UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[ X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2004
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934.
For the transition period from ________ to ________
Commission File Number: 1.000-26099
FARMERS & MERCHANTS BANCORP
(Exact name of registrant as specified in its charter)
Delaware 94-3327828
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
111 W. Pine Street, Lodi, California 95240
(Address of principal Executive offices) (Zip Code)
Registrant's telephone number, including area code (209) 367-2300
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [ X ] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [ X ] No [ ]
Number of shares of common stock of the registrant: Par value $0.01, authorized
2,000,000 shares; issued and outstanding 760,642 as of April 27, 2004.
1
FARMERS & MERCHANTS BANCORP
FORM 10-Q
TABLE OF CONTENTS
PART I. - FINANCIAL INFORMATION Page
Item 1 - Financial Statements
Consolidated Balance Sheets as of March 31, 2004,
December 31, 2003 and March 31, 2003. 3
Consolidated Statements of Income for the Three Months
Ended March 31, 2004 and 2003. 4
Consolidated Statements of Comprehensive Income for the Three
Months Ended March 31, 2004 and 2003. 5
Statement of Changes in Shareholders' Equity for the Three
Months Ended March 31, 2004 and 2003. 6
Consolidated Statement of Cash Flows for the Three
Months Ended March 31, 2004 and 2003. 7
Notes to Consolidated Financial Statements 8
Item 2 - Management's Discussion and Analysis 13
Item 3 - Quantitative and Qualitative Disclosures About Market Risk 21
Item 4 - Controls and Procedures 25
PART II. - OTHER INFORMATION 28
Signatures 29
Index to Exhibits 30
2
PART I. - FINANCIAL INFORMATION
Item 1 - Financial Statements
FARMERS & MERCHANTS BANCORP
Consolidated Balance Sheets
- -------------------------------------------------------------------------- -------------- -------------- --------------
(in thousands) March 31, December 31, March 31,
2004 2003 2003
Assets (Unaudited) (Unaudited)
- -------------------------------------------------------------------------- -------------- -------------- --------------
Cash and Cash Equivalents:
Cash and Due From $34,764 $35,800 $32,997
Federal Funds Sold 2,900 0 5,790
- -------------------------------------------------------------------------- -------------- -------------- --------------
Total Cash and Cash Equivalents 37,664 35,800 38,787
Investment Securities:
Available-for Sale 210,330 223,965 272,239
Held-to-Maturity 35,981 37,957 44,602
- -------------------------------------------------------------------------- -------------- -------------- --------------
Total Investment Securities 246,311 261,922 316,841
- -------------------------------------------------------------------------- -------------- -------------- --------------
Loans 799,034 808,998 688,802
Less: Unearned Income (1,929) (2,092) (1,977)
Less: Allowance for Loan Losses (17,564) (17,220) (16,871)
- -------------------------------------------------------------------------- -------------- -------------- --------------
Loans, Net 779,541 789,686 669,954
- -------------------------------------------------------------------------- -------------- -------------- --------------
Land, Buildings & Equipment 11,130 11,209 11,323
Interest Receivable and Other Assets 46,915 49,948 42,689
- -------------------------------------------------------------------------- -------------- -------------- --------------
Total Assets $1,121,561 $1,148,565 $1,079,594
========================================================================== ============== ============== ==============
Liabilities & Shareholders' Equity
- -------------------------------------------------------------------------- -------------- -------------- --------------
Deposits:
Demand $217,328 $223,000 $189,999
Interest Bearing Transaction 93,655 96,869 90,675
Savings 279,263 276,016 249,862
Time Deposits 316,346 308,464 319,452
- -------------------------------------------------------------------------- -------------- -------------- --------------
Total Deposits 906,592 904,349 849,988
- -------------------------------------------------------------------------- -------------- -------------- --------------
Fed Funds Purchased 0 1,000 0
FHLB Borrowings 80,918 111,928 100,956
Subordinated Debentures 10,310 10,310 0
Other Liabilities 10,278 11,373 22,444
- -------------------------------------------------------------------------- -------------- -------------- --------------
Total Liabilities 1,008,098 1,038,960 973,388
- -------------------------------------------------------------------------- -------------- -------------- --------------
Shareholders' Equity
Common Stock 8 8 7
Additional Paid In Capital 71,560 72,506 64,479
Retained Earnings 41,551 37,650 40,150
Accumulated Other Comprehensive Income 344 (559) 1,570
- -------------------------------------------------------------------------- -------------- -------------- --------------
Total Shareholders' Equity 113,463 109,605 106,206
- -------------------------------------------------------------------------- -------------- -------------- --------------
Total Liabilities & Shareholders' Equity $1,121,561 $1,148,565 $1,079,594
========================================================================== ============== ============== ==============
The accompanying notes are an integral part of these consolidated financial
statements
3
FARMERS & MERCHANTS BANCORP
Consolidated Statements of Income (Unaudited)
- -------------------------------------------------------------------------- --------------- --------------
Three Months
Ended March 31,
2004 2003
- -------------------------------------------------------------------------- --------------- --------------
Interest Income
Interest & Fees on Loans $11,673 $10,592
Federal Funds Sold 52 79
Securities:
Taxable 1,726 1,909
Non-taxable 594 619
- -------------------------------------------------------------------------- --------------- --------------
Total Interest Income 14,045 13,199
- -------------------------------------------------------------------------- --------------- --------------
Interest Expense
Interest Bearing Transaction 14 49
Savings 256 345
Time Deposits 1,322 1,907
Interest on Borrowed Funds 716 577
Interest on Subordinated Debentures 105 0
- -------------------------------------------------------------------------- --------------- --------------
Total Interest Expense 2,413 2,878
- -------------------------------------------------------------------------- --------------- --------------
Net Interest Income 11,632 10,321
Provision for Loan Losses 375 200
- -------------------------------------------------------------------------- --------------- --------------
Net Interest Income After Provision for Loan Losses 11,257 10,121
- -------------------------------------------------------------------------- --------------- --------------
Non-Interest Income
Service Charges on Deposit Accounts 1,189 1,176
Net Gain (Loss) on Sale of Investment Securities 641 132
Credit Card Merchant Fees 384 354
Increase in Cash Surrender Value of Life Insurance 420 383
Other 910 906
- -------------------------------------------------------------------------- --------------- --------------
Total Non-Interest Income 3,544 2,951
- -------------------------------------------------------------------------- --------------- --------------
Non-Interest Expense
Salaries & Employee Benefits 6,053 4,939
Occupancy 459 405
Equipment 440 601
Other Operating 1,746 1,804
- -------------------------------------------------------------------------- --------------- --------------
Total Non-Interest Expense 8,698 7,749
- -------------------------------------------------------------------------- --------------- --------------
Net Income Before Taxes 6,103 5,323
Provision for Taxes 2,201 1,922
- -------------------------------------------------------------------------- --------------- --------------
Net Income $3,902 $3,401
========================================================================== =============== ==============
Earnings Per Share $5.12 $4.43
========================================================================== =============== ==============
The accompanying notes are an integral part of these consolidated financial
statements
4
FARMERS & MERCHANTS BANCORP
Consolidated Statements of Comprehensive Income (Unaudited)
- --------------------------------------------------------------------------------------- ----------- ----------
(in thousands) For Three Months
Ended March 31,
2004 2003
- --------------------------------------------------------------------------------------- ----------- ----------
Net Income $ 3,902 $ 3,401
Other Comprehensive Income (Loss) -
Unrealized Gains on Derivative Instruments:
Unrealized holding gains arising during the period, net
of income tax effects of $75 and $55 for the quarters ended
March 31, 2004 and 2003, respectively. 104 76
Less: Reclassification adjustment for realized gains included in net
income, net of related income tax effects of $(32) and $0 for the
quarters ended March 31, 2004 and 2003, respectively. (44) -
Unrealized Gains (Losses) on Securities:
Unrealized holding gains (losses) arising during the period, net of income
tax effects of $882 and $(188) for the quarters ended March 31, 2004 and
2003, respectively. 1,215 (260)
Less: Reclassification adjustment for realized gains included in net
income, net of related income tax effects of $(269) and $(56) for the
quarters ended March 31, 2004 and 2003, respectively. (372) (76)
- --------------------------------------------------------------------------------------- ----------- ----------
Total Other Comprehensive Income (Loss) 903 (260)
- --------------------------------------------------------------------------------------- ----------- ----------
Comprehensive Income $ 4,805 $ 3,141
======================================================================================= =========== ==========
The accompanying notes are an integral part of these consolidated financial
statements
5
FARMERS & MERCHANTS BANCORP
Consolidated Statements of Changes in Shareholders' Equity (Unaudited)
- -----------------------------------------------------------------------------------------------------------------------------------
(in thousands except share data) Accumulated
Common Additional Other Total
Shares Common Paid-In Retained Comprehensive Shareholders'
Outstanding Stock Capital Earnings Income Equity
- --------------------------------------- --------------- ------------ ------------- ------------- ------------------ ----------------
Balance, December 31, 2002 733,021 $ 7 $ 64,979 $ 36,749 $ 1,830 $ 103,565
======================================= =============== ============ ============= ============= ================== ================
Net Income - - 3,401 - 3,401
Redemption of Stock (2,000) - (500) - - (500)
Unrealized Gains on Derivative Instruments - - - 76 76
Changes in Net Unrealized Gain (Loss) on
