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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended JUNE 30, 2004
[ ] TRANSITION REPORT PURSUANT TO 13 or 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the transition period from ____________ to ____________
Commission file number 000-25287
TOWER FINANCIAL CORPORATION
- --------------------------------------------------------------------------------
(Exact name of Registrant as specified in its charter)
INDIANA 35-2051170
------- ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
116 East Berry Street, Fort Wayne, Indiana 46802
(Address of principal executive offices)
(260) 427-7000
- --------------------------------------------------------------------------------
(Registrant's telephone number)
Indicate by check whether the Registrant (1) filed all reports required to
be filed by Section 13 or 15(d) of the 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 whether the Registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [ X ]
Number of shares of the issuer's common stock, without par value, outstanding
as of July 30, 2004: 3,944,394.
1
INDEX
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements page no.
Consolidated Condensed Balance Sheets at
June 30, 2004 (unaudited) and December 31, 2003 .............................. 3
Consolidated Condensed Statements of Operations for the three and
six months ended June 30, 2004 and June 30, 2003 (unaudited) ................. 4
Consolidated Condensed Statements of Comprehensive Income for the three
and six months ended June 30, 2004 and June 30, 2003 (unaudited) ............. 5
Consolidated Condensed Statements of Changes in Stockholders' Equity for
the six months ended June 30, 2004 and June 30, 2003 (unaudited) ............. 6
Consolidated Condensed Statements of Cash Flows for the six months ended
June 30, 2004 and June 30, 2003 (unaudited) .................................. 7
Notes to Consolidated Condensed Financial Statements.......................... 8
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations......................................................... 10
Item 3. Quantitative and Qualitative Disclosures About Market Risk.................... 19
Item 4. Controls and Procedures....................................................... 21
PART II. OTHER INFORMATION
Item 1. Legal Proceedings............................................................. 22
Item 4. Submission of Matters to a Vote of Security Holders........................... 22
Item 6. Exhibits and Reports on Form 8-K.............................................. 22
SIGNATURES.......................................................................................... 23
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
TOWER FINANCIAL CORPORATION
CONSOLIDATED CONDENSED BALANCE SHEETS
At June 30, 2004 and December 31, 2003
(unaudited)
JUNE 30, DECEMBER 31,
2004 2003
- ----------------------------------------------------------------------------------------------------------
ASSETS
Cash and due from banks $ 14,148,278 $ 12,708,817
Short-term investments and interest-earning deposits 10,261,047 4,017,755
Federal funds sold 19,742,266 11,115,643
------------- -------------
Total cash and cash equivalents 44,151,591 27,842,215
Securities available for sale, at fair value 40,169,535 24,324,935
FHLB and FRB stock 2,361,700 2,332,500
Loans 381,689,715 376,838,578
Allowance for loan losses (5,180,796) (5,259,273)
------------- -------------
Net loans 376,508,919 371,579,305
Premises and equipment, net 3,195,711 2,932,580
Accrued interest receivable 1,604,843 1,289,370
Other assets 5,623,444 6,168,085
------------- -------------
Total assets $ 473,615,743 $ 436,468,990
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Deposits:
Noninterest-bearing $ 61,381,105 $ 62,638,230
Interest-bearing 338,830,655 300,238,538
------------- -------------
Total deposits 400,211,760 362,876,768
Short-term borrowings 200,000 1,060,000
Federal Home Loan Bank (FHLB) advances 27,000,000 27,000,000
Junior subordinated debt 3,608,000 3,608,000
Accrued interest payable 446,734 278,964
Other liabilities 883,268 736,609
------------- -------------
Total liabilities 432,349,762 395,560,341
STOCKHOLDERS' EQUITY
Preferred stock, no par value, 4,000,000 shares authorized;
no shares issued and outstanding
Common stock and paid-in-capital, no par value, 6,000,000
shares authorized; 3,944,394 shares issued and outstanding
at June 30, 2004 and 3,942,519 shares issued and
outstanding at December 31, 2003 37,347,861 37,322,694
Retained earnings 4,495,718 3,560,844
Accumulated other comprehensive income (loss), net of tax of
$(385,065) at June 30, 2004 and $16,741 at December 31, 2003 (577,598) 25,111
------------- -------------
Total stockholders' equity 41,265,981 40,908,649
------------- -------------
Total liabilities and stockholders' equity $ 473,615,743 $ 436,468,990
============= =============
The following notes are an integral part of the financial statements.
3
TOWER FINANCIAL CORPORATION
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
For the three and six months ended June 30, 2004 and 2003
(unaudited) (unaudited)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------- -------------------------
2004 2003 2004 2003
---------- ---------- ---------- ----------
INTEREST INCOME:
Loans, including fees $4,494,231 $4,268,756 $8,937,882 $8,401,182
Securities - taxable 243,623 88,347 429,984 174,176
Securities - tax exempt 124,807 24,794 214,089 41,504
Other interest income 41,979 55,663 71,907 97,639
---------- ---------- ---------- ----------
Total interest income 4,904,640 4,437,560 9,653,862 8,714,501
INTEREST EXPENSE:
Deposits 1,356,259 1,359,442 2,587,479 2,690,188
Short-term borrowings 485 26,488 4,131 29,457
FHLB advances 176,830 116,985 340,561 261,045
Junior subordinated debt 81,180 79,335 162,360 158,670
---------- ---------- ---------- ----------
Total interest expense 1,614,754 1,582,250 3,094,531 3,139,360
---------- ---------- ---------- ----------
Net interest income 3,289,886 2,855,310 6,559,331 5,575,141
PROVISION FOR LOAN LOSSES 310,000 690,000 810,000 1,535,000
---------- ---------- ---------- ----------
Net interest income after provision
for loan losses 2,979,886 2,165,310 5,749,331 4,040,141
NONINTEREST INCOME:
Trust fees 411,501 337,384 818,333 693,344
Service charges 147,520 159,508 305,879 308,795
Loan broker fees 82,651 284,291 170,415 484,936
Net gain on sale of securities 376 - 3,286 190,766
Other fees 173,940 151,101 306,509 289,880
---------- ---------- ---------- ----------
Total noninterest income 815,988 932,284 1,604,422 1,967,721
NONINTEREST EXPENSE:
Salaries and benefits 1,701,328 1,332,750 3,233,025 2,604,465
Occupancy and equipment 412,129 302,285 748,794 606,063
Marketing 111,891 158,126 300,541 211,056
Data processing 102,262 83,524 190,780 172,403
Loan and professional costs 327,355 157,426 568,102 327,083
Office supplies and postage 67,086 67,113 159,336 137,939
Courier services 78,670 68,451 149,847 136,285
Business development 78,955 65,060 154,085 146,493
Other expense 235,532 175,668 417,489 694,213
---------- ---------- ---------- ----------
Total noninterest expense 3,115,208 2,410,403 5,921,999 5,036,000
---------- ---------- ---------- ----------
INCOME BEFORE INCOME TAXES 680,666 687,191 1,431,754 971,862
Income taxes expense 226,230 257,470 496,880 356,670
---------- ---------- ---------- ----------
NET INCOME $ 454,436 $ 429,721 $ 934,874 $ 615,192
========== ========== ========== ==========
BASIC EARNINGS PER COMMON SHARE $ 0.12 $ 0.11 $ 0.24 $ 0.16
DILUTED EARNINGS PER COMMON SHARE $ 0.11 $ 0.11 $ 0.23 $ 0.15
Average common shares outstanding 3,944,394 3,932,194 3,943,953 3,931,759
Average common shares and dilutive
potential common shares outstanding 4,017,018 3,969,399 4,031,425 4,007,177
The following notes are an integral part of the financial statements
4
TOWER FINANCIAL CORPORATION
CONSOLIDATED CONDENSED STATEMENTS OF COMPREHENSIVE INCOME
For the three and six months ended June 30, 2004 and 2003
(unaudited) (unaudited)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
-------------------------------------------------------------------------
2004 2003 2004 2003
- --------------------------------------------------------------------------------------- ----------------------------------
Net income $ 454,436 $ 429,721 $ 934,874 $ 615,192
Other comprehensive income (loss):
Change in net unrealized appreciation
(depreciation) on securities available for
sale, net of tax of $(541,232) and $6,135 for
the three months ended June 30, 2004
and 2003 and $(401,806) and $(93,380) for
the six months ended June 30, 2004
and 2003. (811,849) 9,205 (602,709) (140,071)
------------------------------- ----------------------------------
COMPREHENSIVE INCOME $ (357,413) $ 438,926 $ 332,165 $ 475,121
=============================== ==================================
The following notes are an integral part of the financial statements.
