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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 and year to date period ended SEPTEMBER 30, 2003
[ ] 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 Identification No.)
incorporation or organization)
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 during the past
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 October 31, 2003: 3,932,444.
INDEX
page no.
--------
PART I. FINANCIAL STATEMENTS
Item 1. Financial Statements
Consolidated Condensed Balance Sheets at September 30, 2003
(unaudited) and December 31, 2002....................................... 3
Consolidated Condensed Statements of Operations for the three
and nine months ended September 30, 2003 and September 30,
2002 (unaudited) ....................................................... 4
Consolidated Condensed Statements of Comprehensive Income for
the three and nine months ended September 30, 2003 and
September 30, 2002 (unaudited) ......................................... 5
Consolidated Condensed Statements of Changes in Stockholders'
Equity for the nine months ended September 30, 2003 and
September 30, 2002 (unaudited).......................................... 6
Consolidated Condensed Statements of Cash Flows for the nine
months ended September 30, 2003 and September 30, 2002
(unaudited)............................................................. 7
Notes to Consolidated Condensed Financial Statements
(unaudited)............................................................. 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 ............ 21
Item 4. Controls and Procedures .............................................. 21
PART II. OTHER INFORMATION
Item 1. Legal Proceedings...................................................... 22
Item 5. Other Information...................................................... 22
Item 6. Exhibits and Reports on Form 8-K ..................................... 22
SIGNATURES ............................................................................. 22
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
TOWER FINANCIAL CORPORATION
CONSOLIDATED CONDENSED BALANCE SHEETS
At September 30, 2003 and December 31, 2002
(unaudited)
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------- -------------
ASSETS
Cash and due from banks $ 13,923,286 $ 9,228,782
Short-term investments and interest-earning deposits 9,386,607 13,598,037
Federal funds sold 14,392,772 13,341,860
------------- -------------
Total cash and cash equivalents 37,702,665 36,168,679
Securities available for sale, at fair value 10,066,980 11,170,570
FHLBI and FRB stock 2,085,200 2,057,500
Loans held for sale 108,203 5,769,700
Loans 373,959,995 321,339,946
Allowance for loan losses (5,628,757) (4,745,672)
------------- -------------
Net loans 368,331,238 316,594,274
Premises and equipment, net 2,710,526 2,625,602
Accrued interest receivable 1,353,369 1,092,806
Other assets 5,645,554 1,831,785
------------- -------------
Total assets $ 428,003,735 $ 377,310,916
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Deposits:
Noninterest-bearing $ 54,935,268 $ 42,966,347
Interest-bearing 308,528,314 267,617,640
------------- -------------
Total deposits 363,463,582 310,583,987
Short-term borrowings 1,060,000 1,060,000
Federal Home Loan Bank (FHLB) advances 19,000,000 21,500,000
Trust preferred securities 3,500,000 3,500,000
Accrued interest payable 259,716 272,303
Other liabilities 554,551 1,219,763
------------- -------------
Total liabilities 387,837,849 338,136,053
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;
3,932,194 shares issued and outstanding at September 30, 2003 and 3,931,184
shares issued and
outstanding at December 31, 2002 37,202,542 37,190,692
Retained earnings 2,990,948 1,760,778
Accumulated other comprehensive income (loss), net of tax
of $(18,403) at September 30, 2003 and $148,928 at
December 31, 2002 (27,604) 223,393
------------- -------------
Total stockholders' equity 40,165,886 39,174,863
------------- -------------
Total liabilities and stockholders' equity $ 428,003,735 $ 377,310,916
============= =============
The following notes are an integral part of the financial statements.
3
TOWER FINANCIAL CORPORATION
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
For the three months and nine months ended September 30, 2003 and 2002
(unaudited)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------------------- ----------------------------
2003 2002 2003 2002
----------- ----------- ----------- -----------
INTEREST INCOME:
Loans, including fees $ 4,354,464 $ 4,081,900 $12,755,646 $11,481,755
Securities - taxable 72,247 106,510 246,423 267,716
Securities - tax exempt 29,950 17,339 71,454 37,365
Other interest income 36,868 114,742 134,507 319,098
----------- ----------- ----------- -----------
Total interest income 4,493,529 4,320,491 13,208,030 12,105,934
INTEREST EXPENSE:
Deposits 1,242,841 1,451,724 3,933,029 4,279,489
Short-term borrowings (18,163) 4,963 11,294 18,549
FHLB advances 150,306 156,914 411,351 286,384
Trust preferred securities 79,335 79,336 238,005 238,298
----------- ----------- ----------- -----------
Total interest expense 1,454,319 1,692,937 4,593,679 4,822,720
----------- ----------- ----------- -----------
Net interest income 3,039,210 2,627,554 8,614,351 7,283,214
PROVISION FOR LOAN LOSSES 300,000 475,000 1,835,000 1,295,000
----------- ----------- ----------- -----------
Net interest income after provision
for loan losses 2,739,210 2,152,554 6,779,351 5,988,214
NONINTEREST INCOME:
Trust fees 337,974 278,255 1,031,318 797,509
Service charges 164,075 103,340 472,870 292,576
Loan broker fees 259,925 228,282 744,861 441,560
Net gain on sale of securities -- -- 190,766 --
Other fees 158,339 101,163 448,219 291,790
----------- ----------- ----------- -----------
Total noninterest income 920,313 711,040 2,888,034 1,823,435
NONINTEREST EXPENSE:
Salaries and benefits 1,532,737 1,243,213 4,137,202 3,538,758
Occupancy and equipment 303,888 270,124 909,951 752,462
Marketing 47,298 65,116 258,354 178,107
Data processing 88,353 74,659 260,756 207,464
Loan and professional costs 202,433 150,837 529,516 368,018
Office supplies and postage 64,723 77,193 202,662 174,757
Courier services 72,975 60,205 209,260 174,553
Other expense 364,898 220,888 1,205,604 603,938
----------- ----------- ----------- -----------
Total noninterest expense 2,677,305 2,162,235 7,713,305 5,998,057
----------- ----------- ----------- -----------
INCOME BEFORE INCOME TAXES 982,218 701,359 1,954,080 1,813,592
Income taxes expense 367,240 273,100 723,910 709,900
----------- ----------- ----------- -----------
NET INCOME $ 614,978 $ 428,259 $ 1,230,170 $ 1,103,692
=========== =========== =========== ===========
BASIC EARNINGS PER COMMON SHARE $ 0.16 $ 0.14 $ 0.31 $ 0.41
DILUTED EARNINGS PER COMMON SHARE $ 0.15 $ 0.14 $ 0.31 $ 0.40
