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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
Securities and Exchange Act of 1934
For the quarterly period ended September 30, 2004, 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 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 [ ]
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.
Class Outstanding at October 22, 2004
----- -------------------------------
Common Stock 4,097,777
No Par Value
INDEX
PART I FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of September 30, 2004 (unaudited) and
December 31, 2003 (Page 3)
Consolidated Statements of Income and Other Comprehensive Income
(unaudited) for the three and nine months ended September 30, 2004
and September 30, 2003 (Page 4)
Consolidated Statements of Changes in Shareholders' Equity
(unaudited) for the nine months ended September 30, 2004 and
September 30, 2003 (Page 5)
Consolidated Statements of Cash Flows (unaudited) for the nine months ended
September 30, 2004 and September 30, 2003 (Page 6)
Notes to Consolidated Financial Statements (unaudited) (Page 7-9)
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Page 10-13)
Item 3. Quantitative and Qualitative Disclosures about Market Risk (Page 13-15)
Item 4. Controls and Procedures (Page 15)
PART II OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Item 6. Exhibits (Page 17)
SIGNATURES (Page 18)
COMMERCIAL NATIONAL FINANCIAL CORPORATION
ITEM 1: FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS
September 30, December 31,
2004 2003
------------- -------------
(Unaudited)
ASSETS
Cash and due from $ 4,580,199 $ 6,113,498
Federal funds sold 2,392 644,807
Other interest bearing deposits 2,016,425 1,961,444
------------- -------------
Total cash and cash equivalents 6,599,016 8,719,749
Securities available for sale 21,007,131 23,029,107
Securities held to maturity (fair value $2,104,242-
September 30, 2004; $3,171,283-December 31, 2003) 2,038,706 3,047,763
Federal Home Loan Bank stock, at cost 1,910,000 1,710,700
Gross loans receivable 204,698,389 194,389,682
Allowance for loan losses (2,437,117) (1,970,309)
------------- -------------
Net loans 202,261,272 192,419,373
Bank owned life insurance 3,975,503 3,736,505
Premises and equipment, net 3,904,713 3,933,347
Accrued interest receivable and other assets 2,163,169 3,191,703
------------- -------------
Total assets $ 243,859,510 $ 239,788,247
============= =============
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities
Deposits
Non-interest bearing demand $ 22,896,009 $ 23,203,653
Interest-bearing demand 27,337,102 29,141,354
Savings 61,523,479 62,028,217
Time 54,245,693 55,191,313
------------- -------------
Total deposits 166,002,283 169,564,537
Securities sold under agreements to repurchase 13,526,736 11,766,630
Other short-term borrowings 379,164 412,389
Federal Home Loan Bank advances 37,284,786 32,104,222
Accrued expenses and other liabilities 1,730,012 1,657,642
------------- -------------
Total liabilities 218,922,981 215,505,420
Shareholders' equity
Common stock and paid-in-capital, no par value: 5,000,000 shares
Authorized; shares issued and outstanding September 30, 2004-
4,083,278 and December 31, 2003-4,052,480 24,450,290 24,117,375
Accumulated earnings/(deficit) 339,136 (112,306)
Accumulated other comprehensive income, net of tax 147,103 277,758
------------- -------------
Total shareholders' equity 24,936,529 24,282,827
------------- -------------
Total liabilities and shareholders' equity $ 243,859,510 $ 239,788,247
============= =============
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,
2004 2003 2004 2003
Interest and dividend income
Loans, including fees $ 3,335,239 $ 3,283,747 $ 9,424,155 $ 9,503,415
Taxable securities 126,081 176,486 420,255 539,648
Nontaxable securities 72,938 90,415 240,417 297,219
Federal funds sold 10,575 10,207 30,038 77,236
Federal Home loan Bank stock dividends 19,647 19,741 60,462 64,099
Interest on other deposits 3,116 2,315 6,664 12,730
----------- ----------- ------------ ------------
Total interest and dividend income 3,567,596 3,582,911 10,181,991 10,494,347
Interest expense
Deposits 523,900 560,532 1,618,149 1,901,464
Securities sold under agreements to repurchase 43,977 33,731 102,882 119,167
