896,993 $ 2,783,234 $ 2,586,025
Loan charge-offs (13,218) (15,997) (1,958,580) (27,219)
Loan recoveries 21,008 10,734 104,851 45,924
----------------------------------------------------------------------------
Net loan recoveries/(charge-offs) 7,790 (5,263) (1,853,729) 18,705
Provision for loan losses 431,000 274,000 1,781,000 561,000
----------------------------------------------------------------------------
Ending balance $ 2,710,505 $ 3,165,730 $ 2,710,505 $ 3,165,730
============================================================================
Average loan balance $ 186,086,000 $ 183,368,000 $ 182,867,000 $ 177,935,000
Percentage of net charge-offs
as a percentage of average loans 0.00% 0.00% (1.01)% .01%
The allowance for loan losses was 1.44% of total loans at September 30, 2003
compared to 1.24% at June 30, 2003 and 1.51% at December 31, 2002. Management
systematically evaluates the adequacy of the allowance such that the balance is
commensurate with the performance of the loan portfolio.
For purposes of evaluating the adequacy of the allowance, the performance of the
loan portfolio is divided into four classifications: non-classified, watch,
substandard-not impaired, and substandard-impaired. Management has subdivided
the classifications of non-classified and watch into the following categories of
loans: residential, consumer and business loans.
Non-classified loans are loans that are viewed as homogeneous categories. These
loans are generally current and performing as agreed. Commercial establishes a
reserve on these categories of non-classified loans using the last three year
historical charge-off experience.
Watch credits are loans that management has identified as having some change
that requires additional loan officer monitoring. These loans are generally
paying as agreed, however, the ability to meet debt obligations, while adequate,
has deteriorated. These loans are not considered impaired within the definition
of FAS 114 and 118 and are viewed as homogeneous categories.
11
COMMERCIAL NATIONAL FINANCIAL CORPORATION
Substandard-impaired and substandard-not impaired loans are business loans that
management reviews for impairment under FAS 114 and 118. Management reviews
these loans individually for impairment using either the present value of
expected cash flow or the value of collateral. Loans not considered impaired are
grouped as a homogenous category. A reserve is established on this category
using historical loss experience. A specific reserve is calculated for each loan
identified as impaired, however, the total allowance is available for any loan.
Management believes the business loan portfolio contains the highest risk of
loss of principal. The residential real estate loan portfolio has experienced
net recoveries during the last three calendar years of $45,000. The consumer
loan portfolio has experienced net recoveries of $8,000 during the last three
calendar years. Despite a slowing economy, the consumer and residential real
estate portfolios continue to perform at levels consistent with prior years.
However, the business portfolio has not performed as well. During the quarter,
management identified additional collateral deficiency for a loan relationship
previously identified as impaired. This event, incorporated into management's
allowance for loan loss methodology resulted in a $431,000 provision for loan
loss during the quarter.
Capital Resources
CNFC's capital ratios continue to exceed regulatory guidelines for a "well
capitalized" institution. It is management's intent to maintain capital ratios
in excess of the minimum required to be well capitalized. A summary of CNFC's
capital ratios follows:
Minimum Required to be
Well Capitalized Under Minimum Required
September 30, December 31, Prompt Corrective Action for Capital
2003 2002 Regulations Adequacy Purposes
- ---------------------------------------------------------------------------------------------------------
Total capital to
risk weighted assets 14.6% 14.2% 10.0% 8.0%
Tier 1 capital to
risk weighted assets 13.4% 13.0% 6.0% 4.0%
Tier 1 capital to
average assets 10.1% 10.0% 5.0% 4.0%
RESULTS OF OPERATIONS
Summary
Net income for the quarter ended September 30, 2003 was $818,000, an increase of
$75,000 or 10.2% compared to the same period in 2002. The primary factors that
affected the increase in net income are: a $365,000 increase in net interest
income, a $271,000 increase in non-interest income caused by continued strong
level of sales of residential real estate loans to the secondary market and a
$250,000 gain on sale of other real estate, offset by a $157,000 increase in the
provision for loan loss acknowledging weakness in the business loan portfolio,
and a $290,000 increase in non-interest expense caused by the additional
overhead to support new facilities.
Net Interest Income
The following table illustrates the effect that changes in rates and balances of
interest-earning assets and interest-bearing liabilities had on tax-equivalent
net interest income for the three and nine months ending September 30, 2003 and
2002.