Average common shares outstanding 3,932,194 3,030,464 3,931,905 2,698,654
Average common shares and dilutive
potential common shares outstanding 3,999,995 3,042,338 4,004,821 2,763,588
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 nine months ended September 30, 2003 and 2002 (unaudited)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------------- -----------------------------
2003 2002 2003 2002
----------- ----------- ----------- -----------
Net income $ 614,978 $ 428,259 $ 1,230,170 $ 1,103,692
Other comprehensive income (loss):
Change in net unrealized appreciation
(depreciation) on securities available for
sale, net of tax of $(73,951) and $89,176 for
the three months ended September 30, 2003 and 2002
and $(167,131) and $185,173 for the nine months
ended September 30, 2003 and 2002 (110,926) 133,764 (250,997) 277,740
----------- ----------- ----------- -----------
COMPREHENSIVE INCOME $ 504,052 $ 562,023 $ 979,173 $ 1,381,432
=========== =========== =========== ===========
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 nine months ended September 30, 2003 and 2002 (unaudited)
COMMON ACCUMULATED
STOCK AND OTHER
PAID-IN RETAINED COMPREHENSIVE
CAPITAL EARNINGS INCOME (LOSS) TOTAL
------------ ------------ ------------ ------------
BALANCE, JANUARY 1, 2002 $ 23,469,770 $ 45,149 $ (9,580) $ 23,505,339
Issuance of common stock, net
of marketing agent's fee and
offering costs 13,685,365 13,685,365
Net income for 2002 1,103,692 1,103,692
Change in net unrealized
appreciation (depreciation)
on securities available
for sale, net of tax of $185,173 277,740 277,740
------------ ------------ ------------ ------------
BALANCE, SEPTEMBER 30, 2002 $ 37,155,135 $ 1,148,841 $ 268,160 $ 38,572,136
============ ============ ============ ============
BALANCE, JANUARY 1, 2003 $ 37,190,692 $ 1,760,778 $ 223,393 $ 39,174,863
Net income for 2003 1,230,170 1,230,170
Issuance of 1,010 shares of common stock
for stock options exercised and tax benefits 11,850 11,850
Change in net unrealized
appreciation (depreciation)
on securities available
for sale, net of tax of $(167,331) (250,997) (250,997)
------------ ------------ ------------ ------------
BALANCE, SEPTEMBER 30, 2003 $ 37,202,542 $ 2,990,948 $ (27,604) $ 40,165,886
============ ============ ============ ============
The following notes are an integral part of the financial statements.
6
TOWER FINANCIAL CORPORATION
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
For the nine months ended September 30, 2003 and 2002
(unaudited)
NINE MONTHS ENDED
SEPTEMBER 30,
--------------------------------
2003 2002
------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 1,230,170 $ 1,103,692
Adjustments to reconcile net income
to net cash from operating activities:
Depreciation and amortization 362,647 272,947
Provision for loan losses 1,835,000 1,295,000
Earnings on life insurance (106,499) --
Net gain on sale of securities (190,766) --
Change in accrued interest receivable (260,563) (207,475)
Change in other assets (539,939) (524,571)
Change in accrued interest payable (12,587) (66,771)
Change in other liabilities (665,212) (124,736)
Origination of loans held for sale (16,402,150) (16,983,400)
Proceeds from sales of loans held for sale 22,063,647 19,567,350
------------ ------------
Net cash from operating activities 7,313,748 4,332,036
CASH FLOWS FROM INVESTING ACTIVITIES:
Net change in loans (53,571,964) (69,419,630)
Net change in interest-earning deposits -- 2,806,000
Purchase of securities available for sale (6,650,850) (8,446,845)
Proceeds from maturities of securities
available for sale 4,352,098 3,000,000
Proceeds from sale of securities
available for sale 3,174,780 --
Purchase of FHLBI & FRB Stock (27,700) (750,000)
Purchase of life insurance (3,000,000) --
Purchase of equipment and leasehold
expenditures (447,571) (1,399,670)
------------ ------------
Net cash from investing activities (56,171,207) (74,210,145)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net change in deposits 52,879,595 34,788,185
Proceeds from issuance of common stock and
from exercise of stock options and tax benefits 11,850 14,998,744
Payments of marketing agent's fee and offering costs (1,313,379)
Proceeds from FHLB advances 8,500,000 15,000,000
Repayment of FHLB advances (11,000,000) --
------------ ------------
Net cash from financing activities 50,391,445 63,473,550
------------ ------------
NET CHANGE IN CASH AND CASH EQUIVALENTS 1,533,986 (6,404,559)
Cash and cash equivalents, beginning of period 36,168,679 48,676,039
------------ ------------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 37,702,665 $ 42,271,480
============ ============
Supplemental disclosures of cash flow information
Cash paid during the year for:
Interest $ 4,606,266 $ 4,889,491
Income taxes 1,218,076 1,279,080
The following notes are an integral part of the financial statements.
7
TOWER FINANCIAL CORPORATION
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (UNAUDITED)
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, consisting of normal recurring
adjustments, necessary to present fairly the Company's consolidated
financial position at September 30, 2003, its consolidated results of
operations and comprehensive income for the three and nine month
periods ended September 2003 and 2002, and its consolidated changes in
stockholders' equity and cash flows for the nine-month periods ended
September 30, 2003 and 2002. The results for the period ended
September 30, 2003 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, 2002, 2001, and 2000 and related
notes included in the Company's Annual Report on Form 10-KSB for the
year ended December 31, 2002.
C. PRINCIPLES OF CONSOLIDATION: The accompanying consolidated condensed
financial statements include the accounts of the Company, the Bank and
TCT1. All significant intercompany accounts and transactions have been
eliminated in consolidation.
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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------------------- --------------------------------
2003 2002 2003 2002
------------- ------------- ------------- -------------
Net income as reported $ 614,978 $ 428,259 $ 1,230,170 $ 1,103,692
Deduct: Stock-based compensation expense
determined under fair value-based method (41,815) (41,806) (103,729) (121,727)
------------- ------------- ------------- -------------
Pro forma net income $ 573,163 $ 386,453 $ 1,126,441 $ 981,965
============= ============= ============= =============
Basic earnings per share as reported $ 0.16 $ 0.14 $ 0.31 $ 0.41
Pro forma basic earnings per share 0.15 0.13 0.29 0.36
Diluted earnings per share as reported 0.15 0.14 0.31 0.40
Pro forma diluted earnings per share 0.14 0.13 0.28 0.36
The pro forma effects are computed using option-pricing models with
the following weighted average assumptions as of grant date.