Federal Home Loan Bank advances 374,577 379,753 1,079,587 1,178,106
Other 784 640 1,910 2,059
----------- ----------- ------------ ------------
Total interest expense 943,238 974,656 2,802,528 3,200,796
Net interest income 2,624,358 2,608,255 7,379,463 7,293,551
Provision for loan losses 90,000 431,000 270,000 1,781,000
----------- ----------- ------------ ------------
Net interest income after provision for loan losses 2,534,358 2,177,255 7,109,463 5,512,551
Noninterest income
Service charges and fees 119,936 124,365 337,573 358,774
Net gain on loan sales 72,165 238,554 175,364 779,685
Receivable financing fees 31,751 36,840 126,437 121,266
Other 118,467 372,182 403,791 476,285
----------- ----------- ------------ ------------
Total noninterest income 342,319 771,941 1,043,165 1,736,010
----------- ----------- ------------ ------------
Noninterest expense
Salaries and employee benefits 985,373 961,804 2,948,386 2,795,473
Occupancy and equipment 329,062 292,474 997,780 914,967
FDIC insurance 6,260 7,245 19,189 21,429
Printing, postage and supplies 51,417 67,639 181,955 205,570
Professional and outside services 90,893 118,053 266,269 310,312
Other 334,119 321,545 919,052 837,860
----------- ----------- ------------ ------------
Total non-interest expense 1,797,124 1,768,760 5,332,631 5,085,611
----------- ----------- ------------ ------------
Income before income tax expense 1,079,553 1,180,436 2,819,997 2,162,950
Income tax expense 318,000 362,000 819,000 576,000
----------- ----------- ------------ ------------
Net income $ 761,553 $ 818,436 $ 2,000,997 $ 1,586,950
=========== =========== ============ ============
Net change in unrealized gains on securities available
for sale $ 136,849 $ (265,940) $ (197,962) $ (185,751)
Tax effects (46,529) 90,419 67,307 63,155
----------- ----------- ------------ ------------
Total comprehensive income $ 851,873 $ 642,915 $ 1,870,342 $ 1,464,354
=========== =========== ============ ============
Per share information
Basic earnings $ .19 $ .20 $ .49 $ .39
Diluted earnings $ .19 $ .20 $ .49 $ .39
Dividends declared $ .12 $ .13 $ .38 $ .40
See accompanying notes
4
COMMERCIAL NATIONAL FINANCIAL CORPORATION
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
Nine Months Ended September 30, 2004 and September 30, 2003 (Unaudited)
Accumulated
Shares Common Retained Other
Issued Stock and Earnings/ Comprehensive Total
and Paid in (Accumulated Income/(Loss), Shareholder'
Outstanding Capital Deficit) Net of Tax Equity
----------- ------------- ------------- -------------- -------------
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 effect 63,155 63,155
-------------
Total comprehensive income 1,464,354
Cash dividends declared, $.40 per share (1,608,845) (1,608,845)
Issued under dividend reinvestment plan 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
========= ============= ============= ============== =============
Accumulated
Shares Common Retained Other
Issued Stock and Earnings/ Comprehensive Total
and Paid in (Accumulated Income/(Loss), Shareholder'
Outstanding Capital Deficit) Net of Tax Equity
----------- ------------- ------------- -------------- -------------
Balance at January 1, 2004 4,052,480 $ 24,117,375 $ (112,306) $ 277,758 $ 24,282,827
Comprehensive income:
Net income 2,000,997 2,000,997
Net change in unrealized gains/(losses) on
securities available for sale (197,962) (197,962)
Tax effect 67,307 67,307
-------------
Total comprehensive income 1,870,342
Cash dividends declared, $.38 per share (1,549,555) (1,549,555)
Issued under dividend reinvestment plan 49,947 556,794 556,794
Issued under stock option plans 1,700 11,050 11,050
Issued under employee benefit plan 4,395 55,969 55,969
Repurchase and retirement of shares (25,244) (290,898) (290,898)
--------- ------------- ------------- -------------- -------------
Balance at September 30, 2004 4,083,278 $ 24,450,290 $ 339,136 $ 147,103 $ 24,936,529
========= ============= ============= ============== =============
See accompanying notes
5
COMMERCIAL NATIONAL FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
Nine Months Ended
September 30,
2004 2003
------------ ------------
Cash flows from operating activities
