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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended September 30, 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 NUMBER: 0-49771
MERCHANTS BANCORP, INC.
(Exact name of registrant as specified in its charter)
Ohio 31-1467303
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
100 North High Street, Hillsboro, Ohio 45133
(Address of principal executive offices) (Zip Code)
(937) 393-1993
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act.) Yes [ ] No [X]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Common stock -- 2,666,650 shares outstanding at November 14, 2004
PART I -- FINANCIAL INFORMATION
ITEM 1. CONDENSED FINANCIAL STATEMENTS
The accompanying information has not been audited by a registered independent
public accounting firm; however, in the opinion of management such information
reflects all adjustments necessary for a fair presentation of the results for
the interim period. All such adjustments are of a normal and recurring nature.
The accompanying financial statements are presented in accordance with the
requirements of Form 10-Q and consequently do not include all of the disclosures
normally required by accounting principles generally accepted in the United
States of America or those made in the Registrant's Form 10-K. Accordingly, the
reader of the Form 10-Q should refer to the Registrant's Form 10-K for the year
ended December 31, 2003 for further information in this regard.
2
MERCHANTS BANCORP, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, 2004 AND DECEMBER 31, 2003 (IN THOUSANDS EXCEPT SHARE DATA)
SEPTEMBER 30, DECEMBER 31,
2004 2003
ASSETS (UNAUDITED)
CASH AND CASH EQUIVALENTS:
Cash and due from banks $ 11,970 $ 13,770
Federal funds sold 8,475 8,625
--------- ---------
Total cash and cash equivalents 20,445 22,395
--------- ---------
SECURITIES AVAILABLE FOR SALE
(amortized cost of $33,326 and $31,835 respectively) 34,517 33,085
--------- ---------
LOANS 299,669 288,624
Less allowance for loan losses (2,517) (2,432)
--------- ---------
Net loans 297,152 286,192
--------- ---------
OTHER ASSETS:
Bank premises and equipment, net 3,706 3,844
Accrued interest receivable 2,962 3,112
Deferred income tax 282 262
Other 4,635 3,531
--------- ---------
Total other assets 11,585 10,749
--------- ---------
TOTAL $ 363,699 $ 352,421
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES:
Deposits:
Noninterest bearing $ 29,846 $ 31,693
Interest bearing 256,713 238,739
--------- ---------
Total deposits 286,559 270,432
--------- ---------
Repurchase agreements 3,534 2,784
FHLB borrowings 40,966 43,706
Other liabilities 1,882 7,272
--------- ---------
Total liabilities 332,941 324,194
--------- ---------
SHAREHOLDERS' EQUITY:
Common stock - no par value; 4,500,000 shares authorized and 3,000,000 shares
issued, outstanding shares of 2,666,650 and
2,945,000 at September 30, 2004 and December 31, 2003, respectively 2,000 2,000
Additional paid-in capital 2,000 2,000
Retained earnings 33,141 30,571
Accumulated other comprehensive income 617 656
Treasury Stock, at cost, 333,350 shares and 55,000 shares at
September 30, 2004 and December 31, 2003, respectively (7,000) (7,000)
--------- ---------
Total shareholders' equity 30,758 28,227
--------- ---------
TOTAL $ 363,699 $ 352,421
========= =========
See notes to condensed consolidated financial statements.
3
MERCHANTS BANCORP, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS EXCEPT PER SHARE DATA)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------- ----------------------
2004 2003 2004 2003
(UNAUDITED) (UNAUDITED)
INTEREST INCOME:
Interest and fees on loans $ 4,761 $ 4,804 $ 14,146 $ 14,266
Interest and dividends on securities:
Taxable 181 154 451 547
Exempt from income taxes 239 258 726 757
Interest on federal funds sold and other short-term investments 33 21 101 123
-------- -------- -------- --------
Total interest income 5,214 5,237 15,424 15,693
-------- -------- -------- --------
INTEREST EXPENSE:
Interest on deposits 1,320 1,245 3,698 3,972
Interest on repurchase agreements and federal funds purchased 24 20 76 72
Interest on FHLB borrowings 428 402 1,308 994
-------- -------- -------- --------
Total interest expense 1,772 1,667 5,082 5,038
-------- -------- -------- --------
NET INTEREST INCOME 3,442 3,570 10,342 10,655
PROVISION FOR LOAN LOSSES (160) (1,785) (494) (2,451)
-------- -------- -------- --------
NET INTEREST INCOME AFTER PROVISION
FOR LOAN LOSSES 3,282 1,785 9,848 8,204
-------- -------- -------- --------
NONINTEREST INCOME - Service charges and fees 396 384 1,176 1,125
-------- -------- -------- --------
NONINTEREST EXPENSE:
Salaries and employee benefits 980 747 3,028 2,778
Occupancy 251 309 770 926
Legal and professional services 155 115 411 333
Franchise tax 88 52 215 196
Data processing 84 60 237 227
Advertising 71 70 211 160
Other 363 312 1,120 936
-------- -------- -------- --------
Total noninterest expense 1,992 1,665 5,992 5,556
-------- -------- -------- --------
INCOME BEFORE INCOME TAXES 1,686 504 5,032 3,773
INCOME TAXES (498) (19) (1,555) (1,060)
-------- -------- -------- --------
NET INCOME $ 1,188 $ 485 $ 3,477 $ 2,713
======== ======== ======== ========
BASIC AND DILUTED EARNINGS PER SHARE $ 0.45 $ 0.16 $ 1.30 $ 0.90
======== ======== ======== ========
See notes to condensed consolidated financial statements.