8
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------- ----------------------
2003 2002 2003 2002
------- ------- ------- -------
Risk-free interest rate 3.83% 4.40% 3.20% 4.83%
Expected option life 8.0 8.0 5.8 8.0
Expected stock price volatility 28.07% 27.91% 25.74% 25.78%
Dividend yield None None None None
E. NEWLY ISSUED ACCOUNTING STANDARDS: The Financial Accounting Standards
Board ("FASB") has issued two new accounting standards, Statement of
Financial Accounting Standards ("SFAS") No 149, "Amendment of
Statement 133 on Derivative Instruments and Hedging Activities", and
SFAS No 150, "Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity", both of which
generally became effective in the quarter beginning July 1, 2003.
Management has determined that the adoption of these standards did not
have a material impact on the Company's operating results or financial
condition. However, the Federal Reserve is reviewing the regulatory
capital implications of the requirements to report trust preferred
securities with liabilities.
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 nine-month periods ended September
30, 2003 and 2002.
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------------- ---------------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
BASIC
Net income $ 614,978 $ 428,259 $1,230,170 $1,103,692
---------- ---------- ---------- ----------
Weighted average common shares outstanding 3,932,194 3,030,464 3,931,905 2,698,654
---------- ---------- ---------- ----------
Basic earnings per common share $ 0.16 $ 0.14 $ 0.31 $ 0.41
DILUTED
Net income $ 614,978 $ 428,259 $1,230,170 $1,103,692
---------- ---------- ---------- ----------
Weighted average common shares outstanding 3,932,194 3,030,464 3,931,905 2,698,654
Add: dilutive effect of assumed stock option exercises 67,801 11,874 72,916 64,934
---------- ---------- ---------- ----------
Weighted average common shares and dilutive
potential common shares outstanding 3,999,995 3,042,338 4,004,821 2,763,588
---------- ---------- ---------- ----------
Diluted earnings per common share $ 0.15 $ 0.14 $ 0.31 $ 0.40
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 of our common stock 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 September 30, 2003, options for 410,678 shares were outstanding to
certain officers, employees and directors. The options were granted at the
market price of our common stock on the dates of the grant in a range from
$7.625 to $13.55 per share. Of the total options outstanding, options for
316,726 shares were vested and exercisable at September 30, 2003, of which
options for 43,250 shares had exercise prices above the market price on
such date. During the third quarter of 2003, there were 3,000 options
granted at a per share price of $13.50 while no shares were cancelled or
exercised.
9
NOTE 4 - CONTINGENCY LOSS
The first nine months of 2003 results were adversely affected by total
pretax special charges of $965,000 ($130,000 in the third quarter) for
losses discovered in the Company's residential mortgage operation. During
the first nine months of 2003 special charges were recorded as a $600,000
($40,000 in the third quarter) addition to the provision for loan losses
for unauthorized mortgage loans and a $365,000 ($90,000 in the third
quarter) addition to other expense for improper mortgage transactions and
other unreconciled activity in a mortgage operating account.
During the fourth quarter of 2002, the Company recorded a $428,000 addition
to other expense as audit results showed stale-dated receivables existed in
the mortgage operating account. Further investigation by the Company during
the first nine months of 2003 uncovered unauthorized loans and improper
mortgage activity in the operating account. A total of $1,393,000 in pretax
special charges has been recorded to date to address these identified
issues. An employee of the Company was terminated as a result of this
investigation, and management has made appropriate modifications in the
Company's internal controls. 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 a portion of 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 September 30, 2003 and December 31,
2002 and results of operations for the three month and nine month periods ended
September 30, 2003 and September 30, 2002. 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-KSB for the year ended December 31, 2002.
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:
o the Company's status as a start-up company with only four years of
operating history;
o the effect of extensive banking regulation on the Bank's ability to
grow and compete;
o 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;
o the competitive disadvantage resulting from the Company's status as a
highly regulated, start-up company;
o the Company's dependence on key management personnel;
o the increased risk of losses due to loan defaults caused by the Bank's
commercial loan concentration;
o the Company's dependence on a favorable local economy in the Bank's
primary service area;
o the Bank's dependence on net interest spread for profitability;
10
o the Bank's ability to implement developments in technology to be
competitive;
o failure of a significant number of borrowers to repay their loans;
o general changes in economic conditions, including interest rates and
real estate values; and
o 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.
CRITICAL ACCOUNTING POLICIES
A comprehensive discussion of the Company's critical accounting policies is
disclosed in our Form 10-KSB for the year ended December 31, 2002. There have
been no material changes in the information regarding our critical accounting
policies since December 31, 2002.
FINANCIAL CONDITION
The Company continued to experience growth in the third quarter of 2003. Total
assets of the Company were $428.0 million at September 30, 2003 compared to
total assets at December 31, 2002 of $377.3 million. The 13.4% increase in
assets was mainly due to an increase in loans and was supported in part by a
$52.9 million inflow of funds from deposit growth at the Bank during the first
nine months of 2003. Asset growth has been substantial during each quarter since
the Bank began operations. The significant growth during previous quarters was
also a result of deposit growth at the Bank. During the Bank's fifth year of
operation, the Company anticipates that, in the near-term, assets will increase
at a rate similar to our 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 $37.7 million at September 30, 2003, a $1.5 million or 4.2% increase
from $36.2 million at December 31, 2002. Securities available for sale were
$10.1 million at the end of the third quarter of 2003, a decrease of $1.1
million from December 31, 2002. The net increase in cash and cash equivalents
during the first nine months of 2003 was reflective of cash needs of the Bank
relative to loan growth, the purchase of securities and normal daily liquidity
activity. The decrease in securities available for sale was a result of the net
sale and reinvestment activity for the Bank's investment portfolio during the
first nine months of 2003.
Loans. Total loans were $374.0 million at September 30, 2003 reflecting a 16.4%
increase from total loans of $321.3 million at December 31, 2002. Loan growth in
the first nine months of 2003 occurred mainly in the commercial and commercial
real estate portfolios, however growth also occurred in the residential real
estate portfolio. The mix of the loan portfolio has changed slightly since
year-end as the total of commercial and commercial real estate loans
approximated 79.8% of the portfolio at September 30, 2003 compared to 81.5% at
December 31, 2002. Management believes that strong loan growth during the first
nine months of 2003 was the result of the Bank's lending experience and client
demand in our local markets.