Securities Available for Sale - - - (336) (336)
- --------------------------------------- --------------- ------------ ------------- ------------- ------------------ ----------------
Balance, March 31, 2003 731,021 $ 7 $ 64,479 $ 40,150 $ 1,570 $ 106,206
======================================= =============== ============ ============= ============= ================== ================
- --------------------------------------- --------------- ------------ ------------- ------------- ------------------ ----------------
Balance, December 31, 2003 763,274 $ 8 $ 72,506 $ 37,650 $ (559) $ 109,605
======================================= =============== ============ ============= ============= ================== ================
Net Income - - 3,902 - 3,902
Redemption of Stock (2,632) - (946) (1) - (947)
Unrealized Gains on Derivative Instruments - - - 59 59
Changes in Net Unrealized Gain (Loss) on
Securities Available for Sale - - - 844 844
- --------------------------------------- --------------- ------------ ------------- ------------- ------------------ ----------------
Balance, March 31, 2004 760,642 $ 8 $ 71,560 $ 41,551 $ 344 $ 113,463
======================================= =============== ============ ============= ============= ================== ================
The accompanying notes are an integral part of these consolidated financial
statements
6
FARMERS & MERCHANTS BANCORP
Consolidated Statement of Cash Flows (Unaudited) Three Months Ended
- ------------------------------------------------------------------------------------ ---------------------------
(in thousands) Mar. 31 Mar. 31
2004 2003
- ----- ------------------------------------------------------------------------------ ------------- -------------
Operating Activities:
Net Income $3,902 $3,401
Adjustments to Reconcile Net Income to Net
Cash Provided by Operating Activities:
Provision for Loan Losses 375 200
Depreciation and Amortization 389 396
Provision for Deferred Income Taxes (180) (25)
Net Amortization of Investment Security Premium & Discounts 344 286
Net Gain on Sale of Investment Securities (641) (133)
Net Decrease in Interest Receivable and Other Assets 3,213 689
Net (Decrease) Increase in Interest Payable and Other Liabilities (1,095) 12,331
- ------------------------------------------------------------------------------------ ------------- -------------
Net Cash Provided by Operating Activities 6,307 17,145
Investing Activities:
Securities Available-for-Sale:
Purchased (36,981) (113,013)
Sold or Matured 51,700 46,087
Securities Held-to-Maturity:
Purchased 0 (18,303)
Matured 2,092 1,589
Net Increase in Loans 9,740 9,814
Principal Collected on Loans Previously Charged Off 30 23
Net Additions to Premises and Equipment (310) (377)
- ------------------------------------------------------------------------------------ ------------- -------------
Net Cash Provided (Used) by Investing Activities 26,271 (74,180)
Financing Activities:
Net Decrease in Demand, Interest-Bearing Transaction,
and Savings Accounts (5,639) (1,071)
Increase in Time Deposits 7,882 834
Net Decrease in Federal Funds Purchased (1,000) (16,997)
Net Increase (Decrease) in Federal Home Loan Bank Advances
Advances (31,000) 59,991
Paydowns (10) (9)
Stock Redemption (947) (500)
- ------------------------------------------------------------------------------------ ------------- -------------
Net Cash (Used) Provided by Financing Activities (30,714) 42,248
Increase (Decrease) in Cash and Cash Equivalents 1,864 (14,787)
Cash and Cash Equivalents at Beginning of Year 35,800 53,574
- ------------------------------------------------------------------------------------ ------------- -------------
Cash and Cash Equivalents as of March 31, 2004 and March 31, 2003 $37,664 $38,787
==================================================================================== ============= =============
The accompanying notes are an integral part of these consolidated financial
statements
7
FARMERS & MERCHANTS BANCORP
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
For the three months ended March 31, 2004 and March 31, 2003
1. Significant Accounting Policies
Farmers & Merchants Bancorp (the Company) was organized March 10, 1999. Primary
operations are related to traditional banking activities through its subsidiary
Farmers & Merchants Bank of Central California (the Bank). The consolidated
financial statements of the Company and its subsidiary, the Bank, are prepared
in conformity with generally accepted accounting principles and prevailing
practices within the banking industry. In preparing the financial statements,
management is required to make estimates and assumptions that affect reported
amounts as of the date of the balance sheet and revenues and expenses for the
period. These estimates are based on information available as of the date of the
financial statements. Therefore, actual results could differ from those
estimates. The following is a summary of the significant accounting and
reporting policies used in preparing the consolidated financial statements.
Basis of Presentation
The accompanying consolidated financial statements include the accounts of the
Company and the Company's wholly owned subsidiaries, F & M Bancorp, Inc. and the
Bank, along with the Bank's wholly owned subsidiaries, Farmers & Merchants
Investment Corporation and Farmers/Merchants Corp. The investment in the Bank is
carried at the Company's equity in the underlying net assets. Significant
intercompany transactions have been eliminated in consolidation. F & M Bancorp,
Inc. was created in March 2002 to protect the name F & M Bank, Farmers &
Merchants Investment Corporation has been dormant since 1991. Farmers/Merchants
Corp. acts as trustee on deeds of trust originated by the Bank. In December
2003, the Company formed a wholly owned subsidiary, FMCB Statutory Trust I. FMCB
Statutory Trust I, is a non-consolidated subsidiary per generally accepted
accounting principals (GAAP), and was formed for the sole purpose of issuing
Trust Preferred Securities.
Certain amounts in the prior years' financial statements and related footnote
disclosures have been reclassified to conform to the current-year presentation.
These reclassifications have no effect on previously reported income.
Cash and Cash Equivalents
For purposes of the Consolidated Statements of Cash Flows, the Company has
defined cash and cash equivalents as those amounts included in the balance sheet
captions Cash and Due from Banks and Federal Funds Sold and Securities Purchased
Under Agreements to Resell. Generally, these transactions are for one-day
periods. For these instruments, the carrying amount is a reasonable estimate of
fair value.
Investment Securities
Investment securities are classified at the time of purchase as held-to-maturity
if it is management's intent and the Company has the ability to hold the
securities until maturity. These securities are carried at cost, adjusted for
amortization of premium and accretion of discount using a methodology which
approximates a level yield of interest over the estimated remaining period until
maturity. Losses, reflecting a decline in value judged by the Company to be
other than temporary, are recognized in the period in which they become known.
8
Securities are classified as available-for-sale if it is management's intent, at
the time of purchase, to hold the securities for an indefinite period of time
and/or to use the securities as part of the Company's asset/liability management
strategy. Securities classified as available-for-sale include securities which
may be sold to effectively manage interest rate risk exposure, prepayment risk,
satisfy liquidity demands and other factors. These securities are reported at
fair value with aggregate, unrealized gains or losses excluded from income and
included as a separate component of shareholders' equity, net of related income
taxes. Fair values are based on quoted market prices or broker/dealer price
quotations on a specific identification basis. Gains or losses on the sale of
these securities are computed using the specific identification method.
Unrealized losses on these securities, reflecting a decline in value judged by
the Company to be other than temporary, are recognized in the period in which
they become known.
Trading securities, if any, are acquired for short-term appreciation and are
recorded in a trading portfolio and are carried at fair value, with unrealized
gains and losses recorded in non-interest income.
Loans
Loans are reported at the principal amount outstanding net of unearned discounts
and deferred loan fees. Interest income on loans is accrued daily on the
outstanding balances using the simple interest method. Loan origination fees are
deferred and recognized over the contractual life of the loan as an adjustment
to the yield. Loans are placed on a non-accrual status when the collection of
principal or interest is in doubt or when they become past due for 90 days or
more unless they are both well-secured and in the process of collection. For
this purpose a loan is considered well-secured if it is collateralized by
property having a net realizable value in excess of the amount of the loan or is
guaranteed by a financially capable party. When a loan is placed on non-accrual
status, the accrued and unpaid interest receivable is reversed and charged
against current income, thereafter; interest income is recognized only as it is
collected in cash. Loans placed on a non-accrual status are returned to accrual
status when the loans are paid current as to principal and interest and future
payments are expected to be made in accordance with the contractual terms of the
loan.
A loan is impaired when, based on current information and events, it is probable
that the Company will be unable to collect all amounts due according to the
contractual terms of the loan agreement. When a loan is impaired, the recorded
amount of the loan in the Consolidated Balance Sheets is based on the present
value of expected future cash flows discounted at the loan's effective interest
rate or on the observable or estimated market price of the loan or the fair
value of the collateral if the loan is collateral dependent. Impaired loans are
placed on a non-accrual status with income reported accordingly. Cash payments
are first applied as a reduction of the principal balance until collection of
the remaining principal and interest can be reasonably assured. Thereafter,
interest income is recognized as it is collected in cash.
Allowance for Loan Losses
As a financial institution which assumes lending and credit risks as a principal
element in its business, the Company anticipates that credit losses will be
experienced in the normal course of business. Accordingly, the allowance for
loan losses is maintained at a level considered adequate by management to
provide for losses that can be reasonably estimated. The allowance is increased
by provisions charged to operating expense and reduced by net charge-offs.