Net income $ 2,000,997 $ 1,586,950
Adjustments to reconcile net income to net cash from operating activities
Provision for loan losses 270,000 1,781,000
Net gains on loan sales (175,364) (779,685)
Originations of loans held for sale (7,117,622) (31,849,988)
Proceeds from sales of loans held for sale 7,292,986 32,629,673
Net (gain) loss on sale of other real estate and repossessed assets 4,436 (258,619)
Stock dividends paid on Federal Home Loan Bank stock (60,300) (42,500)
Bank owned life insurance (134,002) (129,015)
Depreciation, amortization and accretion 567,732 522,945
Net change in accrued interest receivable and other assets 876,268 (346,128)
Net change in accrued expenses and other liabilities 149,722 272,405
------------ ------------
Net cash from operating activities 3,674,853 3,387,038
Cash flow from investing activities
Purchases of securities available for sale (9,640,185) (15,779,027)
Purchases of Federal Home Loan Bank stock (139,000) -
Proceeds from maturities of securities available for sale 11,292,744 12,612,198
Proceeds from maturities of securities held to maturity 1,005,000 1,530,000
Net change in loans (10,111,899) (7,136,830)
Purchases of premises and equipment (363,586) (602,131)
Proceeds from sale of other real estate and repossessed activities 110,141 1,768,812
------------ ------------
Net cash from investing activities (7,846,785) (7,606,978)
Cash flow from financing activities
Net change in deposits (3,562,254) (474,459)
Net change in securities sold under agreements to repurchase 1,760,106 (149,391)
Net change in U.S. treasury demand notes (33,225) (326,036)
Proceeds from Federal Home Loan Bank advances 16,000,000 3,000,000
Repayment of Federal Home Loan Bank advances (10,819,436) (5,915,396)
Repurchase and retirement of shares of common stock (290,898) (197,484)
Dividends paid (1,626,907) (1,602,977)
Proceeds from sale of common stock and fractional shares paid 623,813 678,332
------------ ------------
Net cash from financing activities 2,051,199 (4,987,411)
------------ ------------
Net change in cash and cash equivalents (2,120,733) (9,207,351)
Cash and cash equivalents, at beginning of period 8,719,749 19,269,814
------------ ------------
Cash and cash equivalents, at end of period $ 6,599,016 $ 10,062,463
============ ============
Cash paid during the period for
Interest $ 2,826,112 $ 3,247,715
Federal income taxes $ 20,000 $ 684,000
See accompanying notes
6
COMMERCIAL NATIONAL FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
Note 1-Summary of Significant Accounting Policies
Basis of 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 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, 2004 and December 31, 2003 and the
results of its operations for the three and nine months ending September 30,
2004 and September 30, 2003. The results for the three and nine months ended
September 30, 2004 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. There
were no grants for the period ending September 30, 2004. 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, 2004 September 30, 2003 September 30, 2004 September 30, 2003
------------------ ------------------ ------------------ -----------------
Net income as reported $ 761,553 $ 818,436 $ 2,000,997 $ 1,586,950
Stock-based compensation expense (9,622) (34,860) (41,644) (88,221)
------------- ------------- ------------- -------------
Proforma net income/(loss) $ 751,931 $ 783,576 $ 1,959,353 $ 1,498,729
============= ============= ============= =============
Basic earnings per share as reported $ .19 $ .20 $ .49 $ .39
Proforma basic earnings per share $ .18 $ .20 $ .48 $ .39
Diluted earnings per share as reported $ .19 $ .20 $ .49 $ .39
Proforma diluted earnings per share $ .18 $ .19 $ .48 $ .37
The pro forma effects are computed using option pricing models, using the
following weighted-average assumptions as of the grant date. There were no
grants for the period ending September 30, 2004.
Quarter to Date Year to Date
September 30, 2003 September 30, 2003
------------------ ------------------
Risk-free interest rate 3.57% 3.57%
Expected option life 10.00 10.00
Expected stock price volatility 21.10 21.10
Dividend yield 4.31% 4.31%
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.