4
MERCHANTS BANCORP, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003 (IN THOUSANDS)
2004 2003
(UNAUDITED)
OPERATING ACTIVITIES:
Net income $ 3,477 $ 2,713
Adjustments to reconcile net income to net cash provided by (used in)
operating activities:
Depreciation and amortization 416 661
Provision for loan losses 494 2,451
Gain on sale of mortgage loans (159) (148)
Proceeds from sale of mortgage loans 14,860 11,159
Mortgage loans originated for sale (14,701) (11,011)
Changes in assets and liabilities:
Accrued interest receivable 150 (710)
Other assets (1,104) (758)
Accrued interest, taxes and other liabilities (5,390) (654)
-------- --------
Net cash provided by (used in) operating activities (1,957) 3,703
-------- --------
INVESTING ACTIVITIES:
Proceeds from sales and maturities of securities available for sale 8,068 9,554
Purchases of securities available for sale (9,594) (2,830)
Net increase in loans (11,454) (40,101)
Capital expenditures (244) (203)
-------- --------
Net cash used in investing activities (13,224) (33,580)
-------- --------
FINANCING ACTIVITIES:
Net increase in deposits 16,127 9,816
Net increase in repurchase agreements 750 (677)
FHLB borrowings 27,250
FHLB payments (2,740) (702)
Dividends paid to stockholders (906) (960)
Stock repurchase (1,155)
-------- --------
Net cash provided by financing activities 13,231 33,572
-------- --------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (1,950) 3,695
CASH AND CASH EQUIVALENTS:
Beginning of year 22,395 22,202
-------- --------
End of period $ 20,445 $ 25,897
======== ========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the period for federal income taxes $ 1,160 $ 1,800
======== ========
Cash paid during the period for interest $ 5,043 $ 5,071
======== ========
See notes to condensed consolidated financial statements.
5
MERCHANTS BANCORP, INC. AND SUBSIDIARY
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003
1. SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING POLICIES
The unaudited condensed consolidated financial statements include the
accounts of Merchants Bancorp, Inc. and its wholly-owned subsidiary,
Merchants National Bank (collectively, the "Company"). All significant
intercompany balances and transactions have been eliminated in
consolidation.
In the opinion of management, these condensed consolidated financial
statements include all adjustments (which consist of normal recurring
accruals) necessary to present the condensed consolidated financial
position as of September 30, 2004, the results of operations for the
three and nine months ended September 30, 2004 and 2003, and of cash
flows for the nine-months ended September 30, 2004 and 2003. These
condensed consolidated financial statements have been prepared in
accordance with instructions to Form 10-Q, and therefore do not include
all information and footnote disclosures necessary for a fair
presentation of financial position, results of operations and cash flows
in conformity with accounting principles generally accepted in the United
States of America. Financial information as of December 31, 2003 has been
derived from the audited consolidated financial statements of Merchants
Bancorp, Inc. and subsidiary. The results of operations for the three and
nine months ended September 30, 2004 and 2003 and cash flows for the nine
months ended September 30, 2004 and 2003 are not necessarily indicative
of the results to be expected for the full year. For further information,
refer to the consolidated financial statements and footnotes thereto for
the year ended December 31, 2003, included in the Company's Form 10-K.
Earnings per Share -- Basic earnings per share is computed using the
weighted average number of shares of common stock outstanding during the
period. For the three and nine months ended September 30, 2004 the
Company had 2,666,650 and 2,627,721 weighted average shares outstanding,
respectively. For the three and nine months ended September 30, 2003 the
Company had 2,985,054 shares and 2,994,963 weighted average shares
outstanding, respectively. There were no common stock equivalents or
potentially diluted securities outstanding during the respective periods.
2. NEW ACCOUNTING PRONOUNCEMENTS
In March 2004, the Securities and Exchange Commission staff released
Staff Accounting Bulletin (SAB) No. 105, "Application of Accounting
Principles to Loan Commitments." This SAB disallows the inclusion of
expected future cash flows related to the servicing of a loan in the
determination of the fair value of a loan commitment. Further, no other
internally developed intangible asset should be recorded as part of the
loan commitment derivative. Recognition of intangible assets would only
be appropriate in a third-party transaction, such as a purchase of a loan
commitment or in a business combination. The SAB is effective for all
loan commitments entered into after March 31, 2004, but does not require
retroactive adoption for loan commitments entered into, on or before
March 31, 2004. Adoption of this SAB did not have a material effect on
the Company's Condensed Consolidated Financial Statements.