Management employs a systematic methodology for determining the allowance for
loan losses. On a quarterly basis, management reviews the credit quality of the
loan portfolio and considers problem loans, delinquencies, internal credit
reviews, current economic conditions, loan loss experience and other factors in
determining the adequacy of the allowance balance.
The conditions evaluated in connection with the allowance may include existing
general economic and business conditions affecting the key lending areas of the
Company, credit quality trends, collateral values, loan volumes and
concentration, seasoning of the loan portfolio, specific industry conditions,
recent loss experience, duration of the current business cycle, bank regulatory
examination results and findings of the Company's internal credit examiners.
9
The allowance also incorporates the results of measuring impaired loans as
provided in Statement of Financial Accounting Standards (SFAS) No. 114,
"Accounting by Creditors for Impairment of a Loan" and SFAS No. 118, "Accounting
by Creditors for Impairment of a Loan-Income Recognition and Disclosures". These
accounting standards prescribe the measurement methods, income recognition and
disclosures related to impaired loans.
While the Company utilizes a systematic methodology in determining its
allowance, the allowance is based on estimates, and ultimate losses may vary
from current estimates. The estimates are reviewed periodically and, as
adjustments become necessary, are reported in earnings in the periods in which
they become known.
Premises and Equipment
Premises, equipment and leasehold improvements are stated at cost, less
accumulated depreciation and amortization. Depreciation is computed principally
by the straight line method over the estimated useful lives of the assets.
Estimated useful lives of buildings range from 30 to 40 years, and for furniture
and equipment from 3 to 8 years. Leasehold improvements are amortized over the
lesser of the terms of the respective leases, or their useful lives, which are
generally 5 to 10 years. Remodeling and capital improvements are capitalized
while maintenance and repairs are charged directly to occupancy expense.
Other Real Estate
Other real estate owned, which is included in other assets, is comprised of
properties acquired through foreclosures in satisfaction of indebtedness. These
properties are recorded at fair value less estimated selling costs upon
acquisition. Revised estimates to the fair value less cost to sell are reported
as adjustments to the carrying amount of the asset, provided that such adjusted
value is not in excess of the carrying amount at acquisition. Initial losses on
properties acquired through full or partial satisfaction of debt are treated as
credit losses and charged to the Allowance for Loan Losses at the time of
acquisition. Subsequent declines in value from the recorded amounts, routine
holding costs, and gains or losses upon disposition, if any, are included in
non-interest income or expense as incurred.
Income Taxes
As required, the Company uses the liability method of accounting for income
taxes. This method results in the recognition of deferred tax assets and
liabilities that are reflected at currently enacted income tax rates applicable
to the period in which the deferred tax assets or liabilities are expected to be
realized or settled. As changes in tax laws or rates are enacted, deferred tax
assets and liabilities are adjusted through the provision for income taxes. The
deferred provision for income taxes is the result of the net change in the
deferred tax asset and deferred tax liability balances during the year. This
amount combined with the current taxes payable or refundable results in the
income tax expense for the current year.
Earnings Per Share
The actual number of shares outstanding at March 31, 2004, was 760,642. Basic
earnings per share is calculated on the basis of the weighted average number of
shares outstanding during the period. Weighted average number of shares for the
three months ending March 31, 2004 and 2003 were 762,851 and 768,584,
respectively. Earnings per share for the three months ending March 31, 2004 and
2003 were $5.12 and $4.43, respectively. Prior periods per share amounts have
been restated for the 5% stock dividend declared during 2003 and 2002.
10
Dividends
Farmers & Merchants Bancorp common stock is not traded on any exchange. The
shares are primarily held by local residents and are not actively traded. No
cash or stock dividends were declared during the first quarter of 2004 or 2003.
On April 6, 2004, the Board of Directors declared a 5% stock dividend payable
May 12, 2004, to shareholders of record at the close of business on April 16,
2004. Common stock shareholders of record as of April 16, 2004, will receive one
share of common stock for every 20 shares of common stock owned. Fractional
shares will not be issued. For common stock share lots of less than 20 shares, a
cash dividend in the amount of $17.15 per share will be paid in lieu of the
stock dividend.
Segment Reporting
The Statement of Financial Accounting Standards No. 131, "Disclosures about
Segments of an Enterprise and Related Information" requires that public
companies report certain information about operating segments. It also requires
that public companies report certain information about their products and
services, the geographic areas in which they operate, and their major customers.
The Company is a community bank which offers a wide array of products and
services to its customers. Pursuant to its banking strategy, emphasis is placed
on building relationships with its customers, as opposed to building specific
lines of business. As a result, the Company is not organized around discernable
lines of business and prefers to work as an integrated unit to customize
solutions for its customers, with business line emphasis and product offerings
changing over time as needs and demands change. Thus, all necessary requirements
of SFAS No. 131 have been met by the Company as of March 31, 2004.
Derivative Instruments and Hedging Activities
The Statement of Financial Accounting Standards, No. 133, "Accounting for
Derivative Instruments and Certain Hedging Activities" as amended by the
Statement of Financial Accounting Standards, No. 138, establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities. All
derivatives, whether designated in hedging relationships or not, are required to
be recorded on the balance sheet at fair value. Changes in the fair value of
those derivatives are accounted for depending on the intended use of the
derivative and the resulting designation under specified criteria. If the
derivative is designated as a fair value hedge, the changes in the fair value of
the derivative and of the hedged item attributable to the hedged risk are
recognized in earnings. If the derivative is designated as a cash flow hedge,
designed to minimize interest rate risk, the effective portions of the change in
the fair value of the derivative are recorded in other comprehensive income.
Ineffective portions of changes in the fair value of cash flow hedges are
recognized in earnings. As required, SFAS No. 133 was adopted by the Company
effective January 1, 2001.
The Company utilizes derivative financial instruments such as interest rate
caps, floors, swaps and collars. These instruments are purchased and/or sold to
reduce the Company's exposure to changing interest rates. The Company marks to
market the value of its derivative financial instruments and reflects gain or
loss in earnings in the period of change or in other comprehensive income.
Comprehensive Income
The Statement of Financial Accounting Standards, "Reporting Comprehensive
Income" establishes standards for the reporting and display of comprehensive
income and its components in the financial statements. Other comprehensive
income refers to revenues, expenses, gains and losses that generally accepted
accounting principles recognize as changes in value to an enterprise but are
excluded from net income. For the Company, comprehensive income includes net
income (loss) and changes in fair value of its available-for-sale investment
securities, minimum pension liability adjustments and cash flow hedges.
11
2. Recent Accounting Developments
Derivative Instruments and Hedging Activities
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities" ("SFAS No. 149"). The provisions
of SFAS No.149 that relate to SFAS No. 133 and No. 138 implementation issues
that have been effective for fiscal quarters that began prior to June 15, 2003,
should continue to be applied in accordance with their respective effective
dates. In addition, provisions of SFAS No. 149 which relate to forward purchases
or sales of when-issued securities or other securities that do not yet exist,
should be applied to both existing contracts and new contracts entered into
after June 30, 2003. The changes in SFAS No. 149 improve financial reporting by
requiring that contracts with comparable characteristics be accounted for
similarly. In particular, SFAS No. 149 (1) clarifies under what circumstances a
contract with an initial net investment meets the characteristic of a derivative
discussed in paragraph 6(b) of SFAS No. 133 and No. 138, (2) clarifies when a
derivative contains a financing component, (3) amends the definition of an
underlying to conform it to language used in FIN 45, and (4) amends certain
other existing pronouncements. Those changes will result in more consistent
reporting of contracts as either derivatives or hybrid instruments.
SFAS No. 149 is effective for contracts entered into or modified after June 30,
2003, except as stated above and for hedging relationships designated after June
30, 2003. In addition, except as stated above, all provisions of SFAS No.149
should be applied prospectively.
The adoption of SFAS No. 149 did not have a material impact on the Company's
financial condition or operating results.
Certain Financial Instruments with Characteristics of both Liabilities and
Equity
In May 2003, the FASB issued SFAS No. 150 "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity" ("SFAS No.
150"). This statement requires that an issuer classify financial instruments
that are within its scope as a liability. Many of those instruments were
classified as equity under previous guidance.
Most of the guidance in SFAS No. 150 is effective for all financial instruments
entered into or modified after May 31, 2003, and otherwise effective at the
beginning of the first interim period beginning after June 15, 2003.
The adoption of SFAS No. 150 did not have a material impact on the Company's
financial condition or operating results.
Consolidation of Variable Interest Entities
In January 2003, the FASB issued FIN 46. FIN 46 explains how to identify
variable interest entities and how an enterprise assesses its interests in a
variable interest entity to decide whether to consolidate that entity. FIN 46
requires existing unconsolidated variable interest entities to be consolidated
by their primary beneficiaries if the entities do not effectively disperse risks
among parties involved. Variable interest entities that effectively disperse
risks will not be consolidated unless a single party holds an interest or
combination of interests that effectively recombines risks that were previously
dispersed.
FIN 46 applies immediately to variable interest entities created after January
31, 2003, and to variable interest entities in which an enterprise obtains an
interest after that date. It applies in the first fiscal year or interim period
ending after December 15, 2003, to variable interest entities in which an
enterprise holds a variable interest that it acquired before February 1, 2003.