5
TOWER FINANCIAL CORPORATION
CONSOLIDATED CONDENSED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
For the six months ended June 30, 2004 and 2003
(unaudited)
COMMON ACCUMULATED
STOCK AND OTHER
PAID-IN RETAINED COMPREHENSIVE
CAPITAL EARNINGS INCOME (LOSS) TOTAL
- ---------------------------------------------------------------------------------------------------------------------------------
BALANCE, JANUARY 1, 2003 $ 37,190,692 $ 1,760,778 $ 223,393 $ 39,174,863
Net income for 2003 615,192 615,192
Issuance of 1,010 shares of common
stock for stock options exercised 11,850 11,850
Change in net unrealized
appreciation (depreciation)
on securities available
for sale, net of tax of $(93,380) (140,071) (140,071)
------------------------------------------------------------------------
BALANCE, JUNE 30, 2003 $ 37,202,542 $ 2,375,970 $ 83,322 $ 39,661,834
========================================================================
BALANCE, JANUARY 1, 2004 $ 37,322,694 $ 3,560,844 $ 25,111 $ 40,908,649
Net income for 2004 934,874 934,874
Issuance of 1,875 shares of common
stock for stock options exercised 22,932 22,932
Tax benefit on non-qualified
stock options 2,235 2,235
Change in net unrealized
appreciation (depreciation)
on securities available
for sale, net of tax of $(401,806) (602,709) (602,709)
------------------------------------------------------------------------
BALANCE, JUNE 30, 2004 $ 37,347,861 $ 4,495,718 $(577,598) $ 41,265,981
========================================================================
The following notes are an integral part of the financial statements.
6
TOWER FINANCIAL CORPORATION
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
For the six months ended June 30, 2004 and 2003
(unaudited) (unaudited)
SIX MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 2004 JUNE 30, 2003
---------------- ----------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 934,874 $ 615,192
Adjustments to reconcile net income
to net cash from operating activities:
Depreciation and amortization 342,100 281,820
Provision for loan losses 810,000 1,535,000
Earnings on life insurance (31,318) (66,968)
Net gain on sale of securities (3,286) (190,766)
FHLB stock dividend (29,200) -
Change in accrued interest receivable (315,473) (197,788)
Change in other assets 977,765 (676,555)
Change in accrued interest payable 167,770 (3,554)
Change in other liabilities 146,659 (748,914)
Origination of loans held for sale (13,897,650)
Proceeds from sales of loans held for sale 18,559,872
------------ ------------
Net cash from operating activities 2,999,891 5,209,689
CASH FLOWS FROM INVESTING ACTIVITIES:
Net change in loans (11,595,283) (34,660,928)
Purchase of securities available for sale (20,361,188) (6,023,016)
Proceeds from maturities of securities
available for sale 2,966,212 3,604,718
Proceeds from sale of securities
available for sale 501,769 3,174,780
Purchase of FHLB and FRB stock (14,200)
Purchase of life insurance (3,000,000)
Proceeds from sale of participation loans 5,855,669
Purchase of equipment and leasehold
expenditures (557,853) (230,146)
------------ ------------
Net cash from investing activities (23,190,674) (37,148,792)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net change in deposits 37,334,992 32,464,563
Net change in short-term borrowings (860,000)
Gross proceeds from issuance of common stock
from exercise of stock options and tax benefits 25,167 11,850
Proceeds from FHLB advances 13,000,000 3,500,000
Repayment of FHLB advances (13,000,000) (6,000,000)
------------ ------------
Net cash from financing activities 36,500,159 29,976,413
------------ ------------
NET CHANGE IN CASH AND CASH EQUIVALENTS 16,309,376 (1,962,690)
Cash and cash equivalents, beginning of period 27,842,215 36,168,679
------------ ------------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 44,151,591 $ 34,205,989
============ ============
Supplemental disclosures of cash flow information
Cash paid during the year for:
Interest $ 2,926,761 $ 3,142,914
Income taxes net of refund (603,665) 1,008,076
The following notes are an integral part of the financial statements.
7
TOWER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
a. ORGANIZATION: Tower Financial Corporation (the "Company") was
incorporated on July 8, 1998. The Company's wholly-owned subsidiary,
Tower Bank & Trust Company (the "Bank") opened on February 19, 1999
after receiving federal and state bank regulatory approvals to
commence its banking operations. The Company's wholly-owned special
purpose trust subsidiary, Tower Capital Trust 1 ("TCT1"), was
incorporated on November 1, 2001 for the single purpose of issuing
trust preferred securities.
b. BASIS OF PRESENTATION: The accompanying unaudited consolidated
condensed financial statements were prepared in accordance with
generally accepted accounting principles for interim periods and with
instructions for Form 10-Q and, therefore, do not include all
disclosures required by generally accepted accounting principles for
complete presentation of the Company's financial statements. In the
opinion of management, the unaudited consolidated condensed financial
statements contain all adjustments necessary to present fairly its
consolidated financial position at June 30, 2004 and its consolidated
results of operations, comprehensive income, changes in stockholders'
equity and cash flows for the six-month periods ended June 30, 2004
and June 30, 2003. The results for the period ended June 30, 2004
should not be considered as indicative of results for a full year.
These consolidated condensed financial statements should be read in
conjunction with the audited financial statements for the years ended
December 31, 2003, 2002, and 2001 and related notes included in the
Company's Annual Report on Form 10-K for the year ended December 31,
2003.
c. PRINCIPLES OF CONSOLIDATION: The accompanying consolidated condensed
financial statements include the accounts of the Company and the Bank.
All significant intercompany accounts and transactions have been
eliminated in consolidation. As was discussed in Note 8 of the 2003
annual report, a trust (TCT1) that had previously been consolidated
with the Company prior to December 31, 2003 is now reported
separately, under the caption junior subordinated debt. The effect of
no longer consolidating the trust does not significantly change the
amounts reported as the Company's assets, liabilities, equity or
interest expense.
d. 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 had an
exercise price equal to or greater than the market price of the
underlying common stock at date of grant. The following table
illustrates the effect on net income and earnings per share if expense
was measured using the fair value recognition provisions of FASB
Statement No. 123, Accounting for Stock-Based Compensation.
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
--------------------------- ---------------------------
2004 2003 2004 2003
--------------------------------------------------------------------------- ---------------------------
Net income as reported $ 454,436 $ 429,721 $ 934,874 $ 615,192
Deduct: Stock-based compensation expense
determined under fair value-based method (28,422) (38,480) (56,199) (76,961)
--------------------------- ---------------------------
Pro forma net income $ 426,014 $ 391,241 $ 878,675 $ 538,231
=========================== ===========================
Basic earnings per share as reported $ 0.12 $ 0.11 $ 0.24 $ 0.16
Pro forma basic earnings per share 0.11 0.10 0.22 0.14
Diluted earnings per share as reported 0.11 0.11 0.23 0.15
Pro forma diluted earnings per share 0.11 0.10 0.22 0.13
The pro forma effects are computed using option-pricing models,
with the following weighted average assumptions as of the date of
grant:
8
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------------- -------------------------
2004 2003 2004 2003
-------------------------------------------------------------------------------- -------------------------
Risk-free interest rate 4.47% 3.18% 4.47% 3.16%
Expected option life 8.0 years 6.0 years 8.0 years 5.6 years
Expected stock price volatility 36.88% 24.37% 36.88% 25.56%
Dividend yield None None None None
e. EFFECT OF NEWLY ISSUED BUT NOT YET EFFECTIVE ACCOUNTING STANDARDS:
There are no newly issued but not yet effective accounting standards
issued by the Financial Accounting Standard Board that would
materially affect the Company's financial position or results of
operations.
f. RECLASSIFICATIONS: Certain items from the prior period financial
statements were reclassified to conform to the current presentation.