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 162,438 and 99,248 shares of common
stock were not considered in computing diluted earnings per share for the three
and nine month periods in 2003 and 2004 because they were antidilutive.
8
COMMERCIAL NATIONAL FINANCIAL CORPORATION
Three Months Ended Nine Months Ended
SEPTEMBER 30, September 30, SEPTEMBER 30, September 30,
2004 2003 2004 2003
------------- ------------- ------------- -------------
BASIC EARNINGS PER SHARE:
Net income available to common shareholders $ 761,553 $ 818,436 $2,000,997 $1,586,950
Weighted-average common shares outstanding for
basic earnings per share 4,083,126 4,025,517 4,080,976 4,025,517
---------- ---------- ---------- ----------
BASIC EARNINGS PER SHARE $ .19 $ .20 $ .49 $ .39
========== ========== ========== ==========
DILUTED EARNINGS PER SHARE:
Net income available to common shareholders $ 761,553 $ 818,436 $2,000,997 $1,586,950
Weighted-average common shares outstanding for basic
earnings per share 4,083,126 4,025,517 4,080,976 4,025,517
Add:
Dilutive effect of assumed exercise of stock options 32,399 44,432 38,670 44,432
---------- ---------- ---------- ----------
Weighted-average common and dilutive additional potential
common shares outstanding 4,115,525 4,069,949 4,119,646 4,069,949
---------- ---------- ---------- ----------
DILUTED EARNINGS PER SHARE $ .19 $ .20 $ .49 $ .39
========== ========== ========== ==========
9
COMMERCIAL NATIONAL FINANCIAL CORPORATION
ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FINANCIAL CONDITION
Summary
Total assets ended the quarter at $243.8 million compared to $239.8 million at
December 31, 2003. Management classifies the economic environment as having weak
business loan demand offset by an active residential real estate market. The
residential real estate refinancing activity has been significantly reduced as
interest rates moved higher, however, the Bank has achieved some success in
originating mortgages for home buyers.
Loan totals increased $10.3 million primarily as a result of growth in the
residential real estate loan portfolio. The business loan portfolio has
decreased $4.2 million since December 31, 2003 while the residential real estate
portfolio has increased $13.7 million. The increase in residential real estate
loans was achieved through the origination of non-saleable mortgage loans and a
decision by management to retain in portfolio up to 50% of saleable residential
real estate loans. As discussed later, management closely monitors the interest
rate risk exposure resulting from retaining greater levels of fixed rate assets.
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: $14.8 million in available FHLB advances based on
available collateral and $9 million in short term federal funds lines of credit
with correspondent banks and the Federal Reserve. In addition, CNFC has secured
a $5 million line of credit with a correspondent bank. The stock of Commercial
Bank secures the line of credit. The interest rate on the line of credit is
equal to the prime interest rate at September 30, 2004 of 4.75%.
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, 2004 CNFC has identified $1.3 million of loans as non-accrual.
This compares to $825,000 at December 31, 2003. All non-accrual loans are
considered impaired. The specific allowance for loan loss allocated to non
accrual loans is $442,000 at September 30, 2004 and $189,000 at December 31,
2003. The balance in repossessed assets and other real estate at September 30,
2004 represents one residential real estate property which management believes
will not result in material loss.