12
FIN 46 may be applied prospectively with a cumulative-effect adjustment as of
the date on which it is first applied or by restating previously issued
financial statements for one or more years with a cumulative-effect adjustment
as of the beginning of the first year restated.
FIN 46 may have an impact on the treatment of the trust preferred securities we
have issued and ability for those instruments to continue to provide the Company
with Tier 1 capital. FIN 46 prevents the Company from consolidating the trust
entity that issued these trust preferred securities. The Federal Reserve has
issued regulations which allow for the inclusion of these instruments in Tier 1
capital regardless of the impact of FIN 46 on the consolidation of the trusts.
There remains the potential that this determination by the Federal Reserve may
be changed at a later date. We do not expect FIN 46 to have any other material
impact on the Company's financial condition or operating results.
3. Interim-Period Disclosure of Employee Benefit Plans
Components of Net Periodic Pension Cost:
Three months ended March 31 Pension Benefits
-----------------------------------
(in thousands) 2004 2003
-------------- -------------
Service cost $ 12 $ 13
Interest cost 64 56
Expected return on assets (57) (32)
Amortization of (gain)/loss 126 94
Amortization of prior service cost 0 0
Amortization of transition obligation 0 0
-------------- -------------
Net periodic pension cost $ 145 $ 131
============== =============
Employer Contributions
The Company previously disclosed in its financial statements for the year ended
December 31, 2003 that it expected to contribute $222,000 to its Pension Plan in
2004. As of March 31, 2004, $0 has been contributed to the Plan. The Company
still expects to contribute at least $222,000 to the Plan in 2004.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
Forward-Looking Statements
Management's discussion and analysis is written to provide greater insight into
the results of operations and the financial condition of Farmers & Merchants
Bancorp and its subsidiaries. For a more complete understanding of the Company
and its operations, reference should be made to the financial statements
included in this report and in the Company's 2003 Annual Report on Form 10-K.
Certain statements in this Report on Form 10-Q constitute "forward-looking
statements" and usually contain the words "estimate," "project," "expect,"
"objective," "goal," or similar expressions and includes assumptions concerning
the Company's operations, future results, and prospects. These forward-looking
statements are based upon current expectations and are subject to risk and
uncertainties. In connection with the "safe-harbor" provisions of the private
Securities Litigation Reform Act, the Company provides the following cautionary
statement identifying important factors which could cause the actual results of
events to differ materially from those set forth in or implied by the
forward-looking statements and related assumptions.
13
Such factors include the following: (i) the effect of changing regional and
national economic conditions; (ii) significant changes in interest rates and
prepayment speeds; (iii) credit risks of commercial, real estate, consumer, and
other lending activities; (iv) changes in federal and state banking laws or
regulations; (v) competitive pressure in the banking industry; (vi) changes in
governmental fiscal or monetary policies; (vii) uncertainty regarding the
economic outlook resulting from the continuing war on terrorism, as well as
actions taken or to be taken by the U.S. or other governments as a result of
further acts or threats of terrorism; (viii) dividend restrictions; (ix)
asset/liability pricing risks and liquidity risks; (x) changes in the securities
markets; (xi) certain operational risks involving data processing systems or
fraud; (xii) the State of California's fiscal difficulties; and (xiii) other
external developments which could materially impact the Company's operational
and financial performance. Additional information on these and other factors
that could affect financial results are included in the Company's Securities and
Exchange Commission filings.
Readers are cautioned not to place undue reliance on these forward-looking
statements which speak only as of the date hereof. The Company undertakes no
obligation to update any forward-looking statements to reflect events or
circumstances arising after the date on which they are made.
Overview
The Company's primary service area encompasses the northern Central Valley of
California, a territory that is significantly impacted by the agricultural
industry. Accordingly, any discussion of the Company's Financial Condition and
Results of Operations is influenced by the seasonal banking needs of its
customers. Comparisons of the current quarter's results, both in terms of the
balance sheet and income statement, are most meaningful to the same quarter in
the prior year, not to the prior calendar quarter.
For the three months ended March 31, 2004, Farmers & Merchants Bancorp reported
net income of $3,902,000, earnings per share of $5.12 and return on average
assets of 1.38%. Return on average shareholders' equity was 14.07% for the three
months ended March 31, 2004. For the three months ended March 31, 2003, net
income totaled $3,401,000, earnings per share was $4.43 and return on average
assets was 1.35%. Return on average shareholders' equity for the three months
ended March 31, 2003 was 12.98%.
The Company's improved earnings performance in the first quarter of 2004 when
compared to the same period last year was due to a combination of (1) growth in
earning assets, (2) improvement in the mix of earning assets as reflected by an
increase in loans as a percentage of average earning assets, (3) improvement in
non-interest income and (4) an improvement in the efficiency ratio from 58.39%
for the three months ended March 31, 2003 to 57.31% for the three months ended
March 31, 2004. These factors combined to offset the continuing negative impact
on the Bank's net interest income of declining market interest rates during 2002
and 2003.
The following is a summary of the financial results for the three-month period
ended March 31, 2004 compared to March 31, 2003.
o Net income increased 14.7% to $3.9 million from $3.4 million.
o Earnings per share increased 15.6% to $5.12 from $4.43.
o Net interest income increased 12.7% to $11.6 million from $10.3 million.
o Total assets increased 3.9% to $1.1 billion.
14
o Gross loans increased 16.0% to $799.0 million.
o Total deposits increased 6.7% to $906.6 million.
o Total shareholders' equity increased 6.8% to $113.5 million after stock
repurchases of $947,000.
Results of Operations
Net Interest Income
Net interest income is the amount by which the interest and fees on loans and
other interest earning assets exceed the interest paid on interest bearing
sources of funds. For the purpose of analysis, the interest earned on tax-exempt
investments and municipal loans is adjusted to an amount comparable to interest
subject to normal income taxes. This adjustment is referred to as "taxable
equivalent" and is noted wherever applicable. Interest income and expense are
affected by changes in the volume and mix of average interest earning assets and
average interest bearing liabilities, as well as fluctuations in interest rates.
Therefore, increases or decreases in net interest income are analyzed as changes
in volume, changes in rate and changes in the mix of assets and liabilities.
The Company's earning assets and rate sensitive liabilities are subject to
repricing at different times, which exposes the Company to income fluctuations
when interest rates change. In order to minimize income fluctuations, the
Company attempts to match asset and liability maturities. However, some maturity
mismatch is inherent in the asset and liability mix.
Net interest income increased 12.7% to $11.6 million during the first three
months of 2004, compared to $10.3 million at March 31, 2003. On a fully taxable
equivalent basis, net interest income increased 12.2% and totaled $11.9 million
at March 31, 2004, compared to $10.7 million for the first three months of 2003.
The primary reason for the increase in net interest income during the first
quarter of 2004 when compared to the same period last year was an improvement in
the volume and mix (as reflected by an increase in loans as a percentage of
average earning assets) of earning assets. These factors combined to offset the
continuing negative impact on the Bank's net interest income of declining market
interest rates during 2002 and 2003. During 2003, the Federal Reserve Bank
dropped their Discount Rate by 25 basis points, following a drop of 50 basis
points during 2002. This resulted in an equivalent drop in the Bank's prime
rate, the index on which many of its loans are priced.
Net interest income on a taxable equivalent basis, expressed as a percentage of
average total earning assets, is referred to as the net interest margin. For the
first quarter of 2004, the Company's net interest margin was 4.56% compared to
4.62% in 2003. The decrease in the net interest margin was due primarily to the
continuing negative impact of declines in market interest rates during 2002 and
2003. The Bank's earning assets, particularly loans, generally reprice more
quickly than its interest bearing liabilities, causing a decrease in net
interest margin as market interest rates decline. As market interest rates begin
to rise, the net interest margin is expected to improve.
Loans, generally the Company's highest earning asset, increased $110.2 million
as of March 31, 2004 compared to March 31, 2003. On an average balance basis,
loans increased by $102.5 million for the three months ended March 31, 2004. Due
to the continuing negative impact of a decline in interest rates during 2002 and
2003 the yield on the loan portfolio decreased 31 basis points to 5.95% for the
three months ended March 31, 2004 compared to 6.26% for the three months ended
March 31, 2003. This decrease in yield was offset by the growth in loan
balances, which resulted in interest revenue from loans increasing 10.2% to $1.1
million for the first three months of 2004.
15
The investment portfolio is the other main component of the Company's earning
assets. The Company's investment policy is conservative. The Company invests
primarily in mortgage-backed securities, U.S. Treasuries, U.S. Government
Agencies, and high-grade municipals. Since the risk factor for these types of
investments is significantly lower than that of loans, the yield earned on
investments is generally less than that of loans.
Average investment securities increased $14.4 million compared to the average
balance at March 31, 2003. Even with the increase in the average balance of
investment securities there was a decrease in interest income of $220,000 for
the three months ended March 31, 2004, due to the continuing negative impact of
a decline in interest rates during 2002 and 2003. The average yield, on a
taxable equivalent basis, in the investment portfolio was 4.38% in 2004 compared
to 5.04% in 2003. Net interest income on the Schedule of Year-to-Date Average
Balances and Interest Rates located on page 26 is shown on a taxable equivalent
basis, which is higher than net interest income on the Consolidated Statements
of Income because of adjustments that relate to income on certain securities
that are exempt from federal income taxes.