In March 2004, the Emerging Issues Task Force ("EITF") reached a
consensus on Issue 03-1, "The Meaning of Other-Than-Temporary Impairment
and Its Application to Certain Investments." The EITF reached a consensus
on an other-than temporary impairment model for debt and equity
securities accounted for under SFAS No. 115, "Accounting for Certain
Investments in Debt and Equity Securities," and cost method
6
investments. The basic model developed to evaluate whether an investment
within the scope of Issue 03-1 is other-than temporarily impaired
involves a three-step process including, determining whether an
investment is impaired (fair value less than cost), evaluating whether
the impairment is other-than-temporary and, if other-than-temporary,
requiring recognition of an impairment loss equal to the difference
between the investment's cost and its fair value. In September 2004, the
FASB issued Staff Position ("FSP") No. EITF 03-01-1, "Effective Date of
Paragraphs 10-20 of EITF Issue No. 03-01." This FSP delays the effective
date of the measurement and recognition guidance contained in paragraphs
10-20 of Issue 03-01. The amount of any other-than-temporary impairment
that may need to be recognized in the future will be dependent on market
conditions, the occurrence of certain events or changes in circumstances
relative to an investee, the Company's intent and ability to hold the
impaired investments at the time of valuation and measurement and
recognition guidance defined in a future FSP issuance.
In May 2004, FASB issued FSP No. 106-2, "Accounting and Disclosure
Requirements Related to the Medicare Prescription Drug, Improvement and
Modernization Act of 2003." This FSP provides guidance on accounting for
the effects of the Medicare prescription drug legislation by employers
whose prescriptions drug benefits are actuarially equivalent to the drug
benefit under Medicare Part D, and the subsidy is expected to offset or
reduce the Company's costs for prescription drug coverage. The FSP is
effective for the first interim period beginning after June 15, 2004. The
FS also provides guidance for disclosures concerning the effect of the
subsidy for employers when the employer has not yet determined actuarial
equivalency. The adoption of this FSP did not have a material impact on
the Company's financial condition or results of operations.
In December 2003, the Accounting Standards Executive Committee of the
American Institute of Certified Public Accountants issued Statement of
Position ("SOP") 03-3, "Accounting for Certain Loans and Debt Securities
Acquired in a Transfer." SOP 03-3 addresses the accounting for acquired
loans that show evidence of having deteriorated in terms of credit
quality since their origination (i.e. impaired loans). SOP 03-3 prohibits
the carryover of an allowance for loan loss on certain acquired loans as
credit losses are considered in the future cash flows assessment. SOP
03-3 is effective for loans that are acquired in fiscal years beginning
after December 15, 2004. The Company does not anticipate this Statement
will have a material effect on the Condensed Consolidated Financial
Statements.
3. LOANS
Major classifications of loans are summarized as follows (in thousands):
SEPTEMBER DECEMBER 31,
2004 2003
(unaudited)
Commercial real estate $ 62,685 $ 60,833
Commercial and industrial 26,434 25,165
Agricultural 44,121 40,362
Residential real estate 137,567 131,656
Installment 26,136 27,827
Other 2,726 2,781
--------- ---------
Total 299,669 288,624
Less allowance for loan losses (2,517) (2,432)
--------- ---------
$ 297,152 $ 286,192
========= =========
4. FHLB BORROWINGS
All stock in the Federal Home Loan Bank ("FHLB") and qualifying first
mortgage residential loans are pledged as collateral on FHLB borrowings.
Interest rates of advances from the FHLB at September 30, 2004
are as follows (in thousands):
7
MATURITY INTEREST
YEAR RATE AMOUNT
2008 4.78%-5.39% $ 4,000
2010 6.26% 3,000
2011 5.23% 170
2012 4.64% 10,000
2013 2.82%-3.13% 1,973
2018 2.95%-4.04% 8,455
2023 3.02%-4.24% 13,368
-----------
Total $ 40,966
===========
The maximum amount available to the Company under FHLB borrowings was
approximately $77.6 million and $78.0 million as of September 30, 2004
and December 31, 2003, respectively.
5. OTHER COMPREHENSIVE INCOME
The following details the components of comprehensive income:
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------- -------------
2004 2003 2004 2003
Net Income $ 1,188 $ 485 $ 3,477 $ 2,713
Net change in unrealized gains
(losses) on available for sale
securities arising during the period,
net of tax 363 (417) (39) (177)
------- ------- ------- -------
Comprehensive income (loss) $ 1,551 $ 68 $ 3,438 $ 2,536
======= ======= ======= =======
6. TREASURY STOCK
On August 28, 2003, the Company entered into a stock redemption agreement
with three shareholders. Under the terms of the agreement, the redemption
occurred over two separate dates. The first settlement was for $1,155,000
for 55,000 shares and occurred on September 5, 2003. The second
settlement was for $5,845,349 for 278,350 shares and occurred on January
5, 2004.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
Merchants Bancorp, Inc. (the "Company") is a bank holding company and sole
shareholder of Merchants National Bank (the "Bank"), headquartered in Hillsboro,
Ohio. At September 30, 2004, the Company had total assets of approximately
$363.7 million and total shareholders' equity of approximately $30.7 million.