12
COMMERCIAL NATIONAL FINANCIAL CORPORATION
Three Months Ending September 30, Nine Months Ending September 30,
2003 2002 2003 2002
---- ---- ---- ----
Interest Income (tax equivalent) $ 3,680,352 $ 3,677,941 $ 10,817,188 $ 10,994,572
Interest Expense 974,656 1,313,492 3,200,796 3,923,466
------------ ------------ ------------ ------------
Net Interest Income $ 2,705,696 $ 2,364,449 $ 7,616,392 $ 7,071,106
============ ============ ============ ============
Average Balances
Interest-earning Assets $221,588,374 $217,821,819 $224,041,813 $211,932,197
Interest-bearing Liabilities 188,077,797 184,969,598 191,704,540 179,952,391
------------ ------------ ------------ ------------
Net Differential $ 33,510,577 $ 32,852,221 $ 32,337,273 $ 31,979,806
============ ============ ============ ============
Average Yields/Rates (annualized)
Yield on Earning Assets 6.59% 6.70% 6.46% 6.94%
Rate Paid on Liabilities 2.06% 2.82% 2.23% 2.92%
------------ ------------ ------------ ------------
Interest Spread 4.53% 3.88% 4.23% 4.02%
============ ============ ============ ============
Net Interest Margin 4.84% 4.31% 4.55% 4.46%
============ ============ ============ ============
Three Months Ending Nine Months Ending
September 30, 2003 September 30, 2003
Balance Rate Inc/(Dec) Balance Rate Inc/(Dec)
--------- --------- ----------- --------- --------- ---------
Interest Earning
Assets $ 68,968 $ (66,556) $ 2,412 $ 343,352 $(520,737) $(177,385)
Interest Bearing
Liabilities (46,670) (292,165) (338,835) 74,188 (796,858) (722,670)
--------- --------- --------- --------- --------- ---------
Net Interest Income $ 115,638 $ 225,609 $ 341,247 $ 269,164 $ 276,121 $ 545,285
========= ========= ========= ========= ========= =========
The change in status of a non-accrual loan returned to accrual status resulted
in $180,000 of interest income recorded during the third quarter of 2003. Had
the interest not been recovered, margin would have been 4.52%, an improvement
over the 4.31% margin recorded during the same period of 2002. The improvement
in margin compared to the third quarter of 2002 is due to the ability to reprice
deposits and other liabilities down faster than the rates have declined on
earning assets. Management has also been able to invest balances in low yielding
fed funds sold into higher yielding loans. Though the yield on earning assets
decreased when comparing the three months ending September 30, 2003 and
September 30, 2002, management believes that the yield on earning assets would
have decreased further had alternatives to fed funds not been found.
The factors affecting the $545,000 increase in net interest income for the nine
months ending September 30, 2003 are similar to those described above for the
three months ending September 30, 2003.
Noninterest Income
Noninterest income for the three months ending September 30, 2003 was $772,000.
This represents a $271,000 or 54.1% increase over the same period in 2002.
Net gain on loan sales increased $42,000 or 21.2% compared to the same period in
2002. The Bank continued to experience significant refinancing activity in the
early part of the third quarter of 2003, however, recent increases in mortgage
loan interest rates has significantly reduced the volume of residential real
estate loans being refinanced. We anticipate the gain on loan sales during the
fourth quarter will be significantly lower than the gain recorded during the
third quarter.
During the third quarter management was able to dispose of a foreclosed property
which resulted in a $250,000 gain on sale of other real estate owned.
13
COMMERCIAL NATIONAL FINANCIAL CORPORATION
The factors affecting the $601,000 increase in noninterest income for the nine
months ending September 30, 2003 are similar to those described above for the
three months ending September 30, 2003.
Noninterest Expense
Noninterest expense for the three months ending September 30, 2003 totaled
$1,800,000. This represents a $290,000 or 19.6% increase over the same period in
2002.
Salary and benefit expense for the three months ending September 30, 2003
totaled $962,000 compared to $860,000 for the same period in 2002, an increase
of $102,000 or 11.9%. Increased staffing for the new Greenville and Mt. Pleasant
offices and the creation of a business loan processing department are the
primary reasons for the increase. Full time equivalent employees increased from
75 at September 30, 2002 to 82 at September 30, 2003.
Occupancy and equipment increased $90,200 or 44.6% compared to the same period
in 2002. Costs associated with operating the new Greenville and Mt. Pleasant
offices contributed to the increase expense.
Professional fees for the quarter ending September 30, 2003 increased $26,000 or
29.0% compared to the same period in 2002. Search fees paid to hire the head of
our Greenville, Michigan operation contributed to the increase.