Average interest-bearing sources of funds increased $91.1 million or 13.0%. Of
that increase, average borrowed funds (primarily FHLB Advances) increased $49.3
million, subordinated debentures increased $10.3 million and interest-bearing
deposits increased $31.5 million. Even as interest-bearing sources of funds
increased, interest expense decreased 16.2% as a result of declining interest
rates paid for those sources of funds. Overall, the average interest cost on
interest-bearing sources of funds was 1.2% at March 31, 2004 and 1.7% at March
31, 2003.
Allowance and Provision for Loan Losses
As a financial institution that assumes lending and credit risks as a principal
element of its business, credit losses will be experienced in the normal course
of business. The allowance for loan losses is established to absorb losses
inherent in the portfolio. The allowance for loan losses is maintained at a
level considered by management to be adequate to provide for risks inherent in
the loan portfolio. The allowance is increased by provisions charged to
operating expense and reduced by net charge-offs. In determining the adequacy of
the allowance for loan losses, management takes into consideration examinations
by the Company's supervisory authorities, results of internal credit reviews,
financial condition of borrowers, loan concentrations, prior loan loss
experience, and general economic conditions. The allowance is based on estimates
and ultimate losses may vary from the current estimates. Management reviews
these estimates periodically and, when adjustments are necessary, they are
reported in the period in which they become known.
After reviewing all factors, management concluded that the allowance for loan
losses as of March 31, 2004 was adequate.
The Company has established credit management policies and procedures that
govern both the approval of new loans and the monitoring of the existing
portfolio. The Company manages and controls credit risk through comprehensive
underwriting and approval standards, portfolio diversification guidelines,
dollar limits on loans to one borrower and by restricting loans made primarily
to its principal market area where management believes it is better able to
assess the applicable risk. Management reports regularly to the Board of
Directors regarding trends and conditions in the loan portfolio and regularly
conducts credit reviews of individual loans. Loans that are performing but have
shown some signs of weakness are subjected to more stringent reporting and
oversight.
16
As of March 31, 2004, the allowance for loan losses was $17.6 million, which
represents 2.2% of the total loan balances. As of March 31, 2003 the allowance
was $16.9 million or 2.4% of total loans. The table below illustrates the change
in the allowance for the first three months of 2004 and 2003.
Allowance for Loan Losses (in thousands)
Balance, December 31, 2003 $ 17,220
Provision Charged to Expense 375
Recoveries of Loans Previously Charged Off 31
Loans Charged Off (62)
==============================================================================
Balance, March 31, 2004 $ 17,564
==============================================================================
Balance, December 31, 2002 $ 16,684
Provision Charged to Expense 200
Recoveries of Loans Previously Charged Off 23
Loans Charged Off (36)
==============================================================================
Balance, March 31, 2003 $ 16,871
==============================================================================
Non-Interest Income
Overall, non-interest income increased $593,000 or 20.1% for the three months
ended March 31, 2004 compared to the same period of 2003. Most of the growth
occurred in gain on sale of investment securities, which increased $509,000
through the first three months of 2004. The increase was mainly the result of
the Company's decision to take advantage of the decline in interest rates that
began in early January 2004 and continued through early April 2004, by selling
approximately $29.8 million in investment securities for a gain.
Non-Interest Expense
Overall, non-interest expense increased $949,000 or 12.2% over the first three
months of 2004, primarily as a result of a $1.1 million increase in Salaries and
Employee Benefits. This increase was due primarily to increased contributions to
the Bank's retirement plans and incentive compensation plans.
Income Taxes
The provision for income taxes increased 14.5% to $2.2 million for the first
three months of 2004. The Company's effective tax rate decreased to 36.06% for
the first three months of 2004 compared to 36.11% for the same period in 2003.
Financial Condition
Investment Securities
The Financial Accounting Standards Board statement, Accounting for Certain
Investments in Debt and Equity Securities, requires the Company to classify its
investments as held-to-maturity, trading or available-for-sale. Securities are
classified as held-to-maturity and are carried at amortized cost when the
Company has the positive intent and ability to hold the securities to maturity.
Trading securities are securities acquired for short-term appreciation and are
carried at fair value, with unrealized gains and losses recorded in non-interest
income. Securities classified as available-for-sale include securities, which
may be sold to effectively manage interest rate risk exposure, prepayment risk,
satisfy liquidity demand and other factors. These securities are reported at
fair value with aggregate, unrealized gains or losses excluded from income and
included as a separate component of shareholders' equity, net of related income
taxes.
17
The investment portfolio provides the Company with an income alternative to
loans. As of March 31, 2004 the investment portfolio represented 21.9% of the
Company's total assets. Total investment securities decreased $70.5 million from
a year ago and now total $246.3 million. As previously discussed (see "Non
Interest Income"), the Bank took advantage of the decline in interest rates that
began in January 2004 to sell approximately $29.8 million in investment
securities for a gain. The Bank intends to reinvest these funds as rates rise.
Not included in the investment portfolio are overnight investments in Federal
Funds Sold. For the three months ended March 31, 2004, average Federal Funds
Sold was $20.6 million compared to $19.0 million in 2003.
Loans
The Company's loan portfolio at March 31, 2004 increased $110.2 million from
March 31, 2003. The increase was due to strong loan demand in the Company's
market area, along with an aggressive calling program on high quality loan
prospects. Additionally, on an average balance basis loans have increased $102.5
million or 14.9%. The table following sets forth the distribution of the loan
portfolio by type as of the dates indicated.
Loan Portfolio As Of:
(in thousands) March 31, 2004 Dec. 31, 2003 March 31, 2003
- --------------------------------------------------- -------------------------------------------
Real Estate $407,475 $386,735 $323,487
Real Estate Construction 65,598 77,115 67,607
Home Equity 54,805 55,827 47,171
Agricultural 124,679 134,862 101,162
Commercial 129,804 136,955 130,281
Consumer 16,673 17,504 19,094
- --------------------------------------------------- -------------------------------------------
Gross Loans 799,034 808,998 688,802
Less:
Unearned Income 1,929 2,092 1,977
Allowance for Loan Losses 17,564 17,220 16,871
- --------------------------------------------------- -------------------------------------------
Net Loans $779,541 $ 789,686 $ 669,954
=================================================== ===========================================
In the ordinary course of business, the Company enters into commitments to
extend credit to its customers. These commitments are not reflected in the
accompanying consolidated financial statements. As of March 31, 2004, the
Company had entered into commitments with certain customers amounting to $328.3
million compared to $295.0 million at March 31, 2003. Letters of credit at March
31, 2004, and March 31, 2003, were $12.5 million and $18.7 million,
respectively.
Non-Performing Assets
Non-performing assets are comprised of non-performing loans and other real
estate owned. As set forth in the table below, non-performing loans as of March
31, 2004 were $2.6 million compared to $3.3 million at March 31, 2003. Accrued
interest reversed from income on loans placed on a non-accrual status totaled
$329 thousand at March 31, 2004 compared to $333 thousand at March 31, 2003. The
Company reported no other real estate owned for both March 31, 2004 and March
31, 2003. Non-Performing Assets (dollar amounts in thousands) March 31, 2004
18
December 31, 2003 March 31, 2003
- -------------------------------------------------------------------------
Non-performing Loans $2,580 $2,584 $3,273
Other Real Estate Owned 0 0 0
=========================================================================
Total $2,580 $2,584 $3,273
=========================================================================
Non-Performing Assets
as a % of Total Loans 0.3% 0.3% 0.5%
Allowance for Loan Losses as a % of
Non-Performing Loans 680.77% 666.4% 515.5%
Except for non-performing loans shown in the table above, the Bank's management
is not aware of any loans as of March 31, 2004 for which known credit problems
of the borrower would cause serious doubts as to the ability of such borrowers
to comply with their present loan repayment terms, or any known events that
would result in the loan being designated as non-performing at some future date.
The Bank's management cannot, however, predict the extent to which any
deterioration in general economic conditions, real estate values, increase in
general rates of interest, change in the financial conditions or business of a
borrower may adversely affect a borrower's ability to pay.
Deposits
One of the key sources of funds to support earning assets (loans and
investments) is the generation of deposits from the Company's customer base. The
ability to grow the customer base and subsequently deposits is a significant
element in the performance of the Company.
At March 31, 2004, deposits totaled $906.6 million. This represents an increase
of 6.7% or $56.6 million from March 31, 2003. The increase was focused in demand
and savings deposit accounts, which increased $27.3 million and $29.4 million,
respectively. The Bank's calling efforts for prospective customers includes
acquiring both loan and deposit relationships which results in new demand,
interest bearing transaction and savings accounts.
Federal Home Loan Bank Advances
Advances from the Federal Home Loan Bank are another key source of funds to
support earning assets. These advances are also used to manage the Bank's
interest rate risk exposure, and as opportunities exist to borrow and invest the
proceeds at a positive spread through the investment portfolio. FHLB advances as
of March 31, 2004 were $80.9 million compared to $100.9 million as of March 31,
2003. As previously discussed (see "Non Interest Income"), the Bank sold certain
investment securities during the first quarter of 2004 and used these funds, in
part, to reduce FHLB advances.