NOTE 2 - EARNINGS PER SHARE
The following table reflects the calculation of basic and diluted earnings
per common share for the three-month and six-month periods ended June 30,
2004 and 2003. Options not considered in the calculation of diluted
earnings per common share because they were antidilutive, totaled 7,500 and
8,000 and 0 and 8,000 for the three-month and six-month periods ended June
30, 2004 and 2003 respectively.
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------- -------------------------
2004 2003 2004 2003
------------------------------------------------------------------------------------- -------------------------
BASIC
Net income $ 454,436 $ 429,721 $ 934,874 $ 615,192
------------------------- -------------------------
Weighted average common shares outstanding 3,944,394 3,932,194 3,943,953 3,931,759
------------------------- -------------------------
Basic earnings per common share $ 0.12 $ 0.11 $ 0.24 $ 0.16
DILUTED
Net income $ 454,436 $ 429,721 $ 934,874 $ 615,192
------------------------- -------------------------
Weighted average common shares outstanding 3,944,394 3,932,194 3,943,953 3,931,759
Add: dilutive effect of assumed stock option exercises 72,624 37,205 87,472 75,418
------------------------- -------------------------
Weighted average common shares and dilutive
potential common shares outstanding 4,017,018 3,969,399 4,031,425 4,007,177
------------------------- -------------------------
Diluted earnings per common share $ 0.11 $ 0.11 $ 0.23 $ 0.15
NOTE 3 - STOCK OPTION PLANS
Options to buy stock are granted to directors, officers and employees under
the 1998 and 2001 Stock Option and Incentive Plans (the "Plans"), which
together provide for issuance of up to 435,000 shares of common stock of
the Company. The exercise price of stock options granted under the Plans
may not be less than the market price at the date of grant. The maximum
option term is ten years. Option vesting occurs over various periods of
time ranging from immediate to four years.
At June 30, 2004, options for 396,353 shares were outstanding to certain
officers, employees and directors. The options were granted at the market
price on the dates of the grant in a range from $7.625 to $14.00 per share.
Of the total options outstanding, options for 323,338 shares were vested
and exercisable at June 30, 2004. During the second quarter of 2004, 7,500
options were granted at a price of $14.00 per share and 750 non-vested
options were forfeited. During the second quarter of 2003, there were 8,000
options granted at a price of $13.38 per share and 7,000 options were
forfeited.
9
NOTE 4 - CONTINGENCY LOSS
In the fourth quarter of 2002, the Company's audit results showed stale-dated
receivables existed in a mortgage operating account. Further investigation by
the Company during 2003 uncovered unauthorized mortgage loans and improper
mortgage activity in the operating account. An employee of the Company was
terminated as a result of this investigation, and management made appropriate
changes to internal controls in 2003. During 2002 and 2003, a total of
$1,393,000 in pretax special charges was recorded to address these identified
issues (excluding any professional expenses incurred to investigate, document
and support the Company's related insurance claim). The Company believes that it
has substantially completed its investigation into this matter and that it has
identified the majority of the resulting losses. The Company has filed and is
attempting to recover such losses through fidelity bond insurance and collection
efforts.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following presents management's discussion and analysis of the consolidated
financial condition of the Company as of June 30, 2004 and December 31, 2003 and
results of operations for the three-month and six-month periods ended June 30,
2004 and June 30, 2003. This discussion should be read in conjunction with the
Company's unaudited consolidated condensed financial statements and the related
notes appearing elsewhere in this report and the Company's Annual Report on Form
10-K for the year ended December 31, 2003.
FORWARD-LOOKING STATEMENTS
This report includes "forward-looking statements." All statements regarding the
Company's expected financial position, business and strategies are
forward-looking statements and the Company intends for them to be covered by the
safe harbor provisions for forward-looking statements contained in the Private
Securities Litigation Reform Act of 1995. The words "anticipates," "believes,"
"estimates," "seeks," "expects," "plans," "intends," and similar expressions, as
they relate to the Company, the Bank or its management, are intended to identify
forward-looking statements. Although the Company believes that the expectations
reflected in these forward-looking statements are reasonable and has based these
expectations on its beliefs as well as assumptions it has made, these
expectations may prove to be incorrect. Important factors that could cause
actual results to differ materially from the Company's expectations include,
without limitation, the following:
- the effect of extensive banking regulation on the Bank's ability to
grow and compete;
- the effect of changes in federal economic and monetary policies on the
Bank's ability to attract deposits, make loans and achieve
satisfactory interest spreads;
- the competitive disadvantage resulting from the Company's status as a
highly regulated, start-up company;
- the Company's dependence on key management personnel;
- the increased risk of losses due to loan defaults caused by the Bank's
commercial loan concentration;
- the Company's dependence on a favorable local economy in the Bank's
primary service area;
- the Bank's dependence on net interest spread for profitability;
- the Bank's ability to implement developments in technology to be
competitive;
- failure of a significant number of borrowers to repay their loans;
- general changes in economic conditions, including interest rates and
real estate values; and
- restrictions imposed on the Company by regulators or regulations of
the banking industry.
Readers are also directed to other risks and uncertainties discussed in other
documents filed by the Company with the Securities and Exchange Commission. The
Company undertakes no obligation to update or revise any forward-looking
information, whether as a result of new information, future developments or
otherwise.
10
CRITICAL ACCOUNTING POLICIES
A comprehensive discussion of the Company's critical accounting policies is
disclosed in our Annual Report on Form 10-K for the year ended December 31,
2003. There have been no material changes in the information regarding our
critical accounting policies since December 31, 2003.
FINANCIAL CONDITION
The Company continued to experience growth in the second quarter of 2004. Total
assets of the Company were $473.6 million at June 30, 2004 compared to total
assets at December 31, 2003 of $436.5 million. The 8.5% increase in assets was
mainly due to an increase in investments, cash and cash equivalents and loans
and was supported by a $37.3 million inflow of funds from deposit growth at the
Bank during the first six months of 2004. While assets increased during the
first six months of 2004, the rate of growth was less in the first six months of
2004 than the substantial growth experienced during most of the quarters since
the Bank began operations. The growth during previous quarters was also a result
of deposit growth at the Bank. Management believes that the smaller growth
levels reflected during the last few quarters have been a result of a lagging
local economy. As the Bank enters its sixth year of operation, the Company
anticipates that, in the near-term, assets will increase at a volume similar to
our more recent historical trends as we continue to market our institution,
products and banking expertise, deliver a high level of customer service and
develop our branch network.
Cash and Investments. Cash and cash equivalents, which include federal funds
sold, were $44.2 million at June 30, 2004, a $16.3 million, or 58.6%, increase
from $27.8 million at December 31, 2003. Securities available for sale were
$40.2 million at the end of the first six months of 2004, an increase of $15.9
million from December 31, 2003. The net increase in cash and cash equivalents
during the first six months of 2004 was reflective of the cash needs of the Bank
relative to anticipated loan growth, the purchase of investments and normal
daily liquidity activity offset by the increase in deposits during the second
quarter ended June 30, 2004. The increase in securities available for sale was a
result of planned purchases of investments to continue to diversify the earning
assets as part of our liquidity and asset and liability management strategies.