The following table summarizes the composition of the loan portfolio at
the dates indicated:
11
SEPTEMBER 30, 2003 DECEMBER 31, 2002
-------------------------- --------------------------
BALANCE % BALANCE %
------------- ----- ------------- -----
Commercial $ 207,828,770 55.6% $ 185,250,705 57.7%
Commercial real estate 90,439,646 24.2% 76,545,340 23.8%
Residential real estate 37,593,990 10.1% 26,097,307 8.1%
Home equity 24,780,374 6.6% 20,042,459 6.3%
Consumer 13,145,056 3.5% 13,290,091 4.1%
------------- ----- ------------- -----
Total loans 373,787,836 100.0% 321,225,902 100.0%
Net deferred loan costs 172,159 114,044
Allowance for loan losses (5,628,757) (4,745,672)
------------- -------------
Net loans $ 368,331,238 $ 316,594,274
============= ======== =====
Nonperforming Assets. Nonperforming loans include loans past due over 90 days
and still accruing and all nonaccrual loans. Nonperforming assets include
nonperforming loans and other real estate owned. Nonperforming assets have
increased from $719,441 or .19% of total assets at the end of 2002 to $1.7
million or .40% of total assets at September 30, 2003. Nonperforming assets have
decreased by $310,488 since June 30, 2003. The increase in nonperforming assets
since December 31, 2002 were mainly attributable to the carrying value at
September 30, 2003 of loans totaling of $666,507 made to a borrower who filed
for bankruptcy protection during the first quarter and to the carrying value of
$397,592 for a nonaccrual loan recorded initially in the second quarter. Net
reductions of other various nonperforming loans were recorded during the third
quarter of 2003 as these loans were restructured, worked out or charged off. At
September 30, 2003, nonperforming loans amounted to $1,474,862 million of which,
$150,488 were still accruing but past due 90 days or more. Nonperforming loans
at December 31, 2002 were $719,441 of which, $87,304 were still accruing but
past due 90 days or more.
All nonaccrual loans at September 30, 2003 and December 31, 2002 were also
classified as impaired loans.
At September 30, 2003 and December 31, 2002, the Company did not have any loans
recorded as troubled debt restructurings. It did have one property recorded as
other real estate owned (OREO) for a fair market value of $80,000 at September
30, 2003.
The following table summarizes the Company's nonperforming assets at the dates
indicated:
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------- -------------
Loans past due over 90 days and still accruing $ 150,488 $ 87,304
Nonaccrual loans 1,474,862 632,137
------------- -------------
Total nonperforming loans $ 1,625,350 $ 719,441
Other real estate owned 80,000 --
------------- -------------
Total nonperforming assets $ 1,705,350 $ 719,441
============= =============
Nonperforming loans to total loans 0.43% 0.22%
Nonperforming assets to total assets 0.40% 0.19%
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 is made up of three
types of allocations: identified specific allocation, a percentage allocation
based on loss history for different loan groups, and unallocated. Management
allocates specific portions of the allowance for loan losses based on
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 credit based on delinquency rates, collateral and
other risk factors identified for that credit. 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 the ability of some of those factors, based upon peer
industry
12
data of comparable banks. The unallocated allowance is maintained to recognize
the imprecision of estimating and measuring loss when evaluating loss
allocations for individual loans or pools of loans.
The allowance for loan losses at September 30, 2003 was $5.6 million or 1.51% of
total loans outstanding; an increase over the $4.7 million or 1.48% at December
31, 2002. The provision for loan losses during the first nine months of 2003 was
$1.8 million compared to $1.3 million in the first nine months of 2002. Total
net charge-offs for the nine-month period ended September 30, 2003 were
$951,915, mainly attributable to $600,000 of unauthorized loans identified in
the residential mortgage loan portfolio, and were $368,323 during the same
period a year ago.
The table below summarizes the allowance allocations by type as of the following
dates:
SEPTEMBER 30, 2003 DECEMBER 31, 2002
-------------------- --------------------
Specific allocations $ 3,327,000 $ 2,042,000
Loan pool percentage allocations 2,290,000 2,674,000
Unallocated 12,000 30,000
-------------------- --------------------
Total allowance for loan losses $ 5,629,000 $ 4,746,000
==================== ====================
In general, the addition to the allowance for loan losses during the first three
quarters of this year was directly attributable to the amount of the loan growth
and net charge-off activity during the period and attributable to risk factors,
such as watchlist directed specific allocations as well as peer bank loss
experience. Net charge-offs for the first nine months of 2003 were $951,915
compared to $368,323 for the first nine months of 2002. This increase was mainly
attributable to $600,000 of charge-offs for unauthorized loans identified in the
residential mortgage loan portfolio. In addition to the charge-offs for
unauthorized mortgage loans, there was $351,915 in other net charge-offs for the
period ended September 30, 2003. Nonperforming loans increased during the first
nine months of 2003 by $.9 million and were $1.6 million at September 30, 2003.
As a result of the increased level of nonperforming loans at September 30, 2003,
and some deterioration of credit quality due to the current soft economy,
specific allocations of the loss allowance increased $1.3 million from December
31, 2002. The amount of the allowance allocated for loan pools declined during
the first nine months as a net result of increased loans outstanding, which was
more than offset by a decrease in loss experience percentages mainly for
commercial loans.
Management considers the allowance for loan losses at September 30, 2003 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 2003 as a result of anticipated increases in the total loan
portfolio.
The following table summarizes changes in the Company's allowance for loan
losses for the periods indicated:
2003 2002
----------- -----------
Beginning balance, January 1 $ 4,745,672 $ 3,480,205
Provision charged to operating expense 1,835,000 1,295,000
Charge-offs (984,703) (372,863)
Recoveries 32,788 4,540
----------- -----------
Ending balance, September 30 $ 5,628,757 $ 4,406,882
=========== ===========
Net charge-offs to average loans (annualized) 0.36% 0.18%
Other Assets. The increase in other assets was mainly attributable to the
purchase of $3.0 million in bank-owned life insurance (BOLI). The BOLI
investment provides a complement of income that funds employee benefit plans for
the Company and key man life insurance.