Long-term Subordinated Debentures
On December 17, 2003 the Company raised $10 million through an offering of trust
preferred securities. Although this amount is reflected as subordinated debt on
the Company's balance sheet, under applicable regulatory guidelines, trust
preferred securities qualify as regulatory capital (see Capital). These
securities accrue interest at a variable rate based upon 3-month Libor plus
2.85%. Interest rates reset quarterly and were 3.96% as of March 31, 2004.
19
Capital
The Company and the Bank are subject to various regulatory capital requirements
administered by the federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory, and possibly discretionary, actions
by regulators that, if undertaken, could have a direct material effect on the
Company and the Bank's financial statements. Under capital adequacy guidelines
and the regulatory framework for prompt corrective action, the Company and the
Bank must meet specific capital guidelines that involve quantitative measures of
the Company and the Bank's assets, liabilities, and certain off-balance-sheet
items as calculated under regulatory accounting practices. The Company and the
Bank's capital amounts and classification are also subject to qualitative
judgments by the regulators about components, risk weightings, and other
factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Company and the Bank to maintain minimum amounts and ratios set
forth in the table below of Total and Tier I capital (as defined in the
regulations) to risk-weighted assets (as defined in the regulations), and of
Tier I capital (as defined in the regulations) to average assets (as defined in
the regulations). Management believes, as of March 31, 2004, that the Company
and the Bank meet all capital adequacy requirements to which it is subject.
As of September 30, 2003, the most recent notification from the Federal Reserve
Bank categorized the Company and the Bank as well capitalized under the
regulatory framework for prompt corrective action. To be categorized as well
capitalized the Company and the Bank must maintain minimum Total risk-based,
Tier I risk-based, and Tier I leverage ratios as set forth in the table. There
are no conditions or events since that notification that management believes
have changed the institutions' categories.
To Be Well
Capitalized Under
Regulatory Capital Prompt Corrective
(in thousands) Actual Requirements Action Provisions
- ------------------------------------------------------------------------------------------------------------------
The Company: Amount Ratio Amount Ratio Amount Ratio
- ------------------------------------------------------------------------------------------------------------------
As of March 31, 2004
Total Capital to Risk Weighted Assets $135,864 13.39% $81,185 8.0% N/A N/A
Tier I Capital to Risk Weighted Assets $123,119 12.13% $40,593 4.0% N/A N/A
Tier I Capital to Average Assets $123,119 10.88% $45,257 4.0% N/A N/A
To Be Well
Capitalized Under
Regulatory Capital Prompt Corrective
(in thousands) Actual Requirements Action Provisions
- ------------------------------------------------------------------------------------------------------------------
The Bank: Amount Ratio Amount Ratio Amount Ratio
- ------------------------------------------------------------------------------------------------------------------
As of March 31, 2004
Total Capital to Risk Weighted Assets $131,158 13.04% $ 80,482 8.0% $100,602 10.0%
Tier I Capital to Risk Weighted Assets $118,521 11.78% $ 40,241 4.0% $ 60,361 6.0%
Tier I Capital to Average Assets $118,521 10.53% $ 45,031 4.0% $ 56,289 5.0%
As previously discussed (see Long-term Subordinated Debentures), in order to
supplement its regulatory capital base, during December, 2003 the Company raised
$10 million of trust preferred securities. Under applicable regulatory
guidelines, trust preferred securities qualify as Tier 1 capital up to a maximum
of 25% of Tier 1 capital. Any additional portion of trust preferred securities
would qualify as Tier 2 capital. The Company has received notification from the
Federal Reserve Bank of San Francisco that all of the Company's trust preferred
securities currently qualify as Tier 1 capital.
20
In accordance with the provisions of Financial Accounting Standard Board
Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"),
the Company does not consolidate the subsidiary trust which has issued the trust
preferred securities. Previously, financing subsidiaries were generally
consolidated with their parents under generally accepted accounting principles.
As a result of this new accounting interpretation, on July 2, 2003, the Federal
Reserve Board issued Supervisory Letter (SR 03-13) which preserves the
historical capital treatment of trust preferred securities as Tier I Capital
despite the deconsolidation of these securities. That Supervisory Letter
remained in effect at December 31, 2003 and March 31, 2004, and the Company
continues to include these securities in its Tier I capital. There remains the
potential that this determination by the Federal Reserve Board may change at a
later date and the Federal Reserve Board continues to review its position on
this matter.
If Tier I capital treatment for the Company's trust preferred securities were
disallowed, there would be a reduction in our consolidated capital ratios.
However, the Company would remain "well-capitalized" in the event that the
Federal Reserve Board elected to change its position with regards to the capital
treatment of trust preferred securities. If Tier I capital treatment were
disallowed, the Company may be able to redeem the trust preferred securities
pursuant to their terms, and have the ability to identify and obtain alternative
sources of capital.
As part of an overall capital management program, in 1998 the Board approved a
stock repurchase program. Since 1999, the Company has repurchased over 39,000
shares for total consideration of $9.6 million. The Company will continue to
repurchase shares when it believes it is in the best long-term interest of
shareholder value.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Risk Management
The Company has adopted a Risk Management Plan which aims to ensure the proper
control and management of all risk factors inherent in the operation of the
Company and the Bank. Specifically, credit risk, interest rate risk, liquidity
risk, compliance risk, strategic risk, reputation risk and price risk can all
affect the market risk of the Company. These specific risk factors are not
mutually exclusive. It is recognized that any product or service offered by the
Company may expose the Company and the Bank to one or more of these risk
factors.
Credit Risk
Credit risk is the risk to earnings or capital arising from an obligor's failure
to meet the terms of any contract or otherwise fail to perform as agreed. Credit
risk is found in all activities where success depends on counterparty, issuer or
borrower performance.
Credit risk in the investment portfolio and correspondent bank accounts is
addressed through defined limits in the Bank's policy statements. In addition,
certain securities carry insurance to enhance credit quality of the bond.
Credit risk in the loan portfolio is controlled by limits on industry
concentration, aggregate customer borrowings and geographic boundaries.
Standards on loan quality also are designed to reduce loan credit risk. Senior
Management, Directors' Committees, and the Board of Directors are regularly
provided with information intended to identify, measure, control and monitor the
credit risk of the Bank.
21
The Company's methodology for assessing the appropriateness of the allowance is
applied on a regular basis and considers all loans. The systematic methodology
consists of two major elements. The first major element includes a detailed
analysis of the loan portfolio in two phases. The first phase is conducted in
accordance with SFAS No. 114, "Accounting by Creditors for the Impairment of a
Loan" as amended by SFAS No. 118, "Accounting by Creditors for Impairment of a
Loan -- Income Recognition and Disclosures." Individual loans are reviewed to
identify loans for impairment. A loan is impaired when principal and interest
are deemed uncollectable in accordance with the original contractual terms of
the loan. Impairment is measured as either the expected future cash flows
discounted at each loan's effective interest rate, the fair value of the loan's
collateral if the loan is collateral dependent, or an observable market price of
the loan (if one exists). Upon measuring the impairment, the Company will ensure
an appropriate level of allowance is present or established.
Central to the first phase and the Company's credit risk management is its loan
risk rating system. The originating credit officer assigns borrowers an initial
risk rating, which is based primarily on a thorough analysis of each borrower's
financial position in conjunction with industry and economic trends. Approvals
are made based upon the amount of inherent credit risk specific to the
transaction and are reviewed for appropriateness by senior credit administration
personnel. Credits are monitored by credit administration personnel for
deterioration in a borrower's financial condition, which would impact the
ability of the borrower to perform under the contract. Risk ratings are adjusted
as necessary.
Based on the risk rating system specific allowances are established in cases
where management has identified significant conditions or circumstances related
to a credit that management believes indicates the possibility of loss.
Management performs a detailed analysis of these loans, including, but not
limited to, cash flows, appraisals of the collateral, conditions of the
marketplace for liquidating the collateral and assessment of the guarantors.
Management then determines the inherent loss potential and allocates a portion
of the allowance for losses as a specific allowance for each of these credits.
The second phase is conducted by segmenting the loan portfolio by risk rating
and into groups of loans with similar characteristics in accordance with SFAS
No. 5, "Accounting for Contingencies". In this second phase, groups of loans are
reviewed and applied the appropriate allowance percentage to determine a
portfolio formula allowance.
The second major element in the Company's methodology for assessing the
appropriateness of the allowance consists of management's considerations of all
known relevant internal and external factors that may affect a loan's
collectibility. This includes management's estimates of the amounts necessary
for concentrations, economic uncertainties, the volatility of the market value
of collateral and other relevant factors. The relationship of the two major
elements of the allowance to the total allowance may fluctuate from period to
period.
The second major element of the analysis, which considers all known relevant
internal and external factors that may affect a loan's collectibility, is based
upon management's evaluation of various conditions, the effects of which are not
directly measured in the determination of the formula and specific allowances.
