NOTE 1 - BASIS OF PRESENTATION
The significant accounting policies followed by MainSource Financial Group, Inc. (“Company”) for interim financial reporting are consistent with the accounting policies followed for annual financial reporting. The consolidated interim financial statements have been prepared according to accounting principles generally accepted in the United States of America and in accordance with the instructions for Form 10-Q. The interim statements do not include all information and footnotes normally included in the annual financial statements. All adjustments which are, in the opinion of management, necessary for a fair presentation of the results for the periods reported have been included in the accompanying unaudited consolidated financial statements and all such adjustments are of a normal recurring nature. Some items in prior period financial statements were reclassified to conform to current presentation. It is suggested that these consolidated financial statements and notes be read in conjunction with the financial statements and notes thereto in the MainSource Financial Group December 31, 2005 Annual Report on Form 10-K.
Recently Issued Accounting Standards:
In March 2006, Financial Accounting Standards Board (FASB) issued FAS No. 156, which changes the accounting for all servicing rights recorded as the result of purchasing or originating a loan servicing right. FAS No. 156 amends the current accounting guidance for servicing rights in that it allows companies to carry their servicing rights at fair value, where presently servicing rights are recorded at cost allocated on a fair value basis at inception and assessed for impairment based on their fair value at each reporting date, using lower of cost or market value. This pronouncement is effective beginning January 1, 2007. The Company is in the process of evaluating the impact, if any, the adoption of FAS No. 156 will have on the financial statements.
In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (FIN 48), which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective beginning in 2007. The Company is in the process of evaluating the impact, if any, the adoption of FIN 48 will have on the financial statements.
NOTE 2 - STOCK PLANS AND STOCK BASED COMPENSATION
Options to buy stock were granted to directors and officers of the Company under the Company’s Stock Option Plan, which was adopted in 2003 and provides for the issuance of options to purchase up to 578,813 shares of common stock of the Company, of which 355,833 are still available for granting at June 30, 2006. All stock options have an exercise price that is at least equal to the fair market value of the Company’s stock on the date the options were granted. The maximum option term is ten years, and options vest immediately for the directors’ grant and over four years for the officers’ grant. It is the Company’s intent that shares issued under the above mentioned plan will come from treasury shares. Pursuant to the merger agreement related to the Company’s acquisition of Peoples Ohio Financial Corporation (Peoples) in June 2006, the Company assumed the obligation of Peoples to issue 265,150 shares of Peoples common stock, or 87,431 shares of MainSource common stock, based on the exchange ratio in the merger transaction. Because these options were fully vested at the time of acquisition, no compensation expense was recorded.
Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share Based Payment.” The Company elected to utilize the modified prospective transition method, therefore, prior period results were not restated. Prior to the adoption of SFAS 123R, stock-based compensation expense related to stock options was not recognized in the results of operations if the exercise price was at least equal to the market value of the common stock on the grant date, in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.”
SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized as compensation expense over the service period (generally the vesting period) in the consolidated financial statements based on their fair values. For options with graded vesting, we value the stock option grants and recognize compensation expense as if each vesting portion of the award was a single award. Under the modified prospective method, unvested awards, and awards that were granted, modified, or settled on or after January 1, 2006 are measured and accounted for in accordance with SFAS 123R.
The following table summarizes stock option activity:
| | Six Months Ended
June 30, 2006 | |
| | Shares | | Weighted
Average
Exercise Price | |
Outstanding, beginning of year | | 173,906 | | $ | 19.71 | |
Granted | | 34,500 | | 18.94 | |
Additions related to acquisition | | 87,431 | | 13.64 | |
Exercised | | — | | — | |
Forfeited or expired | | — | | — | |
Outstanding, end of year | | 295,837 | | $ | 17.83 | |
Options exercisable at period end | | 246,593 | | $ | 17.92 | |
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The following table details stock options outstanding:
(dollars in thousands) | | June 30, 2006 | | December 31, 2005 | |
Stock options vested and currently exercisable: | | | | | |
Number | | 246,593 | | 155,662 | |
Weighted average exercise price | | $ | 17.92 | | $ | 20.30 | |
Aggregate intrinsic value | | $ | 572 | | $ | 121 | |
Weighted average remaining life (in years) | | 6.4 | | 8.4 | |
The intrinsic value for stock options is calculated based on the exercise price of the underlying awards and the market price of our common stock as of the reporting date. The Company recorded $16 in stock compensation expense during the three months ended June 30, 2006 to salaries and employee benefits. There were 34,500 options granted in the first quarter of 2006. In order to calculate the fair value of this option grant, the following weighted-average assumptions were used as of the grant date: risk-free interest rate 4.56%, expected option life 6.8 years, expected stock price volatility 21.1%, and dividend yield 2.75%. The resulting weighted average fair value of the options granted in the first quarter of 2006 was $4.19 for each option granted.