10
COMMERCIAL NATIONAL FINANCIAL CORPORATION
September 30, 2004 December 31, 2003
------------------ -----------------
Total loans $204,698,389 $194,389,682
Non-accrual loans $ 1,269,345 $ 825,129
Accruing loans past due 90 days or more 123,385 -
Restructured Loans (non accrual) - -
------------ ------------
Total non-performing loans 1,392,730 825,129
Repossessed assets and other real estate 17,034 598,011
------------ ------------
Total non-performing assets $ 1,409,764 $ 1,423,140
============ ============
Total non-performing loans as a
percentage of total loans .68% .42%
============ ============
Allowance for loan loss as a percentage of
non-performing loans 174.99% 238.78%
============ ============
Total non-performing assets as a percentage of
total assets .58% .59%
============ ============
Allowance for Loan Loss Summary of Activity
Nine Months Ended Year Ended Nine Months Ended
September 30, 2004 December 31, 2003 September 30, 2003
------------------ ----------------- ------------------
Beginning balance $ 1,970,309 $ 2,783,234 $ 2,783,234
Loan charge-offs (103,800) (3,120,283) (1,958,580)
Loan recoveries 300,608 406,358 104,851
------------- ------------- -------------
Net loan recoveries/(charge-offs) 196,808 (2,713,925) (1,853,729)
Provision for loan losses 270,000 1,901,000 1,781,000
------------- ------------- -------------
Ending balance $ 2,437,117 $ 1,970,309 $ 2,710,505
============= ============= =============
Average loan balance $ 196,741,000 $ 184,693,000 $ 182,867,000
Net (charge-offs)/recoveries
as a percentage of average loans 0.10% (1.47)% (1.01)%
Allowance for loan loss
as a percentage of total loans 1.19% 1.01% 1.44%
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. At September 30, 2004 $189.5 million or 92.6%
of loan balances are considered to be non-classified.
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. At September 30,
2004 $9.0 million was classified as watch loans. Business loans represents $7.2
million or 80.0% of the watch loan balances. Seven-million or 97.2% of the watch
business loans were current at September 30, 2004.
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. At September 30, 2004 substandard-not impaired
balances totaled $1.8 million. All payments on loans in this category are
current.
A specific reserve is calculated for each loan identified as impaired, however,
the total allowance is available for any loan. At September 30, 2004, $4.3
million was classified as substandard-impaired. Of the $4.3 million, $1.3
million is on non-accrual status, the remaining balances are less than 60 days
past due. Total specific reserves allocated to those loans are $962,000 at
September 30, 2004.
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
2004 2003 Regulations Adequacy Purposes
------------- ------------ ------------------------ -----------------
Total capital to
risk weighted assets 15.0% 14.4% 10.0% 8.0%
Tier 1 capital to
risk weighted assets 13.7% 13.3% 6.0% 4.0%
Tier 1 capital to
average assets 10.1% 10.2% 5.0% 4.0%
RESULTS OF OPERATIONS
Summary
Net income for the quarter ended September 30, 2004 was $762,000, a decrease of
$56,000 compared to the same period in 2003. The primary factors that affected
the decrease in net income are a $341,000 decrease in the provision for loan
losses offset by a $166,000 decrease in gain on residential mortgage loan sales
and $254,000 decrease in other income.
Net income for the nine months ended September 30, 2004 was $2,001,000, an
increase of $414,000 compared to the same period in 2003. The primary factors
affecting the increase in net income are a $1,511,000 decrease in the provision
for loan losses offset by a $693,000 decrease in non-interest income. Improving
loan quality resulted in the decrease in the provision for loan losses. A
$604,000 decrease in the net gain on sale of loans was the primary cause for the
reduced non-interest income.
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, 2004 and
2003.
12
COMMERCIAL NATIONAL FINANCIAL CORPORATION
Three Months Ending September 30, Nine Months Ending September 30,
2004 2003 2004 2003
------------ ------------ ------------ ------------
Interest income (tax equivalent) $ 3,647,399 $ 3,680,352 $ 10,465,506 $ 10,817,188
Interest expense 943,238 974,656 2,802,528 3,200,796
------------ ------------ ------------ ------------
Net interest income $ 2,704,161 $ 2,705,696 $ 7,662,978 $ 7,616,392
============ ============ ============ ============
Average balances
Interest-earning assets $231,349,246 $221,588,374 $226,265,092 $225,288,866
Interest-bearing liabilities 195,724,084 188,077,797 193,035,283 193,547,969
------------ ------------ ------------ ------------
Net differential $ 35,625,162 $ 33,510,577 $ 33,229,809 $ 31,740,897
============ ============ ============ ============
Average Yields/Rates (annualized)
Yield on earning assets 6.25% 6.59% 6.12% 6.46%
Rate paid on liabilities 1.91% 2.06% 1.91% 2.23%
------------ ------------ ------------ ------------
Interest spread 4.34% 4.53% 4.21% 4.23%
============ ============ ============ ============
Net interest margin 4.64% 4.84% 4.48% 4.55%
============ ============ ============ ============
The following table quantifies the effect on net interest income of changes in
the volume of assets and liabilities and the change in yields and cost of funds
for the three and nine months ended September 30, 2004.