8
The Company, through its banking affiliate, offers a broad range of banking
services to the commercial, industrial and consumer market segments which it
serves. The primary business of the Bank consists of accepting deposits through
various consumer and commercial deposit products, and using such deposits to
fund various loan products. The Bank's primary loan products are as follows: (1)
loans secured by residential real estate, including loans for the purchase of
one to four family residences which are secured by 1st and 2nd mortgages and
home equity loans; (2) consumer loans, including new and used automobile loans,
loans for the purchase of mobile homes and debt consolidation loans; (3)
agricultural loans, including loans for the purchase of real estate used in
connection with agricultural purposes, operating loans and loans for the
purchase of equipment; and (4) commercial loans, including loans for the
purchase of real estate used in connection with office or retail activities,
loans for the purchase of equipment and loans for the purchase of inventory.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires the appropriate
application of certain accounting policies, many of which require us to make
estimates and assumptions about future events and their impact on amounts
reported in our financial statements and related notes. Since future events and
their impact cannot be determined with certainty, the actual results will
inevitably differ from our estimates. Such differences could be material to the
financial statements.
The Company believes the application of accounting policies and the estimates
required therein are reasonable. These accounting policies and estimates are
constantly reevaluated, and adjustments are made when facts and circumstances
dictate a change. Historically, the Company has found its application of
accounting policies to be appropriate, and actual results have not differed
materially from those determined using necessary estimates.
The Company's accounting policies are more fully described in Note 1 to the
condensed consolidated financial statements.
Management believes that the determination of the allowance for loan losses
represents a critical accounting policy. The Company maintains an allowance for
loan losses to absorb probable loan losses inherent in the portfolio. The
allowance for loan losses is maintained at a level management considers to be
adequate to absorb probable loan losses inherent in the portfolio, based on
evaluations of the collectibility and historical loss experience of loans.
Credit losses are charged and recoveries are credited to the allowance.
Provisions for loan losses are based on management's review of the historical
loan loss experience and such factors which, in management's judgment, deserve
consideration under existing economic conditions in estimating probable credit
losses. The allowance is based on ongoing assessments of the probable estimated
losses inherent in the loan portfolio. The Company's methodology for assessing
the appropriate allowance level consists of several key elements, as described
below.
Larger commercial loans that exhibit probable or observed credit weaknesses are
subject to individual review. Where appropriate, reserves are allocated to
individual loans based on management's estimate of the borrower's ability to
repay the loan given the availability of collateral, other sources of cash flow
and available legal options. Included in the review of individual loans are
those that are impaired as provided in Statement of Financial Accounting
Standards No. 114, "Accounting by Creditors for Impairment of a Loan," as
amended. Any specific reserves for impaired loans are measured based on the fair
value of the underlying collateral. The Company evaluates the collectibility of
both principal and interest when assessing the need for a specific reserve.
Historical loss rates are applied to other commercial loans not subject to
specific reserve allocations.
Homogenous loans, such as consumer installment and residential mortgage loans,
are not individually reviewed by management. Reserves are established for each
pool of loans based on the expected net charge-offs. Loss rates are based on the
average five-year net charge-off history by loan category.
9
Historical loss rates for commercial and consumer loans may be adjusted for
significant factors that, in management's judgment, reflect the impact of any
current conditions on loss recognition. Factors which management considers in
the analysis include the effects of the local economy, trends in the nature and
volume of loans (delinquencies, charge-offs, nonaccrual and problem loans),
changes in the internal lending policies and credit standards, collection
practices, and examination results from bank regulatory agencies and the
Company's internal credit review function.
An unallocated reserve is maintained to recognize the imprecision in estimating
and measuring loss when evaluating reserves for individual loans or pools of
loans.
Specific reserves on individual loans and historical loss rates are reviewed
throughout the year and adjusted as necessary based on changing borrower and/or
collateral conditions and actual collection and charge-off experience.
The Company has not substantively changed any aspect of its overall approach in
the determination of the allowance for loan losses since January 1, 2004. There
have been no material changes in assumptions or estimation techniques as
compared to prior years that impacted the determination of the current year
allowance.
COMPARISON OF OPERATING RESULTS FOR THE THREE MONTHS ENDED SEPTEMBER, 2004 AND
2003
The Company reported net income of $1,188,000 and $485,000 for the three months
ended September 30, 2004 and 2003, respectively. During the same periods, basic
and diluted earnings per share were $.45 and $.16, respectively. On an
annualized basis, return on average assets was 1.32% and return on average
equity was 15.94% for the three months ended September 30, 2004, compared to
..57% and 5.93%, respectively, for the comparable period in 2003. The large
increase in the return on average equity is partially due to a treasury stock
transaction which occurred in August, 2003 and resulted in a capital reduction
of approximately $7,000,000 and partially due to the chargeoff of $1.5 million
that occurred in third quarter 2003 that did not occur in 2004.
Net interest income for the three months ended September 30, 2004, was
$3,442,000, a decrease of $128,000, or 3.6%, compared to net interest income of
$3,570,000 for the comparable period in 2003. Net interest margin was 4.1% for
the three months ended September 30, 2004, compared to 4.4% for the comparable
period in 2003. The average annualized yield on earning assets decreased to 6.2%
for the three months ended September 30, 2004, from 6.5% for the comparable
period in 2003. The average cost of interest-bearing funds was 2.38% for the
three months ended September 30, 2004, a decrease from 2.4% for the comparable
period in 2003. Management attributes the decrease in net interest margin to the
recording of lower yielding 1-4 family loans and to loans continuing to reprice
downward. Higher yielding loans have continued to be paid off throughout the
last few years or refinance at a lower rate. The prime rate increased 75 basis
points in the third quarter. However, portions of the bank's loan portfolio that
are tied to prime may not be affected until the beginning of the fourth quarter
of 2004 or the first quarter of 2005, depending on the repricing feature of the
loans. As a result, the loan portfolio has substantially lower yielding loans
than one year ago. Additionally, while loan rates continue to reprice or
refinance downward, deposits have little room for downward repricing. For these
reasons the net interest margin continues to fall.