Loans. Total loans were $381.7 million at June 30, 2004 reflecting a 1.3%
increase from total loans of $376.8 million at December 31, 2003. Loan growth in
the first six months of 2004 occurred in the mortgage and commercial real estate
portfolios. The mix of the loan portfolio has not materially changed since
year-end as the total of commercial and commercial real estate loans of the
portfolio was 78.6% at June 30, 2004 and 79.2% of the portfolio at December 31,
2003. Management believes that the aggregate loan growth during the first six
months of 2004 was the result of slow local market economic conditions.
The following table summarizes the composition of the loan portfolio at the
dates indicated:
JUNE 30, 2004 DECEMBER 31, 2003
----------------------------------------------------------
BALANCE % BALANCE %
----------------------------------------------------------------------------------------------------
Commercial $ 192,450,672 50.4% $ 198,063,494 52.6%
Commercial real estate 107,506,912 28.2% 100,309,154 26.6%
Residential real estate 42,937,696 11.3% 40,648,402 10.8%
Home equity 26,513,604 7.0% 25,943,402 6.9%
Consumer 11,954,393 3.1% 11,593,808 3.1%
----------------------------------------------------------
Total loans 381,363,277 100.0% 376,558,260 100.0%
Net deferred loan costs 326,438 280,318
Allowance for loan losses (5,180,796) (5,259,273)
----------------- ------------------
Net loans $ 376,508,919 $ 371,579,305
================= ==================
Nonperforming Assets. Nonperforming assets include nonperforming loans and other
real estate owned (OREO). Nonperforming loans include loans past due over 90
days and still accruing and all nonaccrual loans. Nonperforming assets have
decreased from $2.0 million, or 0.45% of total assets, at December 31, 2003 to
$1.6 million, or 0.35% of total assets, at June 30, 2004. The decrease in
nonperforming assets was mainly attributable to $923,068 of nonperforming assets
that were restructured, worked out or charged off, offset by the carrying value
of several loans, totaling $555,384, which were recorded as nonaccrual loans
during the first six months of 2004. Additionally, the commercial OREO property
of $80,000 held at December 31, 2003 was sold during the first quarter of 2004.
Total impaired loans at June 30, 2004 were $5.2 million and included all
nonaccrual loans in addition to one commercial credit of $537,519 recorded as a
troubled debt restructuring and one commercial real estate credit of $3.4
million where the borrower has sought bankruptcy protection. At June 30, 2004,
management believes it has allocated adequate specific
11
allowances for these risks of $1.2 million. Impaired loans at December 31, 2003
were $2.2 million with specific allowances for these risks of $807,000.
The following table summarizes the Company's nonperforming assets at the dates
indicated:
JUNE 30, DECEMBER 31,
2004 2003
-------------------------------------------------------------------------------------------------
Loans past due over 90 days and still accruing $ 363,741 $ 290,375
Nonaccrual loans 1,273,332 1,614,447
-----------------------------------
Total nonperforming loans $ 1,637,073 $ 1,904,822
Other real estate owned 80,000
-----------------------------------
Total nonperforming assets $ 1,637,073 $ 1,984,822
===================================
Nonperforming assets to total assets 0.35% 0.45%
Nonperforming loans to total loans 0.43% 0.51%
Allowance for Loan Losses. In each quarter the allowance for loan losses is
adjusted by management to the amount management believes is necessary to
maintain the allowance at adequate levels. The allowance consists of three
allocations: identified specific allocation, a percentage allocation based on
loss history for different loan groups, and an unallocated allowance. Management
will allocate specific portions of the allowance for loan losses based on
specifically identifiable problem loans. Problem loans are identified through a
loan risk rating system and monitored through watchlist reporting. Specific
reserves are determined for each identified problem loan based on delinquency
rates, collateral and other risk factors specific to that problem loan.
Management's evaluation of the allowance for different loan groups is based on
consideration of actual loss experience, the present and prospective financial
condition of borrowers, industry concentrations within the loan portfolio and
general economic conditions, and absent some of those factors, based upon peer
industry data of comparable banks. The unallocated allowance is maintained to
recognize the imprecision of estimation and measuring loss when evaluating loss
allocations for individual loans or pools of loans.
The allowance for loan losses at June 30, 2004 was $5.2 million or 1.36% of
total loans outstanding, a slight decrease from $5.3 million, or 1.40%, at
December 31, 2003. The provision for loan losses during the first six months of
2004 was $810,000 compared to $1,535,000 in the first six months of 2003. A
significant portion of the decrease in the provision for the first six months of
2004 is attributable to the improper mortgage activity issue in 2003.
The table below summarizes the allowance allocations by type as of the indicated
dates:
June 30, 2004 December 31, 2003
-------------------------------------------------------------------------------------------
Specific allocations $ 3,246,000 $ 3,287,000
Loan pool percentage allocations 1,861,000 1,862,000
Unallocated 73,796 110,273
---------------------------------------
Total allowance for loan losses $ 5,180,796 $ 5,259,273
=======================================
In general, the addition to the allowance during the first six months of 2004
was directly attributable to the amount of loan growth and net charge-off
activity during the period and also attributable to risk factors, such as
watchlist directed specific allocations as well as peer bank loss experience.
Net charge-offs for the first six months of 2004 were $888,476 compared to
$766,715 for the first six months of 2003. The charge-offs during the first six
months ended June 30,2004 were primarily attributable to several commercial
loans. Substantially all of the charge-offs on these loans had previously been
specifically reserved in our allowance for loan losses. Nonperforming loans
decreased during the first six months of 2004 by $267,749 and were $1.6 million
at June 30, 2004. During the first six months of 2003, charge-offs included
$560,000 for the unauthorized mortgage loans problem. As a result of the
decreased level of nonperforming loans at June 30, 2004, specific allocations of
the loss allowance decreased $41,000 from December 31, 2003. The amount of the
allowance allocated for loan pools stayed essentially flat during the first six
months as a net result of increased loans outstanding, which was offset by a
decrease in loss experience percentages mainly for commercial loans.
Management considers the allowance for loan losses at June 30, 2004 to be
adequate; however, there can be no assurance that charge-offs in future periods
will not exceed the allowance. Additional provisions for the allowance are
expected during 2004 as a result of anticipated increases in the total loan
portfolio.
12
The following table summarizes changes in the Company's allowance for loan
losses for the periods indicated:
2004 2003
------------------------------------------------------------------------------------------------
Beginning balance, January 1 $ 5,259,273 $ 4,745,672
Provision charged to operating expense 810,000 1,545,000
Charge-offs (904,782) (783,143)
Recoveries 16,305 16,428
-----------------------------------
Ending balance, June 30 $ 5,180,796 $ 5,523,957
===================================
Net charge-offs to average loans (annualized) 0.35% 0.45%
Other Assets. The $544,641 decrease in other assets was mainly attributable to
the $595,958 reduction of the tax assets in the first six months of 2004 net of
other asset increases.
Deposits. Total deposits were $400.2 million at June 30, 2004 compared to total
deposits at December 31, 2003 of $362.9 million. Deposit growth has been
significant since the Bank commenced operations, resulting from new and existing
deposit accounts established from the business, consumer and the municipal
sectors. Deposit growth during the first six months of 2004 was reflected mainly
in time deposits under $100,000 and time deposits $100,000 and over. Growth was
approximately $12.3 million in time deposits under $100,000 and $34.9 million in
time deposits $100,000 and over. Money market accounts decreased by $6.0 million
during the first six months mostly attributable to a decrease in public funds
accounts while noninterest bearing demand deposits also reflected a decrease of
$1.3 million. The majority of the growth during the first six months of 2004 was
from brokered CD accounts. While the vast majority of overall deposit funding
had previously come from the local market, growth in the first six months of
2004 was generated from brokered CDs over $100,000 which grew during the first
six months by $38.6 million and reached $63.8 million at June 30, 2004 or 15.9%
of the total deposit portfolio. The amount of brokered CDs at December 31, 2003
was $25.2 million. This increase in brokered deposits was a result of a
significant amount of public funds withdrawn during the first quarter of 2004
and a need for funding to cover anticipated asset growth, over what could be
generated quickly in the local market.