The factors affecting the $694,000 increase in noninterest expense for the nine
months ending September 30, 2003 are similar to those described above for the
three months ending September 30, 2003.
ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Commercial's primary market risk exposure is interest rate risk and, to a lesser
extent, liquidity risk. Commercial's transactions are denominated in U.S.
dollars with no specific foreign exchange exposure. Also, Commercial has a
limited exposure to commodity prices related to agricultural loans. Any impacts
that changes in foreign exchange rate and commodity prices would have on
interest rates are assumed to be insignificant.
Interest rate risk (IRR) is the exposure of a banking organization's financial
condition to movements in interest rates. Accepting this risk can be an
important source of profitability and stockholder value; however, excessive
levels of IRR could pose a threat to earnings and capital. Accordingly,
effective risk management that maintains IRR at prudent levels is essential to
Commercial's safety and soundness. Evaluating the quantitative level of IRR
exposure requires the assessment of existing and potential future effects of
changes in interest rates on its consolidated financial condition, including
capital adequacy, earnings, liquidity, and, where appropriate, asset quality.
Commercial's Asset/Liability Committee ("Committee") is responsible for managing
this process.
Commercial derives the majority of income from the excess of interest collected
over interest paid. The rates of interest earned on its assets and owed on its
liabilities generally are established contractually for a period of time. Since
market interest rates change over time, Commercial is exposed to lower profit
margins (or losses) if it cannot adapt to interest rate changes.
Commercial is also subject to repayment risk when interest rates fall. For
example, mortgage loans and other financial assets may be prepaid by a debtor so
that the debtor may refinance their obligations at lower rates. Prepayment of
assets carrying higher rates reduces interest income and overall asset yields.
Fluctuating interest rates and prepayment risk provide a challenge in managing
the net interest income of the Bank. For example: the Bank may fund a 15 year
fixed rate residential real estate loan with a long term amortizing Federal Home
Loan Bank Advance. In a stable interest rate environment, the Bank can
reasonably predict the net interest income earned. However, if rates fall
significantly, the residential mortgage customer may refinance their mortgage at
a lower rate. The Bank continues to pay the higher rate on the Federal Home Loan
Bank advance, thus eroding net interest income. In an alternative scenario, the
Bank funds the same 15 year fixed rate residential real estate loan with 1 year
certificates of deposits. If rates rise at the end of one year, the Bank will
pay more interest to continue to fund the residential mortgage loan with 1 year
certificates of deposit. The net interest income will be lower in year two than
it was in the first year of the mortgage loan.
14
COMMERCIAL NATIONAL FINANCIAL CORPORATION
An additional challenge management faces in managing net interest income is the
fact that what would maximize net interest income to the Bank may be in conflict
with the customers request for products and services. In the current low
interest rate environment, management has greater concern that interest rates
will rise significantly over time rather than fall. Management would prefer to
offer variable rate loan products that would reprice upward as interest rates
rise. However, our loan customers are generally requesting long term fixed rate
loans. On the funding side, management would like to extend the maturities of
its liabilities to match the loan customers request for longer term fixed rate
loans. However, our deposit customers are reluctant to commit to long term
certificate of deposits.
Commercial's primary tool in measuring interest rate risk is to perform a
simulation analysis. This analysis forecasts the effect of various interest rate
changes on the balance sheet, economic value of equity, net interest income and
net income. One common scenario performed by the Committee is to "shock" the
balance sheet by assuming that Commercial has just experienced an immediate and
parallel shift in the yield curve up or down 200 basis points. The model, using
data and assumptions determined by management, reprice assets and liabilities at
new market rates. The objective of this testing is to determine how the Bank's
net interest income and the economic value of equity are affected by extreme
changes in interest rates. These results are recorded and compared to previous
results. Management performs this calculation quarterly.
The limitation to this methodology is that the interest rate curve rarely shifts
200 basis points immediate and parallel. In addition, a downward 200 basis point
shift in today's interest rate environment is not likely. Management is in the
process of evaluating software that would allow for comparison of alternative
interest rate scenarios, and provide management with better information to
assess alternative funding and investing strategies.