The fair value of each stock option granted is estimated on the date of grant using the Black-Scholes based stock option valuation model. This model requires the input of subjective assumptions that will usually have a significant impact on the fair value estimate. Expected volatilities are based on historical volatility of the Company’s stock, and other factors. Expected dividends are based on dividend trends and the market price of the Company’s stock price at grant. The Company uses historical data to estimate option exercises within the valuation model. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.
SFAS 123R requires the recognition of stock based compensation for the number of awards that are ultimately expected to vest. The Company did not reduce its compensation expense for estimated forfeitures prior to vesting primarily based on the limited number of holders of unvested stock options in the second quarter of 2006. Estimated forfeitures will be reassessed in subsequent periods and may change based on new facts and circumstances.
Unrecognized stock option compensation expense related to unvested awards (net of estimated forfeitures) for the remainder of 2006 and beyond is estimated as follows:
Year | | | | (in thousands) | |
July 2006 - December 2006 | | $ | 30 | |
2007 | | 46 | |
2008 | | 36 | |
2009 | | 35 | |
2010 | | 5 | |
2011 | | — | |
| | | | | | |
The following table illustrates the effect on net income and earnings per share for the periods indicated if expense was measured using the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation.
| | Three Months Ended | | Six Months Ended | |
(Dollars in thousands, except per share data) | | June 30, 2006 | | June 30, 2005 | | June 30, 2006 | | June 30, 2005 | |
Net income as reported | | $ | 5,482 | | $ | 4,326 | | $ | 10,268 | | $ | 8,116 | |
Deduct: Stock-based compensation expense, net, determined under fair value based method | | — | | 39 | | — | | 80 | |
Pro forma net income | | $ | 5,482 | | $ | 4,287 | | $ | 10,268 | | $ | 8,036 | |
| | | | | | | | | |
Basic earnings per share as reported | | $ | 0.35 | | $ | 0.37 | | $ | 0.70 | | $ | 0.70 | |
Pro forma basic earnings per share | | $ | 0.35 | | $ | 0.37 | | $ | 0.70 | | $ | 0.69 | |
| | | | | | | | | |
Diluted earnings per share as reported | | $ | 0.35 | | $ | 0.37 | | $ | 0.70 | | $ | 0.70 | |
Pro forma diluted earnings per share | | $ | 0.35 | | $ | 0.36 | | $ | 0.70 | | $ | 0.69 | |
NOTE 3 - ACQUISITIONS
In March 2006, the Company consummated its acquisition of Union Community Bancorp (“Union”). As of the date of acquisition, Union, through its subsidiary, Union Federal Savings and Loan Association, had six branches in Montgomery, Warren, Tippecanoe and Fountain Counties, Indiana. Simultaneous to the acquisition, Union Federal was merged into a
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newly-formed subsidiary of the Company, MainSource Bank - Crawfordsville. As of the date of acquisition, Union had $217 million of loans, and $178 million of deposits. Goodwill of $26.1 million and a core deposit of $2.0 million were also recorded. The core deposit intangible asset is being amortized over 10 years using an accelerated method. The Company funded the $56.0 million purchase price by issuing 1,577,222 shares of its common stock valued at $18.50 per the NASDAQ closing bid on March 17, 2006 and using $26.8 million of cash on hand. The results of operations for this acquisition have been included since the transaction date which was March 17, 2006.
In May 2006, the Company consummated its acquisition of HFS Bank, F.S.B. (“HFS”). As of the date of acquisition, HFS had six offices in Lake and Porter Counties, Indiana. Simultaneous to the acquisition, HFS was merged into a newly-formed subsidiary of the Company, MainSource Bank - Hobart. As of the date of acquisition, HFS had $182 million of loans, and $140 million of deposits. Goodwill of $16.4 million was also recorded. The purchase price of $36.1 million was paid with 1,089,736 shares of MainSource common stock valued at $17.28 per share and $17.3 million of cash. The results of operations for this acquisition have been included since the transaction date which was May 24, 2006.