The following table summarizes the Company's deposit balances at the dates
indicated:
JUNE 30, DECEMBER 31, 2003
----------------------------------------------------------
BALANCE % BALANCE %
-----------------------------------------------------------------------------------------------------------
Noninterest-bearing demand $ 61,381,105 15.3% $ 62,638,230 17.3%
Interest-bearing checking 20,497,837 5.1% 23,543,523 6.5%
Money market 92,286,463 23.1% 98,250,351 27.1%
Savings 11,001,781 2.7% 10,575,908 2.9%
Time, under $100,000 75,326,623 18.8% 63,028,461 17.4%
Time, $100,000 and over 139,717,951 35.0% 104,840,295 28.8%
----------------------------------------------------------
Total deposits $ 400,211,760 100.0% $ 362,876,768 100.0%
==========================================================
Borrowings. Short-term borrowings, which were entirely comprised of overnight
federal funds purchased from one correspondent bank decreased to $200,000 at
June 30, 2004 from $1.1 million at December 31, 2003. In addition to federal
funds purchased, the Company also had borrowings in the amount of $27.0 million
in Federal Home Loan Bank ("FHLB") advances at both June 30, 2004 and December
31, 2003. Two of the FHLB advances mature in 2011, and each of these have
quarterly call features. One of the remaining advances is a short-term daily
variable rate advance and the other six are bullet advances and mature in a
range from December 2004 through March 2006.
Other Liabilities. Other liabilities increased $147,000 from year-end 2003. The
increase in other liabilities was primarily related to the increase in payables
at June 30, 2004.
13
RESULTS OF OPERATIONS
For The Three-Month Periods Ended June 30
Results of operations for the three-month period ended June 30, 2004 reflected
net income of $454,436, or $0.11 per diluted share. This was a $24,715, or
5.75%, increase over 2003's second quarter net income of $429,721 or $0.11
diluted share. The operating results for the three-month period ended June 30,
2004 were favorable compared to the same period in 2003 primarily because
earning assets grew providing higher net interest income and the provision for
loan losses was lower in part due to a higher provision for loan losses in 2003
relating to previously disclosed unauthorized mortgage loan activity. This was
offset partially by lower noninterest income and higher noninterest expense,
which will be discussed below in more detail.
The increase in total revenue for the second quarter of 2004 as compared to the
prior year was positive, as total revenue, defined as net interest income plus
total noninterest income, increased 8.4%. For the three-month period ended June
30, 2004, net interest income increased 15.2%, while total noninterest income
decreased 12.5% from the same period one year ago primarily due to lower loan
broker fee income.
PERFORMANCE RATIOS JUNE 30,
-------------------------------
2004 2003
-------------------------------------------------------------------
Return on average assets * 0.40% 0.44%
Return on average equity * 4.38% 4.36%
Net interest margin * 3.06% 3.04%
Efficiency ratio 75.87% 63.62%
* annualized
Net Interest Income. Interest income for the three-month periods ended June 30,
2004 and 2003 was $4.9 million and $4.4 million, respectively, while interest
expense for each of those periods was $1.6 million in both 2004 and 2003,
resulting in net interest income of $3.3 million for the second quarter of 2004
and $2.9 million for the second quarter of 2003. The increase during each
quarter of 2004 and 2003 in net interest income was reflective of the general
growth in loans and other earning assets during those periods. The net interest
margin for the second quarter of 2004 was 3.06%, while the net interest margin
for the second quarter of 2003 was 3.04%. The increase in net interest margin
was mainly due to significant growth in earning assets over interest bearing
liabilities during this flat interest rate environment. The yield on earning
assets fell only 15 basis points during the period while cost of funds decreased
24 basis points improving our rate spread on earning assets.
The following table reflects the average balance; interest earned or paid, and
yields or costs of the Company's assets, liabilities and stockholders' equity at
and for the dates indicated:
14
AT AND FOR THE THREE MONTH PERIOD ENDED
---------------------------------------------------------------------------
JUNE 30, 2004 JUNE 30, 2003
---------------------------------------------------------------------------
INTEREST ANNUALIZED INTEREST ANNUALIZED
AVERAGE EARNED YIELD AVERAGE EARNED YIELD
($ in thousands) BALANCE OR PAID OR COST BALANCE OR PAID OR COST
- -------------------------------------------------------------------------------------------------------------------------
ASSETS
Short-term investments and
interest-earning deposits $ 6,920 $ 16 0.93% $ 4,921 $ 22 1.79%
Federal funds sold 12,015 26 0.87% 13,693 34 0.99%
Securities - taxable 24,386 244 4.01% 9,656 88 3.65%
Securities - tax exempt (1) 11,687 168 5.77% 2,545 37 5.82%
Loans held for sale - - 0.00% 1,022 11 4.31%
Loans 381,613 4,494 4.72% 346,946 4,258 4.91%
------------------------- -------------------------
Total interest-earning assets 436,621 4,948 4.55% 378,783 4,450 4.70%
Allowance for loan losses (5,201) (5,332)
Cash and due from banks 12,333 9,342
Other assets 10,347 9,037
------------- -------------
Total assets $ 454,100 $ 391,830
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Interest-bearing checking $ 22,770 $ 20 0.35% $ 16,317 $ 22 0.54%
Savings 10,891 7 0.26% 9,989 15 0.60%
Money market 86,392 193 0.90% 103,804 321 1.24%
Certificates of deposit 210,102 1,136 2.17% 156,969 1,002 2.55%
Short-term borrowings 200 1 2.01% 1,189 26 8.75%
FHLB advances 27,000 177 2.63% 19,000 117 2.46%
Junior subordinated debt 3,608 81 9.00% 3,500 79 9.03%
------------------------- -------------------------
Total interest-bearing liabilities 360,963 1,615 1.79% 310,768 1,582 2.03%
Noninterest-bearing checking 50,422 40,597
Other liabilities 1,100 884
Stockholders' equity 41,615 39,581
------------- -------------
Total liabilities and stockholders' equity $ 454,100 $ 391,830
============= =============
NET INTEREST INCOME $ 3,333 $ 2,868
============ ============
RATE SPREAD 2.76% 2.67%
NET INTEREST INCOME AS A PERCENT
OF AVERAGE EARNING ASSETS 3.06% 3.04%
============ ============
(1) Computed on a tax equivalent basis for tax exempt securities using a 34%
statutory tax rate.
Provision for Loan Losses. A provision for loan losses was recorded in the
amount of $310,000 during the second quarter of 2004 as compared to $690,000 for
the second quarter of 2003. The provision recorded for the second quarter of
2004 was directly related to the growth in the loan portfolio, risk factors
inherent in the loan portfolio and recorded charge-offs mainly attributable to
commercial loans. The allowance for loan losses at June 30, 2004 totaled $5.2
million and was 1.36% of total loans outstanding on that date. Total net
charge-offs for the three-month period ended June 30, 2004 were $497,117 and
were $254,576 during the same period a year ago.
Noninterest Income. Noninterest income was $815,988 during the second quarter of
2004. This was a $113,866, or 12.2%, decrease compared to the second quarter of
2003. The decrease in noninterest income from the comparable period was
reflected primarily in loan brokered service fees, which decreased $201,640 to
$82,651. This category decreased due to lower loan origination volume in 2004
compared to 2003. Trust services fee income increased $74,117 to $411,501 for
the three-month period ended June 30, 2004, reflective of more assets under
management.
Noninterest Expense. Noninterest expense was $3.1 million for the second quarter
of 2004 while noninterest expense for the three-month period ended June 30, 2003
was $2.4 million. The main components of noninterest expense for the second
quarter of 2004 were salaries and benefits of $1.7 million, occupancy and
equipment costs of $412,129, and loan and professional costs in the amount of
$327,355 and represent mainly infrastructure costs for human resource needs to
operate the Bank, rent expense and equipment depreciation. The 27.7% increase in
salaries and benefits reflects 13.0% growth in FTE's, year over year, as part of
our expansion activities throughout the last twelve months, an incentive
compensation program that was not in place at June 30, 2003
15
due to the unauthorized mortgage issue, and significant benefit cost increases.