The provision for loan losses was $160,000 and $1,785,000 for the three months
ended September 30, 2004 and 2003, respectively. Net charge-offs for the three
months ended September 30, 2004 were $135,000, compared to $1,706,000
experienced during the three months ended September 30, 2003. Management
increased the provision for loan losses during the three month period ending
September 30, 2003 to reflect the increased estimate of probable loan losses in
2003, primarily related to a certain commercial borrower, which was identified
by management on July 23, 2003. The Company assessed the collateral situation
and believed the collateral to be inadequate. In July 2003, the Company provided
$1.5 million against the loan loss reserve relating to this credit loss. In July
2003, the company charged off $1.5 million against the loan loss reserve
relating to this credit loss. Upon further review of the borrower's loans, the
company estimated additional loss potential and made an additional allowance in
the loan loss reserve for $80,000 in September 2003.
Total noninterest income was $396,000 for the three months ended September 30,
2004, an increase of $12,000, or 3.1%, from $384,000 for the comparable period
in 2003. The increase is due to an overall increase in the noninterest income
accounts.
10
Total noninterest expense was $1,992,000 for the three months ended September
30, 2004, an increase of $327,000, or 19.6%, from $1,665,000 for the comparable
period in 2003. It is typically expected for non-interest expense to increase
5-10% each year. The increase is significantly more in 2004 partially due to the
increase in bonus accrual. The bonus paid to employees is based on the average
return on equity of the company. Because of the large credit loss in 2003, the
income and return on equity was significantly less resulting in a lower bonus
expense during 2003. Salaries and benefits expense comprises the largest
component of noninterest expense, with totals of $980,000 and $747,000 for the
three months ended September 30, 2004 and 2003, respectively.
COMPARISON OF OPERATING RESULTS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004 AND
2003
The Company reported net income of $3,477,000 and $2,713,000 for the nine months
ended September 30, 2004 and 2003, respectively. During each of the same
periods, basic and diluted earnings per share were $1.30 and $.90, respectively.
On an annualized basis, return on average assets was 1.30% and return on average
equity was 15.86% for the nine months ended September 30, 2004, compared to
1.08% and 10.83%, respectively, for the comparable period in 2003. The large
increase in the return on average equity is partially due to a treasury stock
transaction which occurred in August, 2003 and resulted in capital reduction of
approximately $7,000,000 and partially due to the chargeoff of $1.5 million that
occurred in third quarter 2003 that did not occur in 2004.
Net interest income for the nine months ended September 30, 2004, was
$10,342,000, a decrease of $313,000, or 2.94%, compared to net interest income
of $10,655,000 for the comparable period in 2003. Net interest margin was 4.06%
for the nine months ended September 30, 2004, compared to 4.45% for the
comparable period in 2003. The average annualized yield on earning assets
decreased to 6.06% for the nine months ended September 30, 2004, from 6.55% for
the comparable period in 2003. The average cost of interest-bearing funds was
2.30% for the nine months ended September 30, 2004, a decrease from 2.48% for
the comparable period in 2003. Management attributes the decrease in net
interest margin to the recording of lower yielding 1-4 family loans and to loans
continuing to reprice downward. Higher yielding loans have continued to be paid
off throughout the last few years or refinance at a lower rate. The prime rate
increased 75 basis points in the third quarter. However, portions of the bank's
loan portfolio that are tied to prime may not be affected until the beginning of
the fourth quarter of 2004 or the first quarter of 2005, depending on the
repricing feature of the loans. As a result, the loan portfolio has
substantially lower yielding loans than one year ago. Additionally, while loan
rates continue to reprice or refinance downward, deposits have little room for
downward repricing. For these reasons the net interest margin continues to fall.
The provision for loan losses was $494,000 and $2,451,000 for the nine months
ended September 30, 2004 and 2003, respectively, representing a decrease of
79.8%. Net charge-offs for the nine months ended September 30, 2004 were
$409,000, compared to $2,183,000 experienced during the nine months ended
September 30, 2003. Management increased the provision for loan losses during
the nine month period ending September 30, 2003 to reflect the increased
estimate of probable loan losses in 2003, that primarily related to a certain
commercial borrower. The borrower was identified by management in July 2003.
Upon review of the borrower and collateral position, the bank believed the
collateral to be inadequate and made a provision for $1.5 million in July 2003
to cover estimated losses. The company charged off $1.5 million of the credit in
September 2003 with additional allowances of $80,000 made to the loan loss
reserve.