Deposits. Total deposits were $363.5 million at September 30, 2003. Total
deposits at December 31, 2002 were $310.6 million. While growth during the first
nine months of 2003 was reflected in most categories, it was evident mainly in
CDs under $100,000, CDs over $100,000, demand deposits and money market
accounts. Growth was approximately $8.3 million in CDs under $100,000 and $13.2
million in CDs over $100,000. Money market accounts increased by
13
$21.6 million since year end 2002 while demand deposits also reflected good
growth and increased $12.0 million. The majority of the increase in deposits
during the first nine months of 2003 was from business, national market CDs and
public fund accounts. While the majority of overall deposit funding has come
from the local market in prior years, during the first nine months of 2003 the
deposit growth was generated primarily from the national market. Non Brokered
national market CDs less than or equal to $100,000 grew during the first nine
months by $17.7 million and reached $44.6 million at September 30, 2003 or 12.3%
of the total deposit portfolio. The amount of non brokered national market CDs
at December 31, 2002 was $26.9 million. During the second and third quarters of
2003 the bank began using brokered deposits and acquired a total of $15.9
million of brokered deposits or 4.4% of the total deposits.
The following table summarizes the Company's deposit balances at the dates
indicated:
SEPTEMBER 30, 2003 DECEMBER 31, 2002
------------------------ ------------------------
BALANCE % BALANCE %
------------ ----- ------------ -----
Noninterest-bearing demand $ 54,935,268 15.1% $ 42,966,347 13.8%
Interest-bearing checking 16,757,173 4.6% 21,582,021 7.0%
Money market 120,725,171 33.2% 99,104,831 31.9%
Savings 10,926,654 3.0% 8,342,455 2.7%
Time, under $100,000 63,132,646 17.4% 54,803,014 17.6%
Time, $100,000 and over 96,986,670 26.7% 83,785,319 27.0%
------------ ----- ------------ -----
Total deposits $363,463,582 100.0% $310,583,987 100.0%
============ ===== ============ =====
Borrowings. Short-term borrowings at both September 30, 2003 and December 31,
2002 were $1.1 million and were entirely comprised of overnight federal funds
purchased from one correspondent bank. In addition to federal funds purchased,
the Company also had borrowings in the amount of $19.0 million and $21.5 million
in Federal Home Loan Bank ("FHLB") advances at September 30, 2003 and December
31, 2002, respectively. The net $2.5 million decrease in FHLB advances during
the first nine months of 2003 reflected the payoff of a $5.5 million maturing
advances and the purchase of one additional $3.0 million advance. Two of the
remaining six FHLB advances mature in 2011, and each of these have quarterly
call features. The other four are bullet advances with maturities that range
from December 2003 to June 2005.
Other Liabilities. Other liabilities decreased $665,212 from year-end 2002. The
decrease in other liabilities was primarily related to the payment of various
payroll expenses in the first quarter 2003 that had been accrued at December 31,
2002.
RESULTS OF OPERATIONS
For The Three Month Periods Ended September 30
Results of operations for the three-month period ended September 30, 2003
reflected net income of $614,978 or $0.15 per diluted share. This was a $186,719
or 43.6% increase over 2002's third quarter net income of $428,259. Net income
per diluted share for third quarter of 2002 was $0.14. In the third quarter
2003, $130,000 of pretax special charges were recorded for unauthorized mortgage
loan activity. Diluted per share performance for the third quarter of 2003 was
also affected by a 30% increase in the number of average dilutive shares
outstanding as a result of the Company's rights offering and limited public
offering completed in August 2002.
The increase in total revenue for the third quarter of 2003 as compared to the
prior year was very positive, as total revenue, defined as net interest income
plus total noninterest income, increased 27.8%. For the three-month period ended
September 30, 2003, net interest income increased 27.3% and total noninterest
income increased 29.4% from the same period one year ago.
14
PERFORMANCE RATIOS SEPTEMBER 30,
-----------------------
2003 2002
------- -------
Return on average assets * 0.60% 0.50%
Return on average equity * 6.12% 5.79%
Net interest margin * 3.06% 3.15%
Efficiency ratio 67.62% 64.77%
* annualized
Net Interest Income. Interest income for the three-month periods ended September
30, 2003 and 2002 was $4.5 million and $4.3 million, respectively, while
interest expense for those periods were $1.5 million and $1.7 million,
respectively, resulting in net interest income of $3.0 million for the third
quarter of 2003 and $2.6 million for the third quarter of 2002. The increase
during each quarter of 2002 and 2003 in net interest income was reflective of
the general growth in loans and other earning assets during those periods. The
net interest margin for the third quarter of 2003 was 3.06%, while the net
interest margin for the third quarter of 2002 was 3.15%. The nine basis point
decrease in net interest margin was due primarily to the average earning assets
increasing faster than net interest income causing a smaller margin. The rate
spread between the yield and cost for the three months ended September 30, 2003
was relatively unchanged from the same period last year.
The following table reflects the average balance, interest earned or paid, and
yield or cost of the Company's assets, liabilities and stockholders' equity at
and for the dates indicated:
15
AT AND FOR THE THREE MONTH PERIODS ENDED
--------------------------------------------------------------------------
SEPTEMBER 30, 2003 SEPTEMBER 30, 2002
----------------------------------- -----------------------------------
INTEREST ANNUALIZED INTEREST ANNUALIZED
AVERAGE EARNED YIELD AVERAGE EARNED YIELD
($ in thousands) BALANCE OR PAID OR COST BALANCE OR PAID OR COST
--------- --------- ---------- --------- --------- ----------
Assets
Short-term investments and
interest-earning deposits $ 5,559 $ 13 0.93% $ 10,154 $ 47 1.84%
Federal funds sold 10,515 24 0.91% 15,079 68 1.79%
Securities - taxable 9,138 72 3.13% 8,722 106 4.82%
Securities - tax exempt (1) 3,196 46 5.71% 1,907 29 6.03%
Loans held for sale 725 9 4.93% 1,359 12 3.50%
Loans 366,453 4,345 4.70% 294,877 4,070 5.48%
--------- --------- --------- ---------
Total interest-earning assets 395,586 4,509 4.52% 332,098 4,332 5.18%
Allowance for loan losses (5,623) (4,259)
Cash and due from banks 10,505 7,523
Other assets 9,444 5,137
--------- ---------
Total assets $ 409,912 $ 340,499
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Interest-bearing checking $ 17,401 $ 15 0.34% $ 13,164 $ 34 1.02%
Savings 10,644 8 0.30% 6,941 26 1.49%
Money market 116,461 317 1.08% 115,096 515 1.78%
Certificates of deposit 155,847 903 2.30% 113,138 877 3.08%
Short-term borrowings 1,705 5 1.16% 1,060 5 1.87%
FHLB advances 19,000 127 2.65% 21,500 157 2.90%
Trust preferred securities 3,500 79 8.95% 3,500 79 8.95%
--------- --------- --------- ---------
Total interest-bearing liabilities 324,558 1,454 1.78% 274,399 1,693 2.45%
Noninterest-bearing checking 44,915 35,512
Other liabilities 564 1,024
Stockholders' equity 39,875 29,564
--------- ---------
Total liabilities and stockholders' equity $ 409,912 $ 340,499
========= =========
NET INTEREST INCOME $ 3,055 $ 2,639
========= =========
RATE SPREAD 2.74% 2.73%
NET INTEREST INCOME AS A PERCENT
OF AVERAGE EARNING ASSETS 3.06% 3.15%
========== ==========
(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 $300,000 during the third quarter of 2003 as compared to $475,000 for
the third quarter of 2002. The provision recorded for the third quarter of 2003
was directly related to the growth in the loan portfolio, risk factors inherent
in the loan portfolio and recorded charge-offs with $40,000 directly
attributable to unauthorized loans identified in the residential mortgage loan
portfolio. The allowance for loan losses at September 30, 2003 totaled $5.6
million and was 1.51% of total loans outstanding on that date. Total net
charge-offs for the three-month period ended September 30, 2003 were $185,200
and were $198,255 during the same period a year ago.