Excluding personnel expenses, noninterest expenses increased 31.2%, largely
reflecting a $109,844 or 36.3% increase in occupancy and equipment due to the
Waynedale branch that opened in January 2004 and the new Wealth Management area
that opened downtown early in the second quarter 2004. The other large increase
in noninterest expenses was for loan and professional costs, which reflect
significant costs incurred in the proof of mortgage losses related to our
current insurance claim resulting from the unauthorized mortgage loans issue.
Income Taxes. During the quarters ended June 30, 2004 and 2003, the Company
recorded $226,230 and $257,470, respectively, in income taxes expense. The
effective tax rate recorded was 33.2% for 2004 as compared to 37.5% for 2003.
The decreased effective tax rate in 2004 was mainly from the tax effect of
additional tax-exempt investments held during 2004 compared to 2003.
For The Six-Month Periods Ended June 30
Results of operations for the six-month period ended June 30, 2004 reflected net
income of $934,874 or $0.23 per diluted share. This was a $319,682 or 52.0%
increase from 2003's six-month period net income of $615,192. Net income per
diluted share for the six-month period ended June 30, 2003 was $0.15. The
operating results for the six-month period ended June 30, 2003 were adversely
affected by total pretax special charges of $835,000 for losses discovered in
the Company's residential mortgage operation. During the first six months of
2003, special charges were recorded as a $560,000 addition to the provision for
loan losses for unauthorized mortgage loans and a $275,000 addition to other
expense for improper mortgage transactions and other unreconciled activity in a
mortgage operating account. See Note 4 of the Notes to Consolidated Condensed
Financial Statements in Part I of this Form 10-Q.
The increase in total revenue for the first six months of 2004 as compared to
the prior year period was 5.4%. For the six-month period ended June 30, 2004,
net interest income increased 17.7% and total noninterest income decreased 18.5%
from the same period one year ago, primarily due to a decrease in loan brokerage
fees of $314,521or 64.9%, and a decrease in net gain on sale of investments of
$187,480, or 98.3%. The first six months of 2003 benefited from the gains on
sale of investments and the higher volume of mortgage loan refinancing that
hasn't effected the first six months of 2004.
PERFORMANCE RATIOS JUNE 30,
------------------------------
2004 2003
-----------------------------------------------------------------
Return on average assets * 0.42% 0.32%
Return on average equity * 4.51% 3.14%
Net interest margin * 3.11% 3.04%
Efficiency ratio 72.54% 66.77%
* annualized
Net Interest Income. Interest income for the six-month periods ended June 30,
2004 and 2003 was $9.7 million and $8.7 million, respectively, while interest
expense for those periods was $3.1 million in each period, resulting in net
interest income of $6.6 million for the six-month period of 2004 and $5.6
million for the six-month period of 2003. The increase during the first six
months of 2004 over 2003 in net interest income was reflective of the general
growth in loans and other earning assets during those periods. The net interest
margin for the first six months of 2004 was 3.11%, while the net interest margin
for the first six months of 2003 was 3.04%. This increase in net interest margin
was partially due to a four basis point net increase in rate spread. The
remainder of the increase in net interest margin was the result of earning asset
growth outpacing growth in the net interest margin.
The following table reflects the average balance, interest earned or paid and
yield or cost of the Company's assets, liabilities and stockholders' equity at
and for the dates indicated:
16
AT AND FOR THE SIX MONTH PERIODS ENDED
------------------------------------------------------------------------
JUNE 30,2004 JUNE 30, 2003
------------------------------------------------------------------------
INTEREST ANNUALIZED INTEREST ANNUALIZED
AVERAGE EARNED YIELD AVERAGE EARNED YIELD
($ in thousands) BALANCE OR PAID OR COST BALANCE OR PAID OR COST
- -------------------------------------------------------------------------------------------------------------------------
ASSETS
Short-term investments and
interest-earning deposits $ 5,071 $ 25 0.99% $ 4,521 $ 30 1.33%
Federal funds sold 11,872 47 0.80% 13,609 68 1.00%
Securities - taxable 21,624 430 4.00% 9,723 175 3.60%
Securities - tax exempt (1) 10,229 287 5.64% 2,272 59 5.19%
Loans held for sale - - 0.00% 1,179 33 5.60%
Loans 379,775 8,938 4.73% 340,108 8,368 4.92%
---------------------- ----------------------
Total interest-earning assets 428,571 9,727 4.56% 371,412 8,733 4.70%
Allowance for loan losses (5,261) (5,091)
Cash and due from banks 12,259 9,272
Other assets 10,182 8,222
---------- ----------
Total assets $ 445,751 $ 383,815
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Interest-bearing checking $ 22,073 $ 37 0.34% $ 16,425 $ 46 0.56%
Savings 10,882 15 0.28% 9,453 32 0.68%
Money market 89,912 397 0.89% 99,682 611 1.23%
Certificates of deposit 197,048 2,139 2.18% 153,271 2,002 2.61%
Short-term borrowings 782 4 1.03% 1,126 29 5.15%
FHLB advances 27,000 341 2.54% 20,036 261 2.61%
Junior subordinated debt 3,608 162 9.03% 3,500 159 9.09%
---------------------- ----------------------
Total interest-bearing liabilities 351,305 3,095 1.77% 303,493 3,140 2.07%
Noninterest-bearing checking 50,929 39,708
Other liabilities 2,015 1,119
Stockholders' equity 41,502 39,495
---------- ----------
Total liabilities and stockholders' equity $ 445,751 $ 383,815
========== ==========
NET INTEREST INCOME $ 6,632 $ 5,593
============ ============
RATE SPREAD 2.79% 2.75%
NET INTEREST INCOME AS A PERCENT
OF AVERAGE EARNING ASSETS 3.11% 3.04%
============ ============
(1) Computed on a tax equivalent basis for tax exempt securities using a 34%
tax rate.
Provision for Loan Losses. A provision for loan losses was recorded in the
amount of $810,000 during the first six months of 2004 as compared to $1.5
million for the first six months of 2003. Total net charge-offs for the
six-month period ended June 30, 2004 were $888,476, and were $766,715 during the
same period a year ago. At June 30, 2004, nonperforming loans amounted to $1.6
million of which $363,741 was still accruing but past due 90 days or more.
Nonperforming loans at June 30, 2003 were $1.9 million of which $76,990 was
still accruing but past due 90 days or more.
Noninterest Income. Noninterest income was $1.6 million during the first six
months of 2004. This was a $363,299, or 18.5%, decrease from the first six
months of 2003. The decrease in noninterest income from the comparable period
was mainly attributable to a 64.9% decrease in loan broker fees from mortgage
originations, and a 98.3% decrease in net gain on sale of securities. These
decreases were partially offset by an 18.0% growth in fees from trust services
resulting from more assets under management.
Noninterest Expense. Noninterest expense was $5.9 million for the first six
months of 2004 while noninterest expense for the six-month period ended June 30,
2003 was $5.0 million. Noninterest expense totals for the first six months of
2004 were higher than those for the first six months of 2003 due primarily to
the general growth of the Bank in the form of personnel, rent and equipment at
the existing locations, as well as the opening of a fourth new branch office in
January 2004 and the new Wealth Management area that opened downtown early in
the second quarter 2004. Noninterest expense for the first six months of 2004
also included higher benefit costs and lower contra deferred costs from slower
loan production. The main components of noninterest expense for the first six
months of 2004 were salaries and benefits of $3.2 million, occupancy and
equipment costs of $748,794, and loan and professional costs in the amount of
$568,102. The 24.1% increase in salaries and benefits reflects 13.0% growth in
FTE's as
17
part of our expansion activities throughout the last twelve months, an incentive
compensation program that was not in place at June 30, 2003 due to the
unauthorized mortgage issue, and significant benefit cost increases. The large
increase in loan and professional costs reflects significant costs incurred in
the proof of mortgage losses related to our current insurance claim resulting
form the unauthorized mortgage issue.