The remaining charge offs in the first nine months of 2003 were primarily within
the agricultural portfolio which were identified by management. Management has
conducted a review of its agricultural lending approval process and made
modifications where necessary to strengthen its underwriting process of
agricultural operating loans. Management believes its review process has
adequately identified probable loans within its portfolio on a timely basis. The
loan loss provision is significantly less in 2004 than in 2003 because the
conditions and potential losses in the loan portfolio have improved considerably
from 2003.
Total noninterest income was $1,176,000 for the nine months ended September 30,
2004, an increase of $51,000, or 4.53%, from $1,125,000 for the comparable
period in 2003. The increase is due to an overall increase in the noninterest
income accounts.
11
Total noninterest expense was $5,992,000 for the nine months ended September 30,
2003, an increase of $436,000, or 7.9%, from $5,556,000 for the comparable
period in 2003. Salaries and benefits expense comprises the largest component of
noninterest expense, with totals of $3,028,000 and $2,778,000 for the nine
months ended September 30, 2004 and 2003, respectively. The increase in salaries
and benefits is significantly more in 2004 mainly due to the increase in bonus
accrual. The bonus paid to employees is based on the average return on equity of
the company. Because of the large credit loss in 2003, the income and return on
equity was significantly less. Therefore the bonus accrual was much less than an
average year in 2003.
FINANCIAL CONDITION
The Company's total assets increased to $363.7 million as of September 30, 2004
from $352.4 million as of December 31, 2003, an increase of 3.2%. The largest
change in the balance sheet is an increase in the loan balances. Loans grew by
$11 million with the other assets only changing slightly.
LOANS AND ALLOWANCE FOR LOAN LOSSES
The Company reported total loans of $299.7 million as of September 30, 2004 and
$288.6 million as of December 31, 2003, an increase of $11.0 million, or 3.83%.
The portfolio composition has remained consistent during the period.
Federal regulations and generally accepted accounting principles require that
the Company establish prudent allowances for loan losses. The Company maintains
an allowance for loan losses to absorb probable loan losses inherent in the
portfolio, based on evaluations of the collectibility and historical loss
experience of loans. Loan losses are charged and recoveries are credited to the
allowance. Provisions for loan losses are based on management's review of the
historical loan loss experience and such factors which, in management's
judgment, deserve consideration under existing economic conditions in estimating
probable loan losses. The allowance is based on ongoing assessments of the
probable estimated losses inherent in the loan portfolio. The Company has not
substantively changed any aspect of its overall approach in the determination of
the allowance for loan losses during 2004. There have been no material changes
in assumptions or estimation techniques as compared to prior years that impacted
the determination of the current year allowance.
The allowance for loan losses was 0.84% of total loans as of September 30, 2004
and December 31, 2003.
The amount of nonaccrual loans decreased to $535,000 as of September 30, 2004,
compared to $735,000 as of June 30, 2004, and $1,462,000 at December 31, 2003.
As a percentage of total loans, nonaccrual loans represented 0.18% as of
September 30, 2004, 0.25% as of June 30, 2004, and 0.51% as of December 31,
2003. The decrease in non accrual loans from year end is mainly due to the
transfer of loan balances of $574,000 to Other Real Estate Owned ("OREO") and
the remaining difference was either charged-off or liquidated.
The category of accruing loans which are past due 90 days or more was $720,000
as of September 30, 2004, $843,000 as of June 30, 2004, and $1,441,000 as of
December 31, 2003. As a percentage of total loans, loans past due 90 days and
still accruing interest represented .24% as of September 30, 2004, 0.29% as of
June 30, 2004, and 0.51% as of December 31, 2003. The decrease of $721,000 from
December 2003 is primarily made up of three loans totaling $545,000. One loan
with a balance of $155,000 was moved to OREO and the bank is in the liquidation
process. The other two loans have been restructured and the borrowers are
current on their payments. Management believes the underlying collateral of the
loans is sufficient to cover the borrowings if liquidation would become
necessary.
As a percentage of the allowance for loan losses, total nonaccrual loans and
loans past due 90 days or more were 49.9% as of September 30, 2004, 63.3% as of
June 30, 2004, and 119.5% as of December 31, 2003.
12
DEPOSITS
Deposits totaled $286.5 million as of September 30, 2004, an increase of $16.1
million, or 6.0%, from $270.4 million as of December 31, 2003. Certificate of
deposits grew $14.0 million. Super now accounts have grown $3.3 million while
savings account balances grew $2.7 million. The other deposit areas decreased
slightly.
FHLB BORROWINGS
Federal Home Loan Bank borrowings decreased $2.7 million to $41.0 million as of
September 30, 2004 from $43.7 million as of December 31, 2003. The decrease in
borrowings was primarily a result of principal loan payments made on the
borrowings.
LIQUIDITY AND CAPITAL RESOURCES
The declaration and payment of dividends by the Company are subject to the
discretion of the Board of Directors and to the earnings and financial condition
of the Company and applicable laws and regulations. The Company paid $906,661
and $960,000 in dividends during the nine months ended September 30, 2004 and
2003, respectively.
At September 30, 2004, consolidated Tier 1 risk based capital was 11.12%, and
total risk-based capital was 12.05%. The minimum Tier 1 and total risk-based
capital ratios required by the Board of Governors of the Federal Reserve are 4%
and 8%, respectively.