In June 2006, the Company consummated its acquisition of Peoples Ohio Financial Corporation (“Peoples”). As of the date of acquisition, Peoples, through its subsidiary, Peoples Savings Bank of Troy, had six offices in Miami and Montgomery counties in Ohio. Simultaneous to the acquisition, Peoples Savings Bank of Troy was merged into a newly-formed subsidiary of the Company, MainSource Bank - Ohio. As of the date of acquisition, Peoples had $183 million of loans, and $118 million of deposits. Goodwill of $17.8 million was also recorded. The purchase price of $41.6 million was paid with 1,817,050 shares of MainSource common stock valued at $16.95 per share and $10.3 million of cash. The results of operations for this acquisition have been included since the transaction date which was June 16, 2006.
As a result of these acquisitions, the Company has expanded its geographical presence in the states of Indiana and Ohio. The Company expects that the acquisitions will allow it to increase its customer base to enhance deposit fee income, market additional products and services to new customers and reduce operating costs through economics of scale. The Company is currently in the process of obtaining third party valuations and completing fair value estimates for certain assets acquired and liabilities assumed in the three transactions, and the allocations of each purchase price is subject to refinement based on such valuations and estimates. For the Peoples and HFS acquisitions, this refinement will include a core deposit intangible that would reduce goodwill.
The following table presents proforma information for the periods ended June 30 as if the acquisitions had occurred at the beginning of 2006 and 2005. The pro forma financial information is not necessarily indicative of the results of operations as they would have been had the transaction been effected on the assumed dates and is not intended to be a projection of future results.
| | Three Months Ended
June 30, | | Six Months Ended
June 30, | |
| | 2006 | | 2005 | | 2006 | | 2005 | |
Net interest income | | $ | 18,854 | | $ | 19,340 | | $ | 37,880 | | $ | 37,952 | |
Net income | | 6,050 | | 5,760 | | 11,388 | | 10,752 | |
Net income per share - Basic | | 0.34 | | 0.32 | | 0.63 | | 0.60 | |
Net income per share - Diluted | | 0.34 | | 0.32 | | 0.63 | | 0.60 | |
| | | | | | | | | | | | | |
Pending Acquisition:
In April 2006, the Company executed a purchase and assumption agreement with First Financial Bank, N.A. to purchase five branch locations with one office in each of Madison, East Enterprise, and Liberty, Indiana and two offices in Vevay, Indiana. In total, these branches comprise approximately $30 million in loans and $53 million in deposits. The transaction is expected to close in the third quarter of 2006. The all-cash purchase price is expected to be approximately $4.6 million. As of the date of this report, all regulatory approvals for this transaction have been received.
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NOTE 4 - SECURITIES
The fair value of securities available for sale and related urealized gains/losses recognized in accumulated other comprehensive income (loss) were as follows:
| | Fair
Value | | Gross
Unrealized
Gains | | Gross
Unrealized
Losses | |
As of June 30, 2006 | | | | | | | |
Available for Sale | | | | | | | |
Federal agencies | | $ | 101,618 | | $ | 25 | | $ | (2,249 | ) |
State and municipal | | 121,531 | | 553 | | (2,865 | ) |
Mortgage-backed securities | | 249,772 | | 134 | | (10,634 | ) |
Equity and other securities | | 10,814 | | 266 | | (2 | ) |
Total available for sale | | $ | 483,735 | | $ | 978 | | $ | (15,750 | ) |
| | | | | | | |
As of December 31, 2005 | | | | | | | |
Available for Sale | | | | | | | |
Federal agencies | | $ | 77,196 | | $ | 94 | | $ | (552 | ) |
State and municipal | | 112,785 | | 995 | | (1,369 | ) |
Mortgage-backed securities | | 246,994 | | 344 | | (5,211 | ) |
Equity and other securities | | 13,839 | | 427 | | — | |
Total available for sale | | $ | 450,814 | | $ | 1,860 | | $ | (7,132 | ) |
Unrealized losses on AFS securities have not been recognized into income because management has the intent and ability to hold these securities for the foreseeable future and the decline in fair value is largely due to increases in market interest rates. The fair value is expected to recover as the securities approach their maturity dates.