Income Taxes. During the six-month periods ended June 30, 2004 and 2003, the
Company recorded $496,880 and $356,670, respectively, in income taxes expense.
The effective tax rate was 34.7% for 2004 as compared to 36.7% for 2003. The
reduced effective tax rate in 2004 compared to 2003 was attributable to a higher
level of tax-exempt security income.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity. The Company's general liquidity strategy is to fund growth with
deposits and to maintain an adequate level of short- and medium-term investments
to meet typical daily loan and deposit activity needs. Strong deposit growth was
realized during the first two quarters of 2004, as it has been each quarter
since 1999. Deposits have been generated mainly from in-market sources; however,
since 2001 the Company has expanded its funding base to include national,
non-brokered certificates of deposit, borrowings from the FHLB and trust
preferred securities and, beginning with the second quarter of 2003, brokered
CDs. In the aggregate these out-of-market deposits and borrowings represented
$125.0 million, or 29.0% of the Company's total funding, at June 30, 2004. Total
deposits at June 30, 2004 were $400.2 million and the loan to deposit ratio was
95.4%. Total borrowings at June 30, 2004 were $30.8 million. The Company expects
to continue to experience loan growth and that funding for the loan growth will
continue to come from in-market sources, as funds are available through the
marketing of products and the development of branch locations. Additionally, the
Company and the Bank will continue to develop wholesale, out-of-market deposits
and borrowing capacities and use them to augment our interest rate sensitivity
strategy and liquidity capabilities and to diversify the funding base of the
Bank.
Capital Resources. Stockholders' equity is a noninterest-bearing source of
funds, which provides support for asset growth. Stockholders' equity was $41.3
million and $40.9 million at June 30, 2004 and December 31, 2003, respectively.
Affecting the increase in stockholders' equity during the first six months of
2004 was $934,874 in net income, $25,167 from the exercise of 1,875 stock
options including tax benefit offset by a $602,709 decrease in the unrealized
appreciation of securities available for sale, net of tax.
The ability of the Company to pay cash and stock dividends is subject to
limitations under various laws and regulations and to prudent and sound banking
practices. The Company has paid no cash or stock dividends in any year thus far.
The Company expects that its future earnings and those of the Bank, if any,
would be retained to finance future growth and operations. The Company does not
anticipate paying any cash dividends on the common stock in the foreseeable
future.
The following table summarizes the capital ratios of the Company and the Bank at
the dates indicated:
JUNE 30, 2004 JUNE 30, 2003
-----------------------------------------------------------------------
Well- Minimum Well- Minimum
Actual Capitalized Required Actual Capitalized Required
-----------------------------------------------------------------------------------------------
THE COMPANY
Leverage capital 9.99% 5.00% 4.00% 10.99% 5.00% 4.00%
Tier 1 risk-based 11.18% 6.00% 4.00% 11.75% 6.00% 4.00%
Total risk-based 12.39% 10.00% 8.00% 13.01% 10.00% 8.00%
THE BANK
Leverage capital 8.53% 5.00% 4.00% 9.24% 5.00% 4.00%
Tier 1 risk-based 9.54% 6.00% 4.00% 9.81% 6.00% 4.00%
Total risk-based 10.79% 10.00% 8.00% 11.06% 10.00% 8.00%
COMMITMENTS AND OFF-BALANCE SHEET RISK
The Bank maintains off-balance-sheet investments in the normal course of
business to meet the financing needs of its customers. These financial
instruments include commitments to extend credit and standby letters of credit.
These instruments involve, to varying degrees, elements of credit risk in excess
of the amount recognized, if any, in the balance sheet. The Bank's maximum
exposure to loan loss in the event of nonperformance by the other party to the
financial instruments for commitments to extend credit and standby letters of
credit is represented by the contractual notional amount of these instruments.
Such financial
18
instruments are recorded when they are funded. Fair value of the Bank's
off-balance-sheet instruments (commitments to extend credit and standby letters
of credit) is based on rates currently charged to enter into similar agreements,
taking into account the remaining terms of the agreements and the
counterparties' credit standing. At June 30, 2004, the rates on existing
off-balance-sheet instruments were equivalent to current market rates,
considering the underlying credit standing of the counterparties.
Tabular disclosure of the Company's contractual obligations as of the end of our
latest fiscal year was provided in our Annual Report on Form 10-K for the year
ended December 31, 2003. On March 24, 2004, the Company signed an addendum to
its original operating lease with Tippmann Properties, Inc, for additional space
at its headquarters location with a remaining term through December 31, 2013 and
total aggregate rental payments through the remainder of the term of $5.7
million.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company's primary market risk exposure is interest rate risk and,
to a lesser extent, liquidity risk. All of the Company's transactions are
denominated in U.S. dollars with no specific foreign exchange exposure. The
Company has no agricultural-related loan assets and therefore has no significant
exposure to changes in commodity prices. Any impact that changes in foreign
exchange rates and commodity prices would have on interest rates is assumed to
be insignificant.
Interest rate risk is the exposure of the Company's financial condition to
adverse movements in interest rates. The Company derives its income primarily
from the excess of interest collected on its interest-earning assets over the
interest paid on its interest-bearing liabilities. The rates of interest the
Company earns on its assets and owes on its liabilities generally are
established contractually for a period of time. Since market interest rates
change over time, the Company is exposed to lower profitability if it cannot
adapt to interest rate changes. Accepting interest rate risk can be an important
source of profitability and stockholder value; however, excessive levels of
interest rate risk could pose a significant threat to the Company's earnings and
capital base. Accordingly, effective risk management that maintains interest
rate risk at prudent levels is essential to the Company's safety and soundness.
Evaluating the exposure to changes in interest rates includes assessing both the
adequacy of the process used to control interest rate risk and the quantitative
level of exposure. The Company's interest rate risk management process seeks to
ensure that appropriate policies, procedures, management information and
internal controls are in place to maintain interest rate risk at prudent levels
with consistency and continuity. In evaluating the quantitative level of
interest rate risk, the Company assesses the existing and potential future
effects of changes in interest rates on its financial condition, including
capital adequacy, earnings, liquidity and overall asset quality.
There are two interest rate risk measurement techniques that may be used by the
Company. The first, which is commonly referred to as GAP analysis, measures the
difference between the dollar amount of interest-sensitive assets and
liabilities that will be refinanced or repriced during a given time period. A
significant repricing gap could result in a negative impact to the Company's net
interest margin during periods of changing market interest rates.
