Management's discussion and analysis of the Company's financial condition is based on the consolidated financial statements which are prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of such financial statements requires Management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an ongoing basis, Management evaluates its estimates, including those related to the allowance for loan losses and the valuation of mortgage servicing rights. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis in making judgments about the carrying values of assets that are not readily apparent from other sources. Actual results could differ from the amount derived from Management's estimates and assumptions under different assumptions or conditions.
Operating results for the Company are prepared using accounting principles generally accepted in the United States of America (GAAP) which, under the purchase methods of accounting, exclude FNB Bankshares results prior to the closing date of the acquisition on January 14, 2005. This discussion also includes pro-forma information which shows how the Company's results of operations would have been presented if the Company and FNB had operated as one entity for the entire periods presented (for a presentation of pro-forma results, see Note 6 to the Consolidated Financial Statements -- Pro-Forma Financial Information).
Executive Summary
Net income for the nine months ended September 30, 2005 was $9,477,000, an increase of 52.9% over net income of $6,197,000 for the comparable period of 2004. The Company's increase in net income for the nine months ended September 30, 2005 in comparison to the same period in 2004 was the result of a 62.1% increase in net interest income driven by the FNB Bankshares acquisition and organic growth. In addition, non-interest income increased 94.3% in comparison to 2004. The level of increase in operating expenses was lower than growth in revenues and assets as a result of economies realized from the FNB acquisition. Fully diluted earnings per share for the nine months ended September 30, 2005 were $0.96, a 15.7% increase over the $0.83 reported for the third quarter of 2004.
Net income for the three months ended September 30, 2005 was $3,347,000, an increase of 51.0% over net income of $2,216,000 in the comparable period of 2004. The increase in net income for the three months ended September 30, 2005 in comparison to 2004 included a 42.4% increase in net interest income driven by the FNB Bankshares acquisition and organic growth. In addition, non-interest income increased 127.2% in comparison to 2004. The level of increase in operating expenses was lower than growth in revenues and assets as a result of economies realized from the FNB acquisition. Fully diluted earnings per share for the three months ended September 30, 2005 were $0.34, a 13.3% increase over the $0.30 reported for the third quarter of 2004.
On a pro-forma basis, net income for the nine months ended September 30, 2005, was $9,302,000, an increase of $1,445,000 or 18.4% over pro-forma net income of $7,856,000 for the first nine months of 2004. Pro-forma fully diluted earnings per share for the first nine months of 2005 were $0.95, an increase of $0.16 or 20.3% over the $0.79 calculated for the first nine months of 2004.
On a pro-forma basis, net income for the three months ended September 30, 2005, was $3,347,000, an increase over pro-forma net income of $2,821,000 for the three months ended September 30, 2004. Pro-forma fully diluted earnings per share for the three months ended September 30, 2005 were $0.34, and increase of $0.06 or 21.4% over the $0.28 calculated for the three months ended September 30, 2004.
Net Interest Income
Total interest income of $36,329,000 for the nine months ended September 30, 2005 is a 62.1% increase from total interest income of $22,414,000 in the comparable period of 2004. In addition to the interest income related to the FNB acquisition, rising interest rates resulted in higher asset yields in 2005 compared to 2004. Total interest expense of $12,931,000 for the first nine months of 2005 is a 95.5% increase from total interest expense of $6,616,000 for the first nine months of 2004. This was a direct result of the rising interest rate climate and the FNB acquisition.
The combination of higher interest rates, asset growth and the FNB acquisition resulted in net interest income of $23,398,000 for the nine months ended September 30, 2005, which represents a 48.1% increase from the $15,798,000 reported for the same period in 2004.
The Company's net interest margin on a tax-equivalent basis decreased from 3.95% in the first nine months of 2004 to 3.88% for the nine months ended September 30, 2005 due to liability costs accruing at a faster rate than the yield on assets. Tax-exempt interest income amounted to $2,485,000 and $1,580,000 for the nine months ended September 30, 2005 and 2004, respectively. Tax equivalency is calculated using a 35% effective tax rate. These results are consistent with the Company's expectations for changes in its net interest margin in the current rate environment.
Total interest income of $13,138,000 for the three months ended September 30, 2005 is a 66.8% increase from total interest income of $7,875,000 in the comparable period of 2004. In addition to the interest income related to the FNB acquisition, rising interest rates resulted in higher asset yields in 2005 compared to 2004. At the same time, total interest expense of $5,149,000 for the three months ended September 30, 2005 is a 127.5% increase from total interest expense of $2,263,000 for the third quarter of 2004. This was a direct result of the rising interest rate climate and the FNB acquisition.