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NOTE 5 - LOANS AND ALLOWANCE
| | June 30,
2006 | | December 31,
2005 | |
| | | | | |
Commercial and industrial loans | | $ | 170,081 | | $ | 149,074 | |
Agricultural production financing | | 24,311 | | 23,871 | |
Farm real estate | | 44,555 | | 38,833 | |
Commercial real estate | | 241,270 | | 160,061 | |
Hotel | | 56,565 | | 47,939 | |
Residential real estate | | 798,837 | | 368,953 | |
Construction and development | | 85,488 | | 45,783 | |
Consumer | | 130,554 | | 123,481 | |
Total loans | | 1,551,661 | | 957,995 | |
Allowance for loan lossess | | (14,426 | ) | (10,441 | ) |
Net loans | | $ | 1,537,235 | | $ | 947,554 | |
| | June 30, | |
| | 2006 | | 2005 | |
Allowance for loan losses | | | | | |
Balances, January 1 | | $ | 10,441 | | $ | 11,698 | |
Addition resulting from acquisition | | 4,474 | | — | |
Adjustments to prior acquisition | | (110 | ) | — | |
Provision for losses | | 723 | | 460 | |
Recoveries on loans | | 241 | | 117 | |
Loans charged off | | (1,343 | ) | (1,000 | ) |
Balances, June 30 | | $ | 14,426 | | $ | 11,275 | |
NOTE 6 - DEPOSITS
| | June 30,
2006 | | December 31,
2005 | |
| | | | | |
Non-interest-bearing demand | | $ | 189,682 | | $ | 161,568 | |
Interest-bearing demand | | 423,999 | | 330,592 | |
Savings | | 369,051 | | 321,661 | |
Certificates of deposit of $100 or more | | 233,430 | | 173,656 | |
Other certificates and time deposits | | 540,907 | | 365,220 | |
Total deposits | | $ | 1,757,069 | | $ | 1,352,697 | |
NOTE 7 - EARNINGS PER SHARE
Earnings per share (EPS) were computed as follows:
For the three months ended | | June 30, 2006 | | June 30, 2005 | |
| | | | Weighted | | Per | | | | Weighted | | Per | |
| | Net | | Average | | Share | | Net | | Average | | Share | |
| | Income | | Shares | | Amount | | Income | | Shares | | Amount | |
Basic earnings per share: | | | | | | | | | | | | | |
Income available to
common shareholders | | $ | 5,482 | | 15,772,464 | | $ | 0.35 | | $ | 4,326 | | 11,738,688 | | $ | 0.37 | |
Effect of dilutive shares | | | | 13,243 | | | | | | 13,143 | | | |
Diluted earnings per share | | $ | 5,482 | | 15,785,707 | | $ | 0.35 | | $ | 4,326 | | 11,751,831 | | $ | 0.37 | |
For the six months ended | | June 30, 2006 | | June 30, 2005 | |
| | | | Weighted | | Per | | | | Weighted | | Per | |
| | Net | | Average | | Share | | Net | | Average | | Share | |
| | Income | | Shares | | Amount | | Income | | Shares | | Amount | |
Basic earnings per share: | | | | | | | | | | | | | |
Income available to
common shareholders | | $ | 10,268 | | 14,750,888 | | $ | 0.70 | | $ | 8,116 | | 11,633,685 | | $ | 0.70 | |
Effect of dilutive shares | | | | 12,198 | | | | | | 15,853 | | | |
Diluted earnings per share | | $ | 10,268 | | 14,763,086 | | $ | 0.70 | | $ | 8,116 | | 11,649,538 | | $ | 0.70 | |
Stock options for 161,275 and 128,425 shares of common stock were not considered in computing diluted earnings per share for 2006 and 2005 because they were antidilutive.
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MAINSOURCE FINANCIAL GROUP, INC.
FORM 10-Q
MANAGEMENT’S DISCUSSION AND ANALYSIS
(Dollar amounts in thousands except per share data)
Item 2.
Overview
MainSource Financial Group, Inc. (“Company”) is a multi-bank, financial holding company that provides an array of financial services and is headquartered in Greensburg, Indiana. The Company’s shares trade on the NASDAQ national securities exchange under the symbol MSFG. On June 30, 2006, the Company controlled five bank subsidiaries, MainSource Bank, MainSource Bank of Illinois, MainSource Bank - Crawfordsville, MainSource Bank - Hobart, and MainSource Bank - Ohio. In addition to the banking subsidiaries, the Company owned the following subsidiaries: MainSource Insurance, LLC, MainSource Statutory Trust I, MainSource Statutory Trust II, MainSource Statutory Trust III, IUB Reinsurance Company, Ltd., MSB Investments of Nevada, Inc., MainSource Title, LLC, and MainSource Mortgage, LLC. As required by current accounting guidance, the trusts are no longer consolidated with the Company. Accordingly, the Company does not report the securities issued by the trusts as liabilities, and instead reports as liabilities the subordinated debentures issued by the Company.