National banking laws restrict the maximum amount of dividends that a bank may
pay in any calendar year. Dividends are limited tot he Bank's retained profits
(as defined by the Office of the Comptroller of the Currency) for that year and
the two preceding years. During 2003 and as a result of tax planning efforts,
the Bank made a special dividend totaling $8,000,000. As a result, the Bank
exceeded the amount of retained earnings available for cash dividends and must
obtain approval from the Office of the Comptroller of the Currency for
additional future dividends.
Effective liquidity management ensures that the cash flow requirements of
depositors and borrowers, as well as company cash needs, are met. The Company
manages liquidity on both the asset and liability sides of the balance sheet.
Community bank liquidity management currently involves the challenge of
attracting deposits while maintaining positive loan growth at a reasonable
interest rate spread. The loan to deposit ratio at September 30, 2004 was 104.6%
compared to 106.7% as of December 31, 2003. Loans to total assets were 82.4% at
September 30, 2004 compared to 81.9% at the end of 2003. The securities
portfolio is available for sale and consists of securities that are readily
marketable. Approximately 87.8% of the available for sale portfolio is pledged
to secure public deposits, short-term and long-term borrowings and for other
purposes as required by law. The balance of the available for sale securities
could be sold if necessary for liquidity purposes. Also, a stable deposit base,
consisting of 88% core deposits, makes the Company less susceptible to large
fluctuations in funding needs. The Company also has both short- and long-term
borrowings capacity available through FHLB with unused available credit of
approximately $25.1 million as of September 30, 2004. The Company has the
ability to obtain deposits in the brokered certificate of deposit market to help
provide liquidity to fund loan growth, if necessary. Generally, the Company uses
short-term borrowings to fund overnight and short-term funding needs in the
Company's balance sheet. Longer-term borrowings have been primarily used to fund
mortgage-loan originations. This has occurred when FHLB longer-term rates are a
more economical source of funding than traditional deposit gathering activities.
Additionally, the Company occasionally uses FHLB borrowings to fund larger
commercial loans.
As of September 30, 2004, management is not aware of any current recommendations
by banking regulatory authorities which, if they were to be implemented, would
have, or would be reasonably likely to have, a material adverse impact on the
Company's liquidity, capital resources, or operations.
13
CONTRACTUAL OBLIGATION AND COMMERCIAL COMMITMENTS
The Company has certain obligations and commitments to make future payments
under contracts. At September 30, 2004, the aggregate contractual obligations
and commercial commitments are:
Contractual Obligations Payments Due by Period
($ in thousands) Less than 1-3 3-5 After 5
Total One Year Years Years Years
- ------------------------------------------------------------------------------------------------------------------------------------
Total Deposits $286,559 $261,554 $ 17,362 $ 7,631 $ 12
FHLB Borrowings 40,966 3,454 5,699 8,374 23,439
Repurchase Agreements 3,534 3,534 0 0 0
-------- -------- -------- -------- --------
Total $331,059 $268,542 $ 23,061 $ 16,005 $ 23,451
Other Commercial Commitments Payments Due by Period
($ in thousands) Less than 1-3 3-5 After 5
Total One Year Years Years Years
- ------------------------------------------------------------------------------------------------------------------------------------
Commitments to Extend Credit $25,482 $10,620 $ 2,983 $ 1,597 $10,282
------- ------- ------- ------- -------
Total $25,482 $10,620 $ 2,983 $ 1,597 $10,282
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of loss arising from adverse changes in the fair value
of financial instruments due to variations in interest rates, exchange rates,
equity price risk and commodity prices. The Company does not maintain a trading
account for any class of financial instrument, and is not currently subject to
currency exchange rate risk, equity price risk or commodity price risk. The
Company's market risk is composed primarily of interest rate risk.
The major source of the Company's interest rate risk is the difference in the
maturity and repricing characteristics between the Company's core banking assets
and liabilities -- loans and deposits. This difference, or mismatch, poses a
risk to net interest income. Most significantly, the Company's core banking
assets and liabilities are mismatched with respect to repricing frequency,
maturity and/or index. Most of the Company's commercial loans, for example,
reprice rapidly in response to changes in short-term interest rates. In
contrast, many of the Company's consumer deposits reprice slowly, if at all, in
response to changes in market interest rates.
The Asset/Liability Committee is responsible for reviewing the interest rate
sensitivity position of the Company and establishing policies to monitor and
limit exposure to interest rate risk. The guidelines established by
Asset/Liability Committee are approved by the Company's Board of Directors. The
primary goal of the asset/liability management function is to maximize net
interest income within the interest rate risk limits set by approved guidelines.
Techniques used include simulation modeling that measures the effect of rate
changes on net interest income and market value of equity under different rate
scenarios.
In the Company's simulation models, each asset and liability balance is
projected over a time horizon. Net interest income is then projected based on
expected cash flows and projected interest rates under a stable rate scenario
and analyzed. The results of this analysis are factored into decisions made
concerning pricing strategies for loan and deposits, balance sheet mix,
securities portfolio strategies, liquidity and capital adequacy.
Simulation models are also performed under an instantaneous parallel 200 basis
point increase or decrease in interest rates. The model includes assumptions as
to repricing and expected prepayments, anticipated calls, and expected decay
rates of transaction accounts under the different rate scenarios. The results of
these simulations include changes in both net interest income and market value
of equity.