The evaluation of the inherent loss with respect to these conditions is subject
to a higher degree of uncertainty because they are not identified with specific
problem credits or portfolio segments. The conditions evaluated in connection
with the second element of the analysis of the allowance include, but are not
limited to the following conditions that existed as of the balance sheet date:
|X| then-existing general economic and business conditions affecting the key
lending areas of the Company;
|X| credit quality trends (including trends in non-performing loans expected to
result from existing conditions);
22
|X| collateral values;
|X| loan volumes and concentrations;
|X| seasoning of the loan portfolio;
|X| specific industry conditions within portfolio segments;
|X| recent loss experience in particular segments of the portfolio;
|X| duration of the current business cycle;
|X| bank regulatory examination results; and
|X| findings of the Company's internal credit examiners.
Management reviews these conditions in discussion with the Company's senior
credit officers. To the extent that any of these conditions is evidenced by a
specifically identifiable problem credit or portfolio segment as of the
evaluation date, management's estimate of the effect of such condition may be
reflected as a specific allowance applicable to such credit or portfolio
segment. Where any of these conditions is not evidenced by a specifically
identifiable problem credit or portfolio segment as of the evaluation date,
management's evaluation of the inherent loss related to such condition is
reflected in the second major element allowance.
Implicit in lending activities is the risk that losses will and do occur and
that the amount of such losses will vary over time. Consequently, the Company
maintains an allowance for loan losses by charging a provision for loan losses
to earnings. Loans determined to be losses are charged against the allowance for
loan losses. The Company's allowance for loan losses is maintained at a level
considered by management to be adequate to provide for estimated losses inherent
in the existing portfolio along with unused commitments to provide financing
including commitments under commercial and standby letters of credit.
Management believes that the allowance for loan losses at March 31, 2004 was
adequate to provide for both recognized losses and estimated inherent losses in
the portfolio. No assurances can be given that future events may not result in
increases in delinquencies, non-performing loans or net loan chargeoffs that
would increase the provision for loan losses and thereby adversely affect the
results of operations.
Market Risk - Interest Rate Risk
The mismatch between maturities of interest sensitive assets and liabilities
results in uncertainty in the Company's earnings and economic value and is
referred to as interest rate risk. The Company's primary objective in managing
interest rate risk is to minimize the potential for significant loss as a result
of changes in interest rates.
The Company measures interest rate risk in terms of potential impact on both its
economic value and earnings. The methods for governing the amount of interest
rate risk include: analysis of asset and liability mismatches (GAP analysis),
the utilization of a simulation model and limits on maturities of investment,
loan and deposit products which reduces the market volatility of those
instruments.
The Gap analysis measures, at specific time intervals, the divergence between
earning assets and interest bearing liabilities for which repricing
opportunities will occur. A positive difference, or Gap, indicates that earning
assets will reprice faster than interest-bearing liabilities. This will
generally produce a greater net interest margin during periods of rising
interest rates and a lower net interest margin during periods of declining
interest rates. Conversely, a negative gap will generally produce a lower net
interest margin during periods of rising interest rates and a greater net
interest margin during periods of decreasing interest rates.
23
The interest rates paid on deposit accounts do not always move in unison with
the rates charged on loans. In addition, the magnitude of changes in the rates
charged on loans is not always proportionate to the magnitude of changes in the
rate paid for deposits. Consequently, changes in interest rates do not
necessarily result in an increase or decrease in the net interest margin solely
as a result of the differences between repricing opportunities of earning assets
or interest bearing liabilities.
The Company also utilizes the results of a dynamic simulation model to quantify
the estimated exposure of net interest income to sustained interest rate
changes. The sensitivity of the Company's net interest income is measured over a
rolling one-year horizon.
The simulation model estimates the impact of changing interest rates on interest
income from all interest earning assets and the interest expense paid on all
interest bearing liabilities reflected on the Company's balance sheet. This
sensitivity analysis is compared to policy limits, which specify a maximum
tolerance level for net interest income exposure over a one-year horizon
assuming no balance sheet growth, given a 200 basis point upward and a 100 basis
point downward shift in interest rates. A shift in rates over a 12-month period
is assumed. Results that exceed policy limits, if any, are analyzed for risk
tolerance and reported to the Board with appropriate recommendations. At March
31, 2004, the Company's estimated net interest income sensitivity to changes in
interest rates, as a percent of net interest income was an increase in net
interest income of 2.60% if rates increase by 200 basis points and a decrease in
net interest income of 1.51% if rates decline 100 basis points.
The estimated sensitivity does not necessarily represent a Company forecast and
the results may not be indicative of actual changes to the Company's net
interest income. These estimates are based upon a number of assumptions
including: the nature and timing of interest rate levels including yield curve
shape, prepayments on loans and securities, pricing strategies on loans and
deposits, replacement of asset and liability cashflows, and other assumptions.
While the assumptions used are based on current economic and local market
conditions, there is no assurance as to the predictive nature of these
conditions including how customer preferences or competitor influences might
change. See Note 13 of the Notes to the Consolidated Financial Statements
located in the 2003 Annual Report to Shareholders.
Liquidity Risk
Liquidity risk is the risk to earnings or capital resulting from the Bank's
inability to meet its obligations when they come due without incurring
unacceptable losses. It includes the ability to manage unplanned decreases or
changes in funding sources and to recognize or address changes in market
conditions that affect the Bank's ability to liquidate assets or acquire funds
quickly and with minimum loss of value. The Company endeavors to maintain a cash
flow adequate to fund operations, handle fluctuations in deposit levels, respond
to the credit needs of borrowers and to take advantage of investment
opportunities as they arise. The principal sources of liquidity include credit
facilities from correspondent banks, brokerage firms and the Federal Home Loan
Bank, as well as, interest and principal payments on loans and investments,
proceeds from the maturity or sale of investments, and growth in deposits.
In general, liquidity risk is managed daily by controlling the level of Federal
Funds and the use of funds provided by the cash flow from the investment
portfolio. The Company maintains overnight investments in Federal Funds as a
cushion for temporary liquidity needs. During the first quarter of 2004, Federal
Funds averaged $20.6 million. The Company maintains Federal Fund credit lines of
$50 million with major banks subject to the customary terms and conditions for
such arrangements and $175 million in repurchase lines with major brokers. In
addition the Company has additional borrowing capacity of $129 million from the
Federal Home Loan Bank.
24
At March 31, 2004, the Company had available liquid assets, which included cash
and cash equivalents and unpledged investment securities of approximately $154.9
million, which represents 13.8% of total assets.
ITEM 4. CONTROLS AND PROCEDURES
The Company maintains controls and procedures designed to ensure that
information is recorded and reported in all filings of financial reports. Such
information is reported to the Company's management, including its Chief
Executive Officer and its Chief Financial Officer to allow timely and accurate
disclosure based on the definition of "disclosure controls and procedures" in
Rule 13a-15(e). In designing these controls and procedures, management
recognizes that they can only provide reasonable assurance of achieving the
desired control objectives. Management also evaluated the cost-benefit
relationship of possible controls and procedures.
As of the end of the period covered by this report, the Company carried out an
evaluation of the effectiveness of Company's controls and disclosure procedures
under the supervision and with the participation of the Chief Executive Officer,
the Chief Financial Officer and other senior management of the Company. Based on
the foregoing, the Company's Chief Executive Officer and the Chief Financial
Officer concluded that the Company's disclosure controls and procedures were
effective.
There have been no significant changes in the Company's internal controls or in
other factors that could significantly affect the internal controls subsequent
to the date the Company completed its evaluation.
Average Balance Sheets
The tables on the following pages reflect the Company's average balance sheets
and volume and rate analysis for the three month periods ending March 31, 2004
and 2003.
The average yields on earning assets and average rates paid on interest-bearing
liabilities have been computed on an annualized basis for purposes of
comparability with full year data. Average balance amounts for assets and
liabilities are the computed average of daily balances.
The volume and rate analysis of net interest revenue summarizes the changes in
average asset and liability balances and interest earned and paid resulting from
changes in average asset and liability balances (volume) and changes in average
interest rates and the total net change in interest income and expenses. The
changes in interest due to both rate and volume have been allocated to volume
and rate changes in proportion to the relationship of the absolute dollar amount
of the change in each.