Forward-Looking Statements
Except for historical information contained herein, the following discussion and analysis includes certain statements which constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements involve risks and uncertainties, including anticipated financial performance, business prospects and other similar matters, which reflect management’s best judgment based on factors currently known. Actual results and experience could differ materially from the anticipated results or other expectations expressed in the Company’s forward-looking statements. Factors which might cause such a difference include, but are not limited to, general economic conditions, monetary and fiscal policies of the federal government, demand for loan products, and other factors discussed in our Annual Report on 10K for the year ended December 31, 2005, under ITEM 1A “Risk Factors”, and our other filings with the Securities and Exchange Commission. The Company does not undertake, and specifically disclaims, any obligation to update any forward-looking statements to reflect the occurrence of events or circumstances after the date of such statements.
Results of Operations
Net income for the second quarter of 2006 was $5,482 compared to $4,326 for the second quarter of 2005. The increase in net income was primarily attributable to the acquisitions detailed in Note 3 as well as the acquisition of The Madison Bank & Trust Company, which occurred in August 2005. Diluted earnings per share for the second quarter totaled $0.35 in 2006, a decrease from the $0.37 reported in the same period a year ago. Key measures of the financial performance of the Company are return on average shareholders’ equity and return on average assets. Return on average shareholders’ equity was 11.11% for the second quarter of 2006 while return on average assets was 1.10% for the same period, compared to 13.66% and 1.15% in the second quarter of 2005. Return on equity has been impacted by shares issued in connection with the public offering in the second and third quarters of 2005, and by the issuance of shares in the first and second quarters of 2006 in the aforementioned acquisitions.
For the six months ended June 30, 2006, net income was $10,268 compared to $8,116 for the same period a year ago. Earnings per share were flat year over year at $0.70 per share. Return on average shareholders’ equity was 11.44% for the first six months of 2006 while return on average assets was 1.13% for the same period, compared to 12.96% and 1.08% in the first six months of 2005.
Net Interest Income
The volume and yield of earning assets and interest-bearing liabilities influence net interest income. Net interest income reflects the mix of interest-bearing and non-interest-bearing liabilities that fund earning assets, as well as interest spreads between the rates earned on these assets and the rates paid on interest-bearing liabilities. Second quarter net interest income of $16,408 in 2006 was an increase of 24.4% versus the second quarter of 2005. Average earning assets increased 29.9% while net interest margin, on a fully-taxable equivalent basis, decreased to 3.82% for the second quarter of 2006 compared to 4.04% for the same period a year ago. The acquisitions of the thrift institutions in the first and second quarters of 2006 and their corresponding lower net interest margins were the primary cause for the decrease in the Company’s net interest margin. In addition, the Company has seen a shift in its existing deposit mix as many customers have moved their balances from lower-cost transactional accounts to higher-yielding time and money market accounts. This shift, coupled with the increase
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in short-term borrowing rates, has resulted in a higher than expected increase in the overall cost of funds.
Provision for Loan Losses
See “Loans, Credit Risk and the Allowance and provision for Probable Loan Losses” below.
Non-interest Income
Second quarter non-interest income for 2006 was $5,895 compared to $4,839 for the second quarter of 2005. This increase was primarily attributable to acquisition activity. Excluding acquisition activity, the Company’s non-interest income would have been $5,418, an increase of 12.0% compared to the same period a year ago. In June 2006, the Company settled its interest rate swap agreement and realized a pre-tax gain of $483, which is reported as other income.
For the six months ended June 30, 2006, non-interest income was $10,794 compared to $9,418 for the same period a year ago. An increase in service charge income due primarily to the acquisition of Madison and the aforementioned gain on the settlement of the Company’s interest rate swap were offset by decreases in mortgage banking, investment security gains, and insurance commissions. Insurance commissions decreased year over year due to the sale of the Kentucky division of MainSource Insurance during the first quarter of 2005.
Non-interest Expense
The Company’s non-interest expense was $14,602 for the second quarter of 2006 compared to $11,863 for the same period in 2005. Increases in employee costs, occupancy expenses, equipment expenses, and intangibles amortization were primarily attributable to the additional physical locations and increased staffing levels related to the acquisitions. These increases were partially offset by a decrease in other expenses (excluding the acquisitions) due primarily to the cost savings derived from the consolidation of the Company’s Indiana banking charters. The Company’s efficiency ratio was 63.9% for the second quarter of 2006 compared to 64.2% for the same period a year ago.
For the six months ended June 30, 2006, non-interest expense was $27,003 compared to $23,957 for the same period a year ago. The aforementioned acquisition activity was the primary reason for the increase. The Company’s efficiency ratio was 63.4% for the first six months of 2006 compared to 66.2% for the same period a year ago.