Three Months Ending Nine Months Ending
September 30, 2004 September 30, 2004
Balance Rate Inc/(Dec) Balance Rate Inc/(Dec)
-------- --------- -------- -------- --------- ---------
Interest Earning
Assets $213,239 $(246,192) $(32,953) $538,051 $(889,733) $(351,682)
Interest Bearing
Liabilities 95,530 126,948) (31,418) 157,666 (555,934) (398,268)
-------- --------- -------- -------- --------- ---------
Net Interest
Income $117,709 $(119,244) $ (1,535) $380,385 $(333,799) $ 46,586
======== ========= ======== ======== ========= =========
In general, interest rates have trended upward during the first nine months of
2004, as economic data supported a strengthening economy. The Federal Reserve
Open Market Committee has increased the Federal Funds rate by 75 basis points
since June 30, 2004. In the short run, margin increased from 4.45% for the
quarter ending June 30, 2004 to 4.64% for the quarter ending September 30, 2004.
The decrease in net interest income for the quarter ending September 30, 2004
compared to the same period in 2003 was primarily caused by a decrease in margin
offset by an increase in average earning assets. The yield on earning assets
continued to decrease, however, management was not able to lower funding costs
accordingly.
The factors affecting the $47,000 increase in tax equivalent net interest income
for the nine months ending September 30, 2004 are similar to those described
above for the three months ending September 30, 2004. The Bank experienced a
decrease in margin offset by an increase in average earning assets.
Noninterest Income
Noninterest income for the three months ending September 30, 2004 was $342,000.
This represents a $430,000 or 55.7% decrease over the same period in 2003.
The decrease in the net gain on loan sales of $167,000 compared to the same
period in 2003 contributed substantially to the overall decrease. Rising
interest rates eliminated the incentive for residential real estate customers to
refinance existing loans. Also, management has elected to portfolio up to 50% of
the new loan originations that are saleable to the secondary market.
13
COMMERCIAL NATIONAL FINANCIAL CORPORATION
Other non-interest income decreased $254,000 compared to the same period in
2003. During the third quarter of 2003, management recorded a gain on sale of
other real estate of $250,000.
The factors affecting the $693,000 decrease in noninterest income for the nine
months ending September 30, 2004 are similar to those described above for the
three months ending September 30, 2004, except for the following. Year to date
other non-interest income decreased $72,000. As rates increased, the average
life of the residential real estate mortgage loan portfolio has extended. This
resulted in an increase in the value of mortgage servicing rights. During the
second quarter of 2004, CNFC recorded a recovery of $132,000 in the value of
mortgage servicing rights previously expensed to a valuation allowance.
Noninterest Expense
Noninterest expense for the three months ending September 30, 2004 totaled
$1,797,000. This represents a $28,000 or 1.6% increase over the same period in
2003.
Salary and benefit expense for the three months ending September 30, 2004
totaled $985,000 compared to $962,000 for the same period in 2003, an increase
of $23,000 or 2.4%. The increase represents normal merit increases in salary,
and normal increases in related benefit expense.
Professional fees for the quarter ending September 30, 2004 totaled $91,000
compared to $118,000 for the same period in 2003. This represents a $27,000 or
22.9% decrease. Included in the 2003 totals was $18,000 in employment search
fees. The search fees for 2004 are $0.
The factors affecting the $247,000 increase in noninterest expense for the nine
months ending September 30, 2004 are similar to those described above for the
three months ending September 30, 2004. Further explanations are detailed below.
Year to date occupancy expense increased $83,000 or 9.1% compared to the same
period in 2003. The 2004 expense includes full year to date operating costs
associated with our new Mt. Pleasant location.
Year to date professional fees are $44,000 less than professional fees for the
same period in 2003. During the nine months ended September 30, 2003 the Bank
paid $43,000 in executive search fees. The Bank has spent $0 in search fees
through September 30, 2004.