25
Farmers & Merchants Bancorp
Year-to-Date Average Balances and Interest Rates
(Interest and Rates on a Taxable Equivalent Basis)
(in thousands)
Three Months Ended March 31, Three Months Ended March 31,
2004 2003
Assets Balance Interest Rate Balance Interest Rate
- --------------------------------------------------------- ------------- --------- ---------- ------------ ---------- ---------
Federal Funds Sold $ 20,585 $ 52 1.02% $ 19,036 $ 79 1.68%
Investment Securities Available-for-Sale
U.S. Treasuries 0 0 0.00% 0 0 0.00%
U.S. Agencies 63,061 577 3.71% 32,318 266 3.34%
Municipals - Taxable 1,089 17 6.33% 1,343 21 6.34%
Municipals - Non-Taxable 24,021 343 5.79% 31,953 446 5.66%
Mortgage Backed Securities 113,393 1,016 3.63% 116,312 1,369 4.77%
Other 7,867 111 5.72% 20,428 249 4.94%
- --------------------------------------------------------- ------------- --------- ---------- ------------ ---------- ---------
Total Investment Securities Available-for-Sale 209,431 2,064 4.00% 202,354 2,351 4.71%
- --------------------------------------------------------- ------------- --------- ---------- ------------ ---------- ---------
Investment Securities Held-to-Maturity
U.S. Treasuries 0 0 0.00% 0 0 0.00%
U.S. Agencies 0 0 0.00% 0 0 0.00%
Municipals - Taxable 0 0 0.00% 0 0 0.00%
Municipals - Non-Taxable 36,301 590 6.59% 28,814 522 7.34%
Mortgage Backed Securities 0 0 0.00% 0 0 0.00%
Other 372 5 5.45% 479 7 5.93%
- --------------------------------------------------------- ------------- --------- ---------- ------------ ---------- ---------
Total Investment Securities Held-to-Maturity 36,673 595 6.58% 29,293 529 7.32%
- --------------------------------------------------------- ------------- --------- ---------- ------------ ---------- ---------
Loans
Real Estate 459,385 7,179 6.29% 384,719 6,442 6.79%
Home Equity 55,201 637 4.64% 46,543 587 5.11%
Agricultural 124,139 1,574 5.10% 100,195 1,289 5.22%
Commercial 133,283 1,884 5.69% 135,856 1,853 5.53%
Consumer 11,439 275 9.67% 13,685 303 8.98%
Credit Card 4,552 112 9.90% 4,352 102 9.51%
Municipal 1,096 12 4.40% 1,250 16 5.19%
- --------------------------------------------------------- ------------- --------- ---------- ------------ ---------- ---------
Total Loans 789,095 11,673 5.95% 686,600 10,592 6.26%
- --------------------------------------------------------- ------------- --------- ---------- ------------ ---------- ---------
Total Earning Assets 1,055,784 $14,384 5.48% 937,283 $13,550 5.86%
========= ========== ========== =========
Unrealized Gain/(Loss) on Securities Available-for-Sale 2,832 4,496
Allowance for Loan Losses (17,382) (16,837)
Cash and Due From Banks 31,471 29,239
All Other Assets 60,139 54,307
- --------------------------------------------------------- ------------- ------------
Total Assets $1,132,844 $1,008,488
========================================================= ============= ============
Liabilities & Shareholders' Equity
Interest Bearing Deposits
Interest Bearing DDA $94,147 $ 14 0.06% $89,325 $ 49 0.22%
Savings 277,378 256 0.37% 243,202 345 0.58%
Time Deposits 313,344 1,322 1.70% 320,855 1,907 2.41%
- --------------------------------------------------------- ------------- --------- ---------- ------------ ---------- ---------
Total Interest Bearing Deposits 684,869 1,592 0.93% 653,382 2,301 1.43%
Other Borrowed Funds 98,766 716 2.92% 49,493 577 4.73%
Subordinated Debentures 10,310 105 4.10% 0 0 0.00%
- --------------------------------------------------------- ------------- --------- ---------- ------------ ---------- ---------
Total Interest Bearing Liabilities 793,945 $2,413 1.22% 702,875 $2,878 1.66%
========= ========== ========== =========
Demand Deposits (Non-Interest Bearing) 217,893 192,794
All Other Liabilities 10,066 7,999
- --------------------------------------------------------- ------------- ------------
Total Liabilities 1,021,904 903,668
Shareholders' Equity 110,940 104,820
- --------------------------------------------------------- ------------- ------------
Total Liabilities & Shareholders' Equity $1,132,844 $1,008,488
========================================================= ============= ============
Net Interest Margin 4.56% 4.62%
========================================================= ============= ========= ========== ============ ========== =========
Notes: Yields on municipal securities have been calculated on a fully taxable
equivalent basis using the combined Federal and State income tax rate of 42.06%.
Loan Fees are included in interest income for loans. Unearned discount is
included for rate calculation purposes. Nonaccrual loans and lease financing
receivables have been included in the average balances. Yields on securities
available-for-sale are based on historical cost.
26
Farmers & Merchants Bancorp
Volume and Rate Analysis of Net Interest Revenue
(Rates on a Taxable Equivalent Basis)
(in thousands) Three Months Ended
Mar. 31, 2004 compared to Mar. 31, 2003
Interest Earning Assets Volume Rate Net Chg.
- -------------------------------------------------------- ------------- ------------ ---------
Federal Funds Sold $ 39 $ (66) $ (27)
Investment Securities Available for Sale
U.S. Treasuries 0 0 0
U.S. Agencies 278 33 311
Municipals - Taxable (4) 0 (4)
Municipals - Non-Taxable (172) 69 (103)
Mortgage Backed Securities (33) (320) (353)
Other (363) 225 (138)
- -------------------------------------------------------- ------------- ------------ ---------
Total Investment Securities Available for Sale (294) 7 (287)
- -------------------------------------------------------- ------------- ------------ ---------
Investment Securities Held to Maturity
U.S. Treasuries 0 0 0
U.S. Agencies 0 0 0
Municipals - Taxable 0 0 0
Municipals - Non-Taxable 360 (292) 68
Mortgage Backed Securities 0 0 0
Other (2) 0 (2)
- -------------------------------------------------------- ------------- ------------ ---------
Total Investment Securities Held to Maturity 358 (292) 66
- -------------------------------------------------------- ------------- ------------ ---------
Loans:
Real Estate 3,344 (2,607) 737
Home Equity 327 (277) 50
Agricultural 476 (191) 285
Commercial (157) 188 31
Installment (147) 119 (28)
Credit Card 5 5 10
Other (1) (2) (3)
- -------------------------------------------------------- ------------- ------------ ---------
Total Loans 3,847 (2,765) 1,082
- -------------------------------------------------------- ------------- ------------ ---------
Total Earning Assets 3,950 (3,116) 834
- -------------------------------------------------------- ------------- ------------ ---------
Interest Bearing Liabilities
Interest Bearing Deposits:
Transaction 18 (53) (35)
Savings 256 (345) (89)
Time Deposits (43) (542) (585)
- -------------------------------------------------------- ------------- ------------ ---------
Total Interest Bearing Deposits 231 (940) (709)
Other Borrowed Funds 1,396 (1,257) 139
Subordinated Debentures 52 53 105
- -------------------------------------------------------- ------------- ------------ ---------
Total Interest Bearing Liabilities 1,679 (2,144) (465)
- -------------------------------------------------------- ------------- ------------ ---------
Total Change $ 2,271 $ (972) $ 1,299
======================================================== ============= ============ =========
Notes: Rate/volume variance is allocated based on the percentage relationship of
changes in volume and changes in rate to the total "net change." The above
figures have been rounded to the nearest whole number.
27
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings
Certain lawsuits and claims arising in the ordinary course of business have been
filed or are pending against the Company or its subsidiaries. Based upon
information available to the Company, its review of such lawsuits and claims and
consultation with its counsel, the Company believes the liability relating to
these actions, if any, would not have a material adverse effect on its
consolidated financial statements.
ITEM 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity
Securities
2(e) The following table indicates the number of shares repurchased by Farmers &
Merchants Bancorp during the first quarter of 2004.
Number of Shares
Average Purchased as Part of a Maximum Number that May
Number of Price per Publicly Announced Yet Be Purchased Under
First Quarter 2004 Shares Share Plan or Program the Plan or Program
- ------------------------------- ---------------- -------------- ------------------------ ---------------------------
01/01/2004 - 01/31/2004 35 300 0 N/A
02/01/2004 - 02/29/2004 0 0 0 N/A
03/01/2004 - 03/31/2004 2,597 360 0 N/A
- ------------------------------- ---------------- -------------- ------------------------ ---------------------------
Total 2,632 360 0
1,000 of the above shares were repurchased in open-market transactions and the
balance in private transactions.
The Company's common stock is not listed on any exchange, nor is it included on
the NASDAQ National Market or the NASDAQ Small Cap Market. However, trades may
be reported on the OTC Bulletin Board under the symbol "FMCB.OB". Management is
aware that there are private transactions in the Company's common stock. When
the Company repurchases shares in private transactions the price is determined
based upon the most recent transactions that have occurred between third party
shareholders.
See Financial Condition - Capital for a discussion of the Company's share
repurchase activities and strategies.
ITEM 3. Defaults Upon Senior Securities
Not applicable
ITEM 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of the Company's stockholders during the
first quarter of 2004.
ITEM 5. Other Information
None
28
ITEM 6(a). Exhibits
See Exhibit Index on Page 30.
ITEM 6(b). Reports on Form 8-K
During the quarter ended March 31, 2004, the Company filed the
following Current Reports of Form 8-K:
Description Date of Report
Annual and quarterly results of operations February 9, 2004
SIGNATURES
Pursuant to the requirement 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.
FARMERS & MERCHANTS BANCORP
/s/ Kent A. Steinwert
Date: May 7, 2004 __________________________
Kent A. Steinwert
President and
Chief Executive Officer
(Principal Executive Officer)
/s/ Stephen W. Haley
Date: May 7, 2004 __________________________
Stephen W. Haley
Executive Vice President and
Chief Financial Officer
(Principal Accounting Officer)
29
Index to Exhibits
Exhibit No. Description
31 Rule 13(a)-14(a)/15d-14(a) Certifications.
32 Chief Executive Officer and Chief Financial Officer Certification pursuant
to 10 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-
Oxley Act of 2002.
30