Income Taxes
The effective tax rate for the first six months was 25.1% for 2006 compared to 25.5% for the same period a year ago. For the second quarter, the effective tax rate was 25.3% in 2006 compared to 25.7% in 2005. The slight decrease in the Company’s effective tax rate was primarily attributable to increased income from tax-free municipal securities. The Company and its subsidiaries file consolidated income tax returns.
Financial Condition
Total assets at June 30, 2006 were $2,375,548 compared to $1,645,605 as of December 31, 2005. The increase in assets from year-end 2005 was primarily attributable to the acquisitions of Union, HFS, and Peoples. Average earning assets represented 89.5% of average total assets for the first six months of 2006 and 90.2% for the same period in 2005. Average loans represented 78.5% of average deposits in the first six months of 2006 and 76.2% for the comparable period in 2005. Management continues to emphasize quality loan growth to increase these averages. Average loans as a percent of average assets were 62.1% and 60.4% for the six-month periods ended June 30, 2006 and 2005 respectively.
The increase in deposits of $404,372 from December 31, 2005 to June 30, 2006 was due primarily to acquisitions adding $436,261 of deposits. Excluding acquisitions, total deposits decreased by $31,889. During the first six months of 2006, the Company has experienced a shift in its overall deposit mix. Customer balances have been moving out of the lower-cost core deposit categories and into higher-rate certificates of deposit. However, the decrease in the core deposit balances have not been offset by the increase in certificates of deposit.
Shareholders’ equity was $239,897 on June 30, 2006 compared to $161,069 on December 31, 2005. The Company issued common stock with an aggregate value of approximately $79 million in the acquisitions of Union, HFS, and Peoples. Book value (shareholders’ equity) per common share was $13.36 at June 30, 2006 versus $11.96 at year-end 2005. Accumulated other comprehensive income/loss decreased book value per share by $0.53 at June 30, 2006 and $0.23 at December 31, 2005. Depending on market conditions, the unrealized gain or loss on securities available for sale can cause fluctuations in shareholders’ equity.
Loans, Credit Risk and the Allowance and Provision for Probable Loan Losses
Loans remain the Company’s largest concentration of assets and, by their nature, carry a higher degree of risk. The loan underwriting standards observed by the Company’s subsidiaries are viewed by management as a means of controlling problem loans and the resulting charge-offs.
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The Company believes credit risks may be elevated if undue concentrations of loans in specific industry segments and to out-of-area borrowers are incurred. Accordingly, the Company’s Board of Directors regularly monitors such concentrations to determine compliance with its loan allocation policy. The Company believes it has no undue concentrations of loans.
Residential real estate loans continue to represent a significant portion of the total loan portfolio. Such loans represented 51.5% of total loans at June 30, 2006 and 38.5% at December 31, 2005. The acquisition of the three institutions in 2006 and their high percentage of residential real estate loans to total loans was the primary reason for the increase.
On June 30, 2006, the Company had $615 of residential real estate loans held for sale, which was a decrease from the year-end balance of $2,566. The Company generally retains the servicing rights on mortgages sold.
Non-performing loans totaled $16,860, or 1.08% of total loans, as of June 30, 2006, compared to $13,151, or 1.44% of total loans, as of June 30, 2005, and $10,217, or 1.07% of loans at December 31, 2005. The increase in non-performing loans since year-end was due primarily to the acquisitions, which had approximately $6,100 of non-performing loans at their respective acquisition dates. The allowance for loan losses was $14,426 as of June 30, 2006 and represented 0.93% of total outstanding loans compared to $10,441 as of December 31, 2005 or 1.09% of total outstanding loans. Because of the acquisition of the three thrift institutions in the first six months of 2006 and their large residential real estate loan portfolios, the Company aniticipated this decrease in its allowance for loan losses as a percent of outstanding loans.
The provision for loan losses was $363 in the second quarter of 2006 compared to $340 for the same period in 2005 and $360 for the first quarter of 2006. The provision remained relatively flat for the second quarter of 2006 as the increase in net loan losses was mitigated by the decrease in specific allocations for certain non-performing and watch list loans. Net loan losses were $695 for the second quarter of 2006 compared to $569 for the same period a year ago. For the six months ended June 30, 2006, net loan losses were $1,102, or 0.20% of average loans outstanding, compared to $883 of net loan losses for the six months ended June 30, 2005, which represented 0.19% of average loans outstanding for that period. The adequacy of the allowance for loan losses in each subsidiary is reviewed at least quarterly. The determination of the provision amount in any period is based on management’s continuing review and evaluation of loan loss experience, changes in the composition of the loan portfolio, current economic conditions, the amount of loans presently outstanding, and information about specific borrower situations. The allowance for loan losses as of June 30, 2006 was considered adequate by management.