The following table depicts the Company's GAP position as of June 30, 2004:
19
RATE SENSITIVITY ANALYSIS
WITHIN THREE TO ONE TO AFTER
THREE TWELVE FIVE FIVE
($ in thousands) MONTHS MONTHS YEARS YEARS TOTAL
- ----------------------------------------------------------------------------------------------------------------
ASSETS
Federal funds sold, short-term
investments and interest-
earning deposits $ 30,003 $ $ $ $ 30,003
Securities available for sale 1,230 2,492 6,971 29,476 40,169
FHLBI and FRB stock 2,362 2,362
Fixed rate loans 8,958 24,250 71,293 25,749 130,250
Variable rate loans 251,130 251,130
Allowance for loan losses (5,181)
Other assets 24,883
----------------------------------------------------------------------
Total assets $ 291,321 $ 26,742 $ 78,264 $ 57,587 $ 473,616
----------------------------------------------------------------------
LIABILITIES
Interest-bearing checking $ 20,498 $ $ $ $ 20,498
Savings accounts 11,002 11,002
Money market accounts 92,286 92,286
Time deposits < $100,000 17,095 33,588 24,644 75,327
Time deposits $100,000 and over 55,454 41,785 42,478 139,717
Short-term borrowings 200 200
FHLB advances 7,500 13,000 6,500 27,000
Junior subordinated debt 3,608 3,608
Noninterest-bearing checking 61,381
Other liabilities 1,331
----------------------------------------------------------------------
Total liabilities 196,535 82,873 80,122 10,108 432,350
STOCKHOLDERS' EQUITY 41,266
----------------------------------------------------------------------
Total sources of funds $ 196,535 $ 82,873 $ 80,122 $ 10,108 $ 473,616
----------------------------------------------------------------------
Net asset (liability) GAP $ 94,786 $(56,131) $ (1,858) $ 47,479 $
----------------------------------------------------------------------
CUMULATIVE GAP $ 94,786 $ 38,655 $ 36,797 $ 84,276 $
----------------------------------------------------------------------
PERCENT OF CUMULATIVE GAP TO
TOTAL ASSETS 20.0% 8.2% 7.8% 17.8%
A second interest rate risk measurement used is commonly referred to as net
interest income simulation analysis. A simulation model assesses the direction
and magnitude of variations in net interest income resulting from potential
changes in market interest rates. Key assumptions in the model include
prepayment speeds on various loan and investment assets; cash flows and
maturities of interest-sensitive assets and liabilities; and changes in market
conditions impacting loan and deposit volume and pricing. These assumptions are
inherently uncertain, subject to fluctuation and revision in a dynamic
environment; therefore, a model cannot precisely estimate net interest income or
exactly predict the impact of higher or lower interest rates on net interest
income. Actual results will differ from simulated results due to timing,
magnitude, and frequency of interest rate changes and changes in market
conditions and the Company's strategies, among other factors.
As growth has dictated, the Company began utilizing simulation analysis as a
tool for measuring the effects of interest rate risk on the income statement
beginning with year-end 2003.
In addition to changes in interest rates, the level of future net interest
income is also dependent on a number of other variables, including the growth,
composition and absolute levels of loans, deposits, and other earning assets and
interest-bearing liabilities; economic and competitive conditions; potential
changes in lending, investing, and deposit gathering strategies; client
preferences; and other factors.
The following table provides information about the Company's financial
instruments used for purposes other than trading that are rate sensitive to
changes in interest rates as of June 30, 2004. It does not provide when these
items may actually reprice. For loans receivable, securities, and liabilities
with contractual maturities, the table presents principal cash flows and related
weighted-average interest rates by contractual maturities as well as the
Company's historical experience of the impact of interest rate fluctuations on
the prepayment of loans and mortgage backed securities. For core deposits
(demand deposits, interest-bearing checking, savings, and money market deposits)
that have no contractual maturity, the table presents principal cash flows and,
as applicable, related weighted-average interest rates based upon the Company's
historical experience and management's judgment,
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as applicable, concerning their most likely withdrawal behaviors. The most
recent historical interest rates for core deposits have been assumed to apply
for future periods in this table as the actual interest rates that will need to
be paid to maintain these deposits are not currently known. Weighted average
variable rates are based upon contractual rates existing at the report date.
PRINCIPAL AMOUNT MATURING IN:
------------------------------------------------------------------------------------------------
($ in thousands) FAIR VALUE
06/30/05 06/30/06 06/30/07 06/30/08 06/30/09 THEREAFTER TOTAL 06/30/04
------------------------------------------------------------------------------------------------
Rate sensitive assets:
Fixed interest rate loans $ 33,207 $ 16,076 $ 15,346 $ 14,950 $ 24,921 $ 25,750 $ 130,250 $ 129,089
Average interest rate 5.42% 6.28% 6.19% 6.19% 4.89% 5.40% 5.60%
Variable interest rate loans 74,359 43,443 48,488 25,903 27,779 31,158 251,130 251,130
Average interest rate 4.25% 4.21% 4.20% 4.27% 4.18% 4.34% 4.24%
Fixed interest rate securities 3,722 4,662 394 1,744 171 29,476 40,169 40,169
Average interest rate 4.38% 3.71% 3.97% 3.82% 4.40% 4.92% 4.67%
Other interest bearing assets 30,003 30,003 30,003
Average interest rate 0.98% 0.98%
Rate sensitive liabilities:
Interest bearing checking 20,498 20,498 20,498
Average interest rate 0.37% 0.34%
Savings accounts 11,002 11,002 11,002
Average interest rate 0.28% 0.28%
Money market accounts 92,286 92,286 92,286
Average interest rate 0.93% 0.96%
Time deposits 147,924 52,897 8,205 5,683 110 226 215,045 215,429
Average interest rate 1.81% 2.30% 3.16% 4.22% 3.26% 4.07% 2.05%
Fixed interest rate
borrowings 5,500 13,000 10,108 28,608 28,620
Average interest rate 2.70% 2.58% 5.41% 3.32%
Variable interest rate
borrowings 2,200 2,200 2,200
Average interest rate 1.53% 1.53%
ITEM 4. CONTROLS AND PROCEDURES
We maintain a set of disclosure controls and procedures, which are designed to
ensure that information required to be disclosed by us in the reports filed by
us under the Securities Exchange Act of 1934, as amended (the "Exchange Act"),
is recorded, processed, summarized and reported within the time periods
specified in the SEC's rules and forms. As of June 30, 2004, we carried out an
evaluation, under the supervision and with the participation of our management,
including our Chairman, President and Chief Executive Officer and our Chief
Financial Officer, of the effectiveness of the design and operation of our
disclosure controls and procedures. Based on that evaluation, our Chairman,
President and Chief Executive Officer and our Chief Financial Officer concluded
that our disclosure controls and procedures are effective.
There was no change in our internal control over financial reporting during the
second quarter of the 2004 fiscal year that has materially affected, or is
reasonably likely to materially affect, our internal control over financial
reporting.
21
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company and the Bank may be involved from time to time in various
routine legal proceedings incidental to its business. Neither the Company
nor the Bank is engaged in any legal proceeding that is expected to have a
material adverse effect on the results of operations or financial position
of the Company or the Bank.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
(a) The annual meeting of the shareholders of the Company was held on April 20,
2004.
(b) The following directors were elected at the meeting to serve until the
annual meeting of shareholders in the year 2007:
Votes For Votes Withheld
------------------------------------
R.V. Prasad Mantravadi, M.D. 3,556,689 16,575
Michael J. Mirro, M.D. 3,391,888 181,376
William G. Niezer 3,472,718 100,546
Larry L. Smith 3,558,689 14,575
John V. Tippmann 3,391,888 181,376
In addition, the following directors continue in office until the annual
meeting of shareholders in the year indicated:
Keith E. Busse 2005 Debra A. Niezer 2006
Peter T. Eshelman 2005 Donald F. Schenkel 2005
Michael S. Gouloff 2005 Joseph D. Ruffolo 2006
Kathryn D. Callen 2006 Irene A. Walters 2005
Jerome F. Henry, Jr. 2006
(c) Other matters voted upon and the results of the voting were as follows:
The shareholders voted 3,438,333 in the affirmative and 123,146 in the
negative, with 11,785 abstentions, to appoint Crowe Chizek and Company LLC
as auditors of the Company for 2004.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
31.1 Rule 13a-14(a) /15-14(a) Certification of Chief Executive
Officer.
31.2 Rule 13a-14(a) /15-14(a) Certification of Chief Financial
Officer.
32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C.
Section 1350.
32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C.
Section 1350.
(b) Reports on Form 8-K
On April 30, 2004, we furnished a current report on Form 8-K dated
March 31, 2004 to report, under Item 12 of Form 8-K, our results of
operations for the quarter ended March 31, 2004.
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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.
TOWER FINANCIAL CORPORATION
Dated: August 13, 2004 /s/ Donald F. Schenkel
-------------------------------------
Donald F. Schenkel, Chairman of the
Board, President and Chief Executive
Officer
Dated: August 13, 2004 /s/ Michael D. Cahill
-------------------------------------
Michael D. Cahill
Chief Financial Officer and Secretary
23