Noninterest Income. Noninterest income was $920,313 during the third quarter of
2003. This was a $209,273 or 29.4% increase over the third quarter of 2002. The
increase in noninterest income from the comparable period was reflected in all
categories and mainly attributable to a 21.5% growth in fees from trust services
resulting from more assets under management, a 58.8% growth in service charge
revenue generally reflective of a growth in and development of deposit accounts,
an 13.9% growth in loan broker fees from mortgage origination, and a 56.5%
increase in other fees. The growth in other fees was in part attributable to an
18.1% increase in the Company's off-balance sheet mutual fund sweep product. The
sweep product fees represent administrative fees paid to the Company to transfer
customer deposits to a third-party mutual fund, which is not reflected on the
balance sheet.
16
Noninterest Expense. Noninterest expense was $2.7 million for the third quarter
of 2003 while noninterest expense for the three-month period ended September 30,
2002 was $2.2 million. The main components of noninterest expense for the third
quarter of 2003 were salaries and benefits of $1.5 million, occupancy and
equipment costs of $303,888, and loan and professional costs in the amount of
$202,433. These costs were mainly the result of human resource needs to operate
the Bank, rent expense and equipment depreciation, as well as normal
professional fees for accountants, attorneys and other professionals. Expense
totals for the 2003 quarter were higher than those for the third quarter of 2002
and were mainly reflective of 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 third new branch office in September 2002. Noninterest expense for the
third quarter of 2003 was also increased by $90,000 of further charges relating
to improper mortgage transactions identified by the Company.
Income Taxes. During the quarters ended September 30, 2003 and 2002, the Company
recorded $367,240 and $273,100, respectively, in income taxes expense. The
effective tax rate was 37.4% for 2003 as compared to 38.9% for 2002. The reduced
effective tax rate in 2003 compared to 2002 was reflective of a higher level of
tax-exempt security income and nontaxable income on BOLI in 2003.
For The Nine Month Periods Ended September 30
Results of operations for the nine-month period ended September 30, 2003
reflected net income of $1,230,170 or $0.31 per diluted share. This reflected a
$126,478 or 11.5% increase from 2002's nine-month period net income of
$1,103,692. Net income per diluted share for the nine-month period ended
September 30, 2002 was $0.40. The operating results for the nine-month period
ended September 30, 2003 were adversely affected by total pretax special charges
of $965,000 for losses discovered in the Company's residential mortgage
operation. During the first nine months of 2003, special charges were recorded
as a $600,000 addition to the provision for loan losses for unauthorized
mortgage loans and a $365,000 addition to other expense for improper mortgage
transactions and other unreconciled activity in a mortgage operating account.
Diluted per share performance for the first nine months of 2003 was also
affected by a 44.9% increase in the number of average dilutive shares
outstanding as a result of the Company's rights offering and limited public
offering completed in August 2002.
During the fourth quarter of 2002, the Company recorded a $428,000 addition to
other expense as audit results showed stale-dated receivables existed in a
mortgage operating account. Further investigation by the Company during the
first nine months of 2003 uncovered unauthorized mortgage loans and improper
mortgage activity in the operating account. A total of $1,393,000 in pretax
special charges has been recorded to date to address these identified issues. An
employee of the Company was terminated as a result of this investigation, and
management has made appropriate modifications in its internal controls. 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.
The increase in total revenue for the first nine months of 2003 as compared to
the prior year period was very positive, as total revenue, defined as net
interest income plus total noninterest income, increased 26.3%. For the
nine-month period ended September 30, 2003, net interest income increased 18.3%
and total noninterest income increased 58.4% from the same period one year ago.
PERFORMANCE RATIOS SEPTEMBER 30,
------------------------
2003 2002
------- -------
Return on average assets * 0.42% 0.47%
Return on average equity * 4.15% 5.66%
Net interest margin * 3.05% 3.18%
Efficiency ratio 67.01% 65.86%
* annualized
Net Interest Income. Interest income for the nine-month periods ended September
30, 2003 and 2002 was $13.2 million and $12.1 million, respectively, while
interest expense for those periods was $4.6 million and $4.8 million,
respectively, resulting in net interest income of $8.6 million for the
nine-month period of 2003 and $7.3 million for the nine-month period of 2002.
The increase during the first nine months of 2002 and 2003 in net interest
income was reflective of the
17
general growth in loans and other earning assets during those periods. The net
interest margin for the first nine months of 2003 was 3.05%, while the net
interest margin for the first nine months of 2002 was 3.18%. This decrease in
net interest margin was partially due to a six basis point net decline in rate
spread consisting of approximately 61 basis points decline in earning asset
yields and a 55 basis points decline in funding costs compared to the first nine
months ended September 30, 2002. The remainder of the decrease in net interest
margin was the result of earning asset growth outpacing growth in the net
interest margin. The decline in yield and cost was primarily attributable to the
repricing of variable rate loans and deposit products as the prime rate was
reduced.