Investment Securities
Investment securities offer flexibility in the Company’s management of interest rate risk and are an important source of liquidity as a response to changing characteristics of assets and liabilities. The Company’s investment policy prohibits trading activities and does not allow investment in high-risk derivative products, junk bonds or foreign investments.
As of June 30, 2006, the Company had $483,735 of investment securities. All of these securities were classified as “available for sale” (“AFS”) and were carried at fair value with unrealized gains and losses, net of taxes, reported as a separate component of shareholders’ equity. An unrealized pre-tax loss of $14,772 was recorded to adjust the AFS portfolio to current market value at June 30, 2006, compared to an unrealized pre-tax loss of $5,272 at December 31, 2005. Unrealized losses on AFS securities have not been recognized into income because management has the intent and ability to hold these securities for the foreseeable future and the decline in fair value is largely due to increases in market interest rates. The fair value is expected to recover as the securities approach their maturity dates.
Sources of Funds
The Company relies primarily on customer deposits, securities sold under agreements to repurchase and shareholders’ equity to fund earning assets. FHLB advances are also used to provide additional funding.
Deposits generated within local markets provide the major source of funding for earning assets. Average total deposits funded 88.4% and 88.0% of total average earning assets for the six-month periods ending June 30, 2006 and 2005. Total interest-bearing deposits averaged 89.1% and 88.5% of average total deposits for the six-month periods ending June 30, 2006 and 2005, respectively. Management constantly strives to increase the percentage of transaction-related deposits to total deposits due to the positive effect on earnings.
The Company had FHLB advances of $273,093 outstanding at June 30, 2006. These advances have interest rates ranging from 2.36% to 6.50%. Approximately $62,000 of these advances were obtained for short-term liquidity needs and had original maturities of six months or less. The remaining advances were originally long-term advances with approximately $10,000 maturing in 2006, $32,000 maturing in 2007, $28,000 maturing in 2008, $9,000 maturing in 2009, $69,000 maturing in 2010 and $63,000 maturing in 2011 and beyond.
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Capital Resources
Total shareholders’ equity was $239,897 at June 30, 2006, which was an increase of $78,828 compared to the $161,069 of shareholders’ equity at December 31, 2005. During the first six months of 2006, the Company completed its acquisitions of Union, HFS, and Peoples and issued approximately 4.5 million shares of common stock with a value of approximately $79 million.
The Federal Reserve Board and other regulatory agencies have adopted risk-based capital guidelines that assign risk weightings to assets and off-balance sheet items. The Company’s core capital consists of shareholders’ equity, excluding accumulated other comprehensive income, while Tier 1 capital consists of core capital less goodwill and intangibles. Trust preferred securities qualify as Tier 1 capital or core capital with respect to the Company under the risk-based capital guidelines established by the Federal Reserve. Under such guidelines, capital received from the proceeds of the sale of trust preferred securities cannot constitute more than 25% of the total core capital of the Company. Consequently, the amount of trust preferred securities in excess of the 25% limitation constitutes Tier 2 capital of the Company. Total regulatory capital consists of Tier 1, certain debt instruments and a portion of the allowance for loan losses. At June 30, 2006, Tier 1 capital to total average assets was 7.0%. Tier 1 capital to risk-adjusted assets was 10.4%. Total capital to risk-adjusted assets was 11.3%. All three ratios exceed all required ratios established for bank holding companies. Risk-adjusted capital levels of the Company’s subsidiary banks exceed regulatory definitions of well-capitalized institutions.
The Company declared and paid common dividends of $0.14 per share in the second quarter of 2006 versus $0.13 for the second quarter of 2005.
Liquidity
Liquidity management involves maintaining sufficient cash levels to fund operations and to meet the requirements of borrowers, depositors, and creditors. Higher levels of liquidity bear higher corresponding costs, measured in terms of lower yields on short-term, more liquid earning assets, and higher interest expense involved in extending liability maturities. Liquid assets include cash and cash equivalents, loans and securities maturing within one year, and money market instruments. In addition, the Company holds AFS securities maturing after one year, which can be sold to meet liquidity needs.
Maintaining a relatively stable funding base, which is achieved by diversifying funding sources and extending the contractual maturity of liabilities, supports liquidity and limits reliance on volatile short-term purchased funds. Short-term funding needs arise from declines in deposits or other funding sources, funding of loan commitments and requests for new loans. The Company’s strategy is to fund assets to the maximum extent possible with core deposits that provide a sizable source of relatively stable and low-cost funds. Average core deposits funded approximately 76.5% of total earning assets for the six months ended June 30, 2006 and 78.7% for the same period in 2005.