The combination of higher interest rates, asset growth and the FNB acquisition resulted in net interest income of $7,989,000 for the three months ended September 30, 2005, a 42.4% increase from the $5,612,000 reported for the same period in 2004.
The Company's net interest margin on a tax-equivalent basis decreased from 4.06% for the three months ended September 30, 2004 to 3.76% for the three months ended September 30, 2005 due to liability costs increasing at a faster rate than yield on assets. Tax-exempt interest income amounted to $869,000 and $571,000 for the three months ended September 30, 2005 and 2004, respectively. Tax equivalency is calculated using a 35% effective tax rate.
Page 13
The following table presents the effect of tax-exempt income on the calculation of the net interest margin, using a 35.0% tax rate in 2005 and 2004:
| For the nine months | For the quarter ended |
| ended September 30, | September 30, |
| 2005 | 2004 | 2005 | 2004 |
Net interest income as presented | $23,398 | $15,798 | $7,989 | $5,612 |
Effect of tax-exempt income | 1,338 | 851 | 468 | 308 |
Net interest income, tax equivalent | $24,736 | $16,649 | $8,457 | $5,920 |
The following table presents the amount of interest earned or paid, as well as the average yield or rate on an annualized basis, for each major category of assets or liabilities for the nine months ended September 30, 2005 and 2004. Tax-exempt income is calculated on a tax-equivalent basis, using a 35.0% tax rate in 2005 and 2004.
Nine months ended September 30, | 2005 | 2004 |
Dollars in thousands | Amount of interest | Average Yield/Rate | Amount of interest | Average Yield/Rate |
Interest on earning assets | | | | |
Interest-bearing deposits | $9 | 2.62% | $4 | 0.89% |
Investments | 6,684 | 5.64% | 5,660 | 5.51% |
Loans held for sale | 24 | 5.70% | 4 | 5.62% |
Loans | 30,950 | 5.97% | 17,597 | 5.52% |
Total interest-earning assets | 37,667 | 5.91% | 23,265 | 5.51% |
Interest-bearing liabilities | | | | |
Deposits | 8,978 | 1.89% | 3,868 | 1.33% |
Other borrowings | 3,953 | 2.82% | 2,748 | 2.47% |
Total interest-bearing liabilities | 12,931 | 2.11% | 6,616 | 1.65% |
Net interest income | $24,736 | | $16,649 | |
Interest rate spread | | 3.81% | | 3.87% |
Net interest margin | | 3.88% | | 3.95% |
The following table presents changes in interest income and expense attributable to changes in interest rates and volume for interest-earning assets and interest-bearing liabilities for the nine months ended September 30, 2005 compared to 2004. Tax-exempt income is calculated on a tax-equivalent basis, using a 35.0% tax rate in 2005 and 2004.
Nine months ended September 30, 2005 compared to 2004 | | |
Dollars in thousands | Volume | Rate | Rate/Volume1 | Total |
Interest on earning assets | | | | |
Interest-bearing deposits | $(1) | $8 | $(2) | $5 |
Investment securities | 879 | 125 | 20 | 1,024 |
Loans held for sale | 13 | 1 | 6 | 20 |
Loans | 11,023 | 1,432 | 898 | 13,353 |
Total interest income | 11,914 | 1,566 | 922 | 14,402 |
Interest expense | | | | |
Deposits | 2,445 | 1,633 | 1,032 | 5,110 |
Other borrowings2 | 714 | 390 | 101 | 1,205 |
Total interest expense | 3,159 | 2,023 | 1,133 | 6,315 |
Change in net interest income | $8,755 | $(457) | $(211) | $8,087 |
1 Represents the change attributable to a combination of change in rate and change in volume.
2 Includes federal funds purchased.
Page 14
The following table presents the amount of interest earned or paid, as well as the average yield or rate on an annualized basis, for each major category of assets or liabilities for the quarters ended September 30, 2005 and 2004. Tax-exempt income is calculated on a tax-equivalent basis, using a 35.0% tax rate in 2005 and 2004.