14
The Company's rate shock simulation models provide results in extreme interest
rate environments and results are used accordingly. Reacting to changes in
economic conditions, interest rates and market forces, the Company has
been able to alter the mix of short and long-term loans and investments, and
increase or decrease the emphasis on fixed and variable rate products in
response to changing market conditions. By managing the interest rate
sensitivity of its asset composition in this manner, the Company has been able
to maintain a fairly stable flow of net interest income.
Complicating management's efforts to control non-trading exposure to interest
rate risk is the fundamental uncertainty of the maturity, repricing, and/or
runoff characteristics of some of the Company's core banking assets and
liabilities. This uncertainty often reflects options embedded in these financial
instruments. The most important embedded options are contained in consumer
deposits and loans.
For example, many of the Company's interest bearing retail deposit products
(e.g., interest checking, savings and money market deposits) have no contractual
maturity. Customers have the right to withdraw funds from these deposit accounts
freely. Deposit balances may therefore run off unexpectedly due to changes in
competitive or market conditions. To forestall such runoff, rates on interest
bearing deposits may have to be increased more (or reduced less) than expected.
Such repricing may not be highly correlated with the repricing of prime
rate-based or U.S. Treasury-based loans. Finally, balances that leave the
banking franchise may have to be replaced with other more expensive retail or
wholesale deposits. Given the uncertainties surrounding deposit runoff and
repricing, the interest rate sensitivity of core bank liabilities cannot be
determined precisely.
Management believes as of September 30, 2004, there have been no material
changes in the Company's interest rate sensitive instruments which would cause a
material change in the market risk exposures which affect the quantitative and
qualitative risk disclosures as presented in the Company's Form 10-K filed for
the period ended December 31, 2003.
15
ITEM 4. CONTROLS AND PROCEDURES
The Company carried out an evaluation, under the supervision and with the
participation of the Company's management, including the Company's President and
Principal Financial Officer, of the effectiveness of the design and operation of
the Company's disclosure controls and procedures as of September 30, 2004,
pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Chief
Executive Officer and Chief Financial Officer concluded that the Company's
disclosure controls and procedures were effective as of September 30, 2004, in
timely alerting them to material information relating to the Company (including
its consolidated subsidiaries) required to be included in the Company's periodic
SEC filings.
There was no change in the Company's internal control over financial reporting
that occurred during the Company's fiscal quarter ended September 30, 2004, that
has materially affected, or is reasonably likely to materially affect, the
Company's internal control over financial reporting.
FORWARD-LOOKING STATEMENTS
Certain of the statements contained herein that are not historical facts are
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act. Economic circumstances, the Company's operation and the
Company's actual results could differ significantly from those discussed in the
forward-looking statements. Forward-looking statements are typically identified
by words or phrases such as "believe," "expect," "anticipate," "intend,"
"estimate," "may increase," "may fluctuate," and similar expressions or future
or conditional verbs such as "will," "should," "would" and "could." These
forward-looking statements involve risks and uncertainties including, but not
limited to, economic conditions, portfolio growth, the credit performance of the
portfolios, including bankruptcies, and seasonal factors; changes in general
economic conditions including the performance of financial markets, the prices
of crops, prevailing inflation and interest rates, and losses on lending
activities; results of various investment activities; the effects of
competitors' pricing policies, of changes in laws and regulations on competition
and of demographic changes on target market populations' savings and financial
planning needs; industry changes in information technology systems on which we
are dependent; and the resolution of legal proceedings and related matters. In
addition, the policies and regulations of the various regulatory authorities
could affect the Company's results. These statements are representative only on
the date hereof, and the Company undertakes no obligation to update any
forward-looking statements made.
PART II -- OTHER INFORMATION
ITEM 6. EXHIBITS.
(A) EXHIBITS - The following exhibits are filed as a part of this report:
Exhibit No. Exhibit
3.1 Articles of Incorporation of Merchants Bancorp, Inc. filed as
Exhibit (3)(I) to the Form 10 filed with SEC on April 30, 2002
and incorporated herein by reference.
3.2 Code of Regulations filed as Exhibit (3)(II) to the Form 10
filed with the SEC on April 30, 2002 and incorporated herein by
reference.
4. Instruments Defining the Rights of Security Holders. (See
Exhibit 3.1 and 3.2)
31 Rule 13a-14(a) Certification
32 Section 1350 Certification
16
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
MERCHANTS BANCORP, INC.
Date: November 13, 2004 By: /s/ Paul W. Pence, Jr.
Paul W. Pence, Jr., President and
Principal Financial Officer
17
EXHIBIT INDEX
Exhibit No. Exhibit
3.1 Articles of Incorporation of Merchants Bancorp, Inc. filed as
Exhibit (3)(I) to the Form 10 filed with SEC on April 30, 2002
and incorporated herein by reference.
3.2 Code of Regulations filed as Exhibit (3)(II) to the Form 10 filed
with the SEC on April 30, 2002 and incorporated herein by
reference.
4. Instruments Defining the Rights of Security Holders. (See
Exhibit 3.1 and 3.2)
31 Rule 13a-14(a) Certification
32 Section 1350 Certification
18