The following table reflects the average balance, interest earned or paid and
yield or cost of the Company's assets, liabilities and stockholders' equity at
and for the dates indicated:
AT AND FOR THE NINE MONTH PERIODS ENDED
---------------------------------------------------------------------------------
SEPTEMBER 30, 2003 SEPTEMBER 30, 2002
------------------------------------- ---------------------------------------
INTEREST ANNUALIZED INTEREST ANNUALIZED
AVERAGE EARNED YIELD AVERAGE EARNED YIELD
($ in thousands) BALANCE OR PAID OR COST BALANCE OR PAID OR COST
--------- --------- ---------- --------- --------- ---------
Assets
Short-term investments and
interest-earning deposits $ 4,844 $ 44 1.21% $ 10,158 $ 160 2.11%
Federal funds sold 12,609 91 0.96% 12,195 159 1.74%
Securities - taxable 9,527 247 3.47% 7,533 267 4.74%
Securities - tax exempt (1) 2,579 108 5.60% 1,306 57 5.84%
Loans held for sale 1,017 42 5.52% 1,977 54 3.65%
Loans 348,879 12,713 4.87% 273,794 11,428 5.58%
--------- --------- --------- ---------
Total interest-earning assets 379,455 13,245 4.67% 306,963 12,125 5.28%
Allowance for loan losses (5,269) (3,932)
Cash and due from banks 9,690 6,680
Other assets 8,637 4,475
--------- ---------
Total assets $ 392,513 $ 314,186
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Interest-bearing checking $ 16,726 $ 61 0.49% $ 12,972 $ 99 1.02%
Savings 9,848 40 0.54% 5,975 69 1.54%
Money market 105,165 928 1.18% 108,413 1,506 1.86%
Certificates of deposit 154,199 2,905 2.52% 110,705 2,607 3.15%
Short-term borrowings 1,318 11 1.12% 1,492 18 1.61%
FHLB advances 19,699 411 2.79% 12,321 286 3.10%
Trust preferred securities 3,500 238 9.09% 3,469 238 9.17%
---------- --------- --------- ---------
Total interest-bearing liabilities 310,455 4,594 1.98% 255,347 4,823 2.53%
Noninterest-bearing checking 41,433 31,980
Other liabilities 983 854
Stockholders' equity 39,642 26,005
--------- ---------
Total liabilities and stockholders' equity $ 392,513 $ 314,186
========= =========
NET INTEREST INCOME $ 8,651 $ 7,302
========= =========
RATE SPREAD 2.69% 2.75%
NET INTEREST INCOME AS A PERCENT
OF AVERAGE EARNING ASSETS 3.05% 3.18%
====== =====
(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 $1.8 million during the first nine months of 2003 as compared to $1.3
million for the first nine months of 2002. Total net charge-offs for the
nine-month period ended September 30, 2003 were $951,915, mainly attributable to
$600,000 of unauthorized loans identified in the residential mortgage loan
portfolio, and were $368,323 during the same period a year ago. At September 30,
2003, nonperforming loans amounted to $1,625,350 of which $150,488 was still
accruing but past due 90 days or more.
18
Noninterest Income. Noninterest income was $2.9 million during the first nine
months of 2003. This was a $1,064,599 or 58.4% increase over the first nine
months of 2002. The increase in noninterest income from the comparable period
was reflected in all categories and mainly attributable to a 29.3% growth in
fees from trust services resulting from more assets under management, a 61.6%
growth in service charge revenue generally reflective of a growth in and
development of deposit accounts, an 68.7% growth in loan broker fees from
mortgage origination, a 53.6% increase in other fees, and a $190,766 net gain on
sale of securities. The growth in other fees was in part attributable to a 27.1%
increase in the Company's off-balance sheet mutual fund sweep product. The sweep
product fees represent administrative fees paid to the Company to transfer
customer deposits to a third-party mutual fund, which is not reflected on the
balance sheet. The net gain on the sale of securities was taken as part of a
normal investment appreciation/reinvestment transaction analysis.
Noninterest Expense. Noninterest expense was $7.7 million for the first nine
months of 2003 while noninterest expense for the nine-month period ended
September 30, 2002 was $6.0 million. The main components of noninterest expense
for the first nine months of 2003 were salaries and benefits of $4.1 million,
occupancy and equipment costs of $909,951, and loan and professional costs in
the amount of $529,516. These costs were mainly the result of human resource
needs to operate the Bank, rent expense and equipment depreciation, as well as
normal professional fees for accountants, attorneys and other professionals.
Expense totals for the first nine months of 2003 were higher than those for the
first nine months of 2002 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 third new branch office in September 2002. Noninterest expense for
the first nine months of 2003 was also increased by a $365,000 addition to other
expense, mainly during the first quarter of 2003, for improper mortgage
transactions and other unreconciled activity identified by the Company in a
mortgage operating account.
Income Taxes. During the nine-month periods ended September 30, 2003 and 2002,
the Company recorded $723,910 and $709,900, respectively, in income taxes
expense. The effective tax rate was 37.0% for 2003 as compared to 39.1% for
2002. The reduced effective tax rate in 2003 compared to 2002 was attributable
to a higher level of tax-exempt security income and nontaxable income on BOLI in
2003.
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. 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, trust preferred securities and, beginning
with the second quarter 2003, brokered CDs. In aggregate these out-of-market
deposits and borrowings represented $83.1 million or 21.5% of the Company's
total funding at September 30, 2003. Total deposits at September 30, 2003 were
$363.5 million and the loan to deposit ratio was 102.9%. Total borrowings at
September 30, 2003 were $23.6 million. Additionally, the Company expects to
continue to experience loan growth and that funding for the loan growth will
continue to come from in-market sources through the marketing of products and
the development of branch locations. The Company and the Bank will continue to
develop and use wholesale, out-of-market deposits (such as national market CDs)
and borrowing capacities 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 $40.2 million
and $39.2 million at September 30, 2003 and December 31, 2002, respectively.
Affecting the increase in stockholders' equity during the first three quarters
of 2003 was $1,230,170 in net income, $11,850 from the exercise of 1,010 stock
options net of the tax effect and a $250,997 decrease in the unrealized
appreciation of securities available for sale, net of tax.
The Company and the Bank are subject to regulatory capital requirements
administered by federal banking agencies. Failure to meet the various capital
requirements can initiate regulatory action that could have a direct material
effect on the financial statements. As a condition to regulatory approvals for
the formation of the Bank, the Company was required to have capitalization
sufficient to provide a ratio of Tier 1 capital to total assets of not less than
eight percent (8%) and Tier 1 capital to average assets in excess of nine
percent (9%), during the first three years of operation. These restrictions
expired in February 2002. Both the Company and the Bank are now subject to the
same capitalization requirements as
19
other financial holding companies and banks. Since the Bank began operations,
both the Company and the Bank have been categorized as "Well Capitalized," the
highest classification contained within the banking regulations.