Quarter ended September 30, | 2005 | 2004 |
Dollars in thousands | Amount of interest | Average Yield/Rate | Amount of interest | Average Yield/Rate |
Interest on earning assets | | | | |
Interest-bearing deposits | $5 | 3.02% | $1 | 0.98% |
Investments | 2,324 | 5.64% | 1,948 | 5.62% |
Loans held for sale | 7 | 5.71% | 1 | 5.58% |
Loans | 11,270 | 6.15% | 6,233 | 5.61% |
Total interest-earning assets | 13,606 | 6.05% | 8,183 | 5.60% |
Interest-bearing liabilities | | | | |
Deposits | 3,911 | 2.17% | 1,342 | 1.33% |
Other borrowings | 1,238 | 3.25% | 921 | 2.38% |
Total interest-bearing liabilities | 5,149 | 2.36% | 2,263 | 1.62% |
Net interest income | $8,457 | | $5,920 | |
Interest rate spread | | 3.69% | | 3.98% |
Net interest margin | | 3.76% | | 4.06% |
The following table presents changes in interest income and expense attributable to changes in interest rates and volume for interest-earning assets and interest-bearing liabilities for the quarter ended September 30, 2005 compared to 2004. Tax-exempt income is calculated on a tax-equivalent basis, using a 35.0% tax rate in 2005 and 2004.
Quarter ended September 30, 2005 compared to 2004 |
Dollars in thousands | Volume | Rate | Rate/Volume1 | Total |
Interest on earning assets | | | | |
Interest-bearing deposits | $1 | $2 | $1 | $4 |
Investment securities | 360 | 14 | 2 | 376 |
Loans held for sale | 6 | - | - | 6 |
Loans | 4,013 | 623 | 401 | 5,037 |
Total interest income | 4,380 | 639 | 404 | 5,423 |
Interest expense | | | | |
Deposits | 1,049 | 853 | 667 | 2,569 |
Other borrowings2 | (17) | 340 | (6) | 317 |
Total interest expense | 1,032 | 1,193 | 661 | 2,886 |
Change in net interest income | $3,348 | $(554) | $(257) | $2,537 |
1 Represents the change attributable to a combination of change in rate and change in volume.
2 Includes federal funds purchased.
On a pro-forma basis, net interest income for the first nine months of 2005 was $23,670,000, an increase of $1,751,000 or 8.0% over net interest income of $21,919,000 for the first nine months of 2004. This increase was the result of asset growth, primarily in the loan portfolio.
On a pro-forma basis, net interest income for the three months ended September 30, 2005 was $7,989,000, an increase of $212,000 or 2.7% over net interest income of $7,777,000 for the three months ended September 30, 2004. This increase was the result of asset growth, primarily in the loan portfolio.
Page 15
Provision for Loan Losses
A $100,000 provision to the allowance for loan losses was made during the first nine months of 2005, compared to a $720,000 provision made for the same period of 2004. The decrease in provision is a result of the analysis of credit quality in the loan portfolio and the level of net chargeoffs experienced by the Company.
Non-Interest Income
Non-interest income was $6,845,000 for the nine months ended September 30, 2005, an increase of 94.3% from the $3,523,000 reported for the first nine months of 2004. The increase in non-interest income was primarily due to the acquisition of FNB Bankshares. On a pro-forma basis, non-interest income increased by $439,000 or 6.7% from $6,551,000 in 2004 to $6,990,000 in 2005. Although investment management and fiduciary income increased by 10.8%, income from mortgage origination declined due to higher interest rates and lower levels of loans sold to the secondary market.
Non-interest income was $2,954,000 for the three months ended September 30, 2005, an increase of 127.2% from the $1,300,000 reported for the three months ended September 30, 2004. The increase in non-interest income was due to the acquisition of FNB Bankshares. On a pro-forma basis, non-interest income increased by $403,000 or 15.8% from $2,551,000 in 2004 to $2,954,000 in 2005, with increases in deposit account income and fiduciary fees.
Non-Interest Expense
Non-interest expense of $16,896,000 for the nine months ended September 30, 2005, is an increase of 70.1% over non-interest expense of $9,934,000 for the first nine months of 2004. In addition to a higher expense base as a result of the FNB acquisition, this increase is due to higher personnel and premises costs to provide more comprehensive and competitive services for customers, as well as increased costs for marketing, supplies and professional fees, in line with the Company's revenue and asset growth. On a pro-forma basis, non-interest expense increased by $889,000 or 5.3% during the first nine months of 2005 compared to the first nine months of 2004, with the largest increase in furniture and equipment expense, which were up by 10.7%.
Non-interest expense of $6,254,