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.
14
COMMERCIAL NATIONAL FINANCIAL CORPORATION
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.
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
certificates 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 cash flows associated with CNFC's assets and liabilities. 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
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 monthly.
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 implemented
a new interest rate risk model during the first quarter of 2004. In addition to
the 200 basis point immediate and parallel shift in interest rates, management
performs additional projections using other interest rate environments, asset
growth assumptions and funding strategies. The results listed below for December
31, 2003 were obtained using the Bank's prior model.
The Table below summarizes the effect a 200 basis point immediate and parallel
shift of the yield curve has on net income. 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 and potentially lower net income. A 200 basis point
immediate and parallel decrease in interest rates is extremely unlikely.
In an environment where interest rates increased 200 basis points in an
immediate and parallel shift in the yield curve, management projects that net
income will increase during the next 12 months. The difference in September 30,
2004 projected net income compared to December 31, 2003 is primarily due to the
change in the interest rate risk model used by management. Management believes
that the new model more accurately predicts the repricing opportunities and cash
flows comprising the balance sheet at September 30, 2004.
Projected Percentage Change in Net Income
September, 2004 December 31, 2003
--------------- -----------------
- -200 basis points (16.0%) .3%
0 basis points 0.0 0.0
+200 basis points 3.6% (35.0%)
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 the end of the period covered by
this Form 10-Q quarterly report. Based on their evaluation, they have
concluded that the Corporation's disclosure controls and procedures were
effective as of September 30, 2004.
(b) Changes in internal controls - The Corporation also conducted an
evaluation of internal control over financial reporting to determine
whether any changes occurred during the quarter ended September 30, 2004,
that have materially affected, or are reasonably likely to materially
affect, the Corporation's internal control over financial reporting. Based
on this evaluation, there has been no such change during the quarter that
ended September 30, 2004.
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.
PART II. OTHER INFORMATION
ITEM 2 UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The following table shows information relating to the repurchase of shares of
Commercial National Financial Corporation common stock for the three months
ended September 30, 2004:
Total Number Maximum
of Shares Number
Purchased as of Shares
Part of Publicly That May Yet be
Total Number Average Announced Purchased Under
of Shares Price Paid Plans or the Plans or
Purchased Per Share Programs(1) Programs(1)
------------ ---------- ---------------- ---------------
July 1-31 10,018 11.25 10,018 61,888
August 1-31 304 11.25 304 61,584
September 1-30 - - - 61,584
------ -------- ------ ------
Total 10,322 $ 11.25 10,322 61,584
====== ======== ====== ======
- ----------
(1) A stock repurchase program was established during 1998. The board of
directors of Commercial National Financial Corporation has authorized the
repurchase of up to 383,340 shares. The repurchase program has no expiration
date.
16
COMMERCIAL NATIONAL FINANCIAL CORPORATION
ITEM 6 EXHIBITS
Exhibits:
Exhibit 31.1 Certification of Chief Executive Officer required by
Rule 13a-14(a).
Exhibit 31.2 Certification of Chief Financial Officer required by
Rule 13a-14(a).
Exhibit 32.1 Certification pursuant to 18 U.S.C. Section 1350 of
Chief Executive Officer.
Exhibit 32.2 Certification pursuant to 18 U.S.C. Section 1350 of
Chief Financial Officer.
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)
Date: November 5, 2004 /s/ Jeffrey S. Barker
____________________________________________
Jeffrey S. Barker
President and Chief Executive Officer
Date: November 5, 2004 /s/ Patrick G. Duffy
____________________________________________
Patrick G. Duffy
Executive Vice President and Chief Financial
Officer
18
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION
- ------- --------------------------------------------------------------------
31.1 Certification of Chief Executive Officer required by Rule 13a-14(a).
31.2 Certification of Chief Financial Officer required by Rule 13a-14(a).
32.1 Certification pursuant to 18 U.S.C. Section 1350 of Chief Executive
Officer.
32.2 Certification pursuant to 18 U.S.C. Section 1350 of Chief Financial
Officer.
19