The Table below summarizes the effect a 200 basis point immediate and parallel
shift of the yield curve has on net income. Net income may decrease in both a
falling and rising interest rate environment. In a falling interest rate
environment, management does not have the ability to lower deposit rates 200
basis points to offset a decrease in rates on earning assets. Therefore, if
rates decreased 200 basis points, margin would likely compress resulting in
lower net interest income. In a rising interest rate environment, the duration
of earning assets would most likely extend and money currently invested in short
term liabilities would benefit from the increase in rates. It is possible that
in this scenario, net interest income would also decrease. Though the interest
rate risk associated with a rising interest rate environment has increased,
management believes the risk is still acceptable.
Projected Percentage Change in Net Income
September 30, 2003 December 31, 2002 September 30, 2002
- ---------------------------------------------------------------------------------
- -200 basis points (5.4)% (3.5)% 1.7%
0 basis points 0.0 0.0 0.0
+200 basis points (13.9) (12.2) (13.9)
15
COMMERCIAL NATIONAL FINANCIAL CORPORATION
ITEM 4. CONTROLS AND PROCEDURES
(a) Evaluation of disclosure controls and procedures--Jeffrey S. Barker, the
Corporation's Principal Executive Officer, and Patrick G. Duffy, the
Corporation's Principal Financial Officer, have reviewed and evaluated the
effectiveness of the Corporation's disclosure controls and procedures (as
defined in Rules 240.13a-15(e) and 15d-15(e) under the Securities Exchange
Act of 1934 (the "Exchange Act)) as of a date within ninety days before the
filing date of this quarterly report. Based on their evaluation, they have
concluded that the Corporation's disclosure controls and procedures are
effective, providing them with material information relating to the
Corporation as required to be disclosed in the reports the Corporation
files or submits under the Exchange Act on a timely basis.
(b) Changes in internal controls--There were no significant changes in the
Corporation's internal controls or in other factors that could
significantly affect the Corporation's disclosure controls and procedures
subsequent to the date of the evaluation, nor were there any significant
deficiencies or material weaknesses in the Corporation's internal controls.
Forward Looking Statements
This discussion and analysis of financial condition and results of operations,
and other sections of this report contain forward looking statements that are
based on management's beliefs, assumptions, current expectations, estimates and
projections about the financial services industry, the economy, and about the
Corporation itself. Words such as "anticipates", "believes", "estimates",
"expects" "forecasts" "intends", "is likely", "plans", "product", "projects",
variations of such words and similar expressions are intended to identify such
forward-looking statements. These statements are not guarantees of future
performance and involve certain risks, uncertainties, and assumptions ("Future
Factors") that are difficult to predict with regard to timing, extent,
likelihood and degree of occurrence. Therefore, actual results and outcomes may
materially differ from what may be expressed or forecasted in such forward
looking statements. Furthermore, CNFC undertakes no obligation to update, amend
or clarify forward-looking statements, whether as a result of new information,
future events, or otherwise.
Future Factors include changes in interest rates and interest rate
relationships; demand for products and services; the degree of competition by
traditional and non-traditional competitors; changes in banking regulations and
tax laws; changes in prices, levies, and assessments; the impact of technology,
governmental and regulatory policy changes; the outcome of pending and future
litigation and contingencies; trends in customer behavior including their
ability to repay loans; and vicissitudes of the national and local economies.
These are representative of the Future Factors that could cause a difference
between an actual outcome and a forward-looking statement.
16
COMMERCIAL NATIONAL FINANCIAL CORPORATION
PART II. OTHER INFORMATION
Item 4 Submission of Matters to a Vote of Security Holders
None
ITEM 6 EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
31.1 Certification of Chief Executive Officer
31.2 Certification of Chief Financial Officer
32 Certification of Chief Executive Officer and Chief
Financial Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
(b) Report on Form 8-K
Current report on Form 8-K dated July 30, 2003 filed
with the Security and Exchange Commission on July 31,
2003 announcing second quarter earnings.
Current report on Form 8-K dated August 22, 2003
filed with the Security and Exchange Commission on
September 4, 2003 announcing third quarter dividend.
17
COMMERCIAL NATIONAL FINANCIAL CORPORATION
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.
Commercial National Financial Corporation
(Registrant)
/s/ Jeffrey S. Barker
Date: November 14, 2003 ------------------------------------------
Jeffrey S. Barker
President and Chief Executive Officer
Date: November 14, 2003 /s/ Patrick G. Duffy
------------------------------------------
Patrick G. Duffy
Executive Vice President and Chief Financial
Officer
18
10-Q EXHIBIT INDEX
EXHIBIT NO. DESCRIPTION
EX-31.1 Certification of Chief Executive Officer
EX-31.2 Certification of Chief Financial Officer
EX-32 Certification of Chief Executive Officer and Chief Financial
Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002