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 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:
SEPTEMBER 30, 2003 DECEMBER 31, 2002
------------------------------------------- ------------------------------------------
Well- Minimum Well- Minimum
Actual Capitalized Required Actual Capitalized Required
------ ----------- --------- ------ ------------ --------
THE COMPANY
Leverage capital 10.65% 5.00% 4.00% 11.75% 5.00% 4.00%
Tier 1 risk-based 11.38% 6.00% 4.00% 12.61% 6.00% 4.00%
Total risk-based 12.63% 10.00% 8.00% 13.86% 10.00% 8.00%
THE BANK
Leverage capital 9.00% 5.00% 4.00% 9.80% 5.00% 4.00%
Tier 1 risk-based 9.61% 6.00% 4.00% 10.52% 6.00% 4.00%
Total risk-based 10.86% 10.00% 8.00% 11.77% 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.
Loan commitments to extend credit are agreements to lend to a customer at any
time, as the customer's needs vary, as long as there is no violation of any
condition established in the contract. Standby letters of credit are conditional
commitments issued by the Bank to guarantee the performance of a customer to a
third party. Commitments generally have fixed expiration dates or other
termination clauses and may require payment of a fee. Since many of the
commitments are expected to expire without being drawn upon, the total
commitment amounts do not necessarily represent future cash requirements. We
monitor fluctuations in loan balances and commitment levels and include such
data in our overall liquidity management.
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 instruments are recorded when they are funded.
The Bank uses the same credit policies in making commitments and conditional
obligations as it does for on-balance-sheet instruments. Collateral, such as
accounts receivable, securities, inventory, property and equipment, is generally
required based on management's credit assessment of the borrower.
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 September 30, 2003, the
rates on existing off-balance-sheet instruments were equivalent to current
market rates, considering the underlying credit standing of the counterparties.
The Company and the Bank occupy their respective headquarters, offices and other
facilities under long-term operating leases and, in addition, are parties to
long-term contracts for data processing and operating systems.
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Under the terms of certain employment contracts, upon the occurrence of certain
events resulting in the severance of certain executive officers' employment with
the Company, payments may be required to be made in excess of amounts that have
been accrued.
Tabular disclosure of the Company's contractual obligations as of the end of our
latest fiscal year was provided in our Form 10-KSB for the year ended December
31, 2002. On April 7, 2003, the Company entered into an additional operating
lease for its fourth branch site in Fort Wayne. The terms of that agreement are
for a ten-year lease and aggregate rental payments of $697,410. The lease
payments do not begin until occupancy, which is scheduled for December 2003.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company previously filed its periodic reports as a small business
issuer through the period ended December 31, 2002. The information required by
Item 305 of Regulation S-K was not required under the disclosure requirements
for small business issuers. Pursuant to Item 305, disclosure of quantitative and
qualitative information about market risk is required in filings that include
audited financial statements. Information relating to interim financial
statements is not required until after the first fiscal year end in which Item
305 is applicable. Consequently, the Company will provide a comprehensive
quantitative and qualitative analysis regarding market risk in our Form 10-K for
the year ending December 31, 2003.
ITEM 4. CONTROLS AND PROCEDURES
We are responsible for establishing and maintaining a set of disclosure controls
and procedures that 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
the end of the third quarter 2003, 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 Executive Vice President
and Chief Financial Officer, of the effectiveness of the design and operation of
our disclosure controls and procedures pursuant to Rule 13a-15 of the Exchange
Act. Based on that evaluation, our Chairman, President and Chief Executive
Officer and our Executive Vice President and Chief Financial Officer concluded
that our disclosure controls and procedures are effective.
During our first quarter evaluation of our internal controls, we discovered (i)
improper transactions and various unreconciled items in a residential mortgage
operating account and (ii) unauthorized loans in the residential mortgage loan
portfolio that have resulted in total pretax special charges of $965,000 for the
nine months ended September 30, 2003. Management believes it has substantially
completed its investigation into this and that it has identified the majority of
the losses. The Company has filed and is attempting to recover a portion of such
losses through fidelity bond insurance and collection efforts.
In response to the significant deficiencies and material weaknesses in internal
controls discovered in the first quarter 2003, bank employees were assigned to
research and identify all improper transactions in the mortgage operating
account. Management believes it implemented modifications to the internal
controls during the first quarter that identified the source of the problem and,
to date, one employee has been terminated. In addition, management increased the
segregation of mortgage operation duties and enhanced the mortgage loan approval
process. The Company also enhanced its internal audit function. Periodic updates
and summary reports have been and will continue to be provided to the Audit
Committee, which has oversight responsibility for implementing appropriate
corrective actions and the Company continues to evaluate existing mortgage
operations and processes for future improvements in internal controls.
There were no changes in our internal controls over financial reporting during
our third quarter 2003 that materially affected or are reasonably likely to
materially affect our internal control over financial reporting.
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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 5. OTHER INFORMATION
Craig S. Hartman resigned from the Board of Directors of the Company and the
Bank with a letter dated September 12, 2003 due to personal time constraints.
The board accepted Mr. Hartman's resignation at its regular meeting on October
21, 2003. The board's present intention is to amend the Company's by-laws and
reduce the size of the board, and therefore, the board does not intend to fill
this vacancy
On October 31, 2003, the Company released results of operations for the third
quarter ended September 30, 2003 which was reported on Form 8K dated November 3,
2003. The Company reported that diluted earnings per share for the three-month
period ended September 30, 2003 was $0.16. As a result of an incorrect number of
average shares outstanding used in that calculation, diluted earnings per share
for the quarter ended September 30, 2003 has been corrected to $0.15, as
disclosed in this quarterly report.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
31.1 Certification of Chief Executive Officer pursuant to Rule 13a -
14(a)/15d - 14(a)
31.2 Certification of Chief Financial Officer pursuant to Rule 13a -
14(a)/15d - 14(a)
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 August 4, 2003, we furnished a current report on Form 8-K dated
July 31, 2003 to report, under Item 12 of Form 8-K, our results of
operations for the quarter ended June 30, 2003.
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
TOWER FINANCIAL CORPORATION
Dated: November 13, 2003 /s/ Donald F. Schenkel
----------------------------------------
Donald F. Schenkel, Chairman of the Board,
President and Chief Executive Officer
Dated: November 13, 2003 /s/ Kevin J. Himmelhaver
----------------------------------------
Kevin J. Himmelhaver, Executive Vice
President, Chief Financial Officer and
Secretary
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