Management believes the Company has sufficient liquidity to meet all reasonable borrower, depositor, and creditor needs in the present economic environment. In addition, the Company’s affiliates have access to the Federal Home Loan Bank for borrowing purposes. The Company has not received any recommendations from regulatory authorities that would materially affect liquidity, capital resources or operations.
Interest Rate Risk
Asset/liability management strategies are developed by the Company to manage market risk. Market risk is the risk of loss in financial instruments including investments, loans, deposits and borrowings arising from adverse changes in prices/rates. Interest rate risk is the Company’s primary market risk exposure, and represents the sensitivity of earnings to changes in market interest rates.
Effective asset/liability management requires the maintenance of a proper ratio between maturing or repriceable interest-earning assets and interest-bearing liabilities. It is the policy of the Company that the cumulative gap divided by total assets must be not greater than plus or minus 20% at the 3-month, 6-month, and 1-year time horizons.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Market risk of the Company encompasses exposure to both liquidity and interest rate risk and is reviewed monthly by the Asset/Liability Committee and the Board of Directors. There have been no material changes in the quantitative and qualitative disclosures about market risks as of June 30, 2006 from the analysis and disclosures provided in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005. As of the date of this report, the Company was evaluating the impact of the acquisitions as it relates to liquidity and interest rate risk. Differences in the balance sheet composition of the acquisitions may potentially add some exposure to the Company’s asset/liability position. However, the Company does not expect this additional exposure to have a material impact on the financial statements.
Item 4. Controls and Procedures
As of the end of the quarterly period covered by this report, an evaluation was carried out under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer,
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of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the Securities Exchange Act of 1934 (“Exchange Act”)). Based on their evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures were, to the best of their knowledge, effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms as of such date.
There was no change in the Company’s internal control over financial reporting that occurred during the Company’s second fiscal quarter of 2006 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
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PART II. OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders
(a) The annual meeting of the shareholders of the Company was held on April 26, 2006.
(c) The sole matter voted upon at the meeting and the votes cast with respect to such matter are as follows:
Proposals and Vote Tabulations
Election of Directors
| | Votes Cast | |
| | | |
Director | | | | For | | Withheld | |
| | | | | |
William G. Barron | | 11,663,666 | | 27,210 | |
Brian J. Crall | | 11,656,843 | | 34,033 | |
Philip A. Frantz | | 11,562,805 | | 128,071 | |
Rick S. Hartman | | 11,569,754 | | 121,122 | |
D.J. Hines | | 11,657,560 | | 33,316 | |
Robert E. Hoptry | | 11,663,363 | | 27,513 | |
Douglas I. Kunkel | | 11,648,289 | | 42,587 | |
James L. Saner, Sr. | | 11,652,991 | | 37,885 | |
| | | | | | | |
Item 6. Exhibits
3.1 Restated Articles of Incorporation (incorporated by reference to Exhibit 3.1 to the Annual Report on Form 10-K of the registrant for the fiscal year ended December 31, 2003 filed March 12, 2004 with the Commission (Commission File No. 0-12422)).
3.2 Bylaws of MainSource Financial Group, Inc. dated September 19, 2005 (incorporated by reference to Exhibit 3 to the Report on Form 8-K of the registrant filed September 22, 2005 with the Commission (Commission File No. 0-12422)).
31.1 Certification pursuant to Rule 13a-14(a)/15d-14(a) by Chief Executive Officer
31.2 Certification pursuant to Rule 13a-14(a)/15d-14(a) by Chief Financial Officer
The following exhibits shall not be deemed filed for purposes of Section 18 of the Securities Exchange Act of 1934, and are not incorporated by reference into any filing under the Securities Act or the Exchange Act, except to the extent the Company specifically incorporates them by reference.
32.1 Certification pursuant to Section 1350 by Chief Executive Officer
32.2 Certification pursuant to Section 1350 by Chief Financial Officer
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MAINSOURCE FINANCIAL GROUP, INC.
FORM 10-Q
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| | MAINSOURCE FINANCIAL GROUP, INC. | |
| | | |
| | | |
| | August 4, 2006 | |
| | | |
| | /s/ James L. Saner, Sr. | |
| | James L. Saner Sr. | |
| | President and Chief Executive Officer | |
| | | |
| | | |
| | August 4, 2006 | |
| | | |
| | /s/ James M. Anderson | |
| | James M. Anderson | |
| | Senior Vice President & Chief Financial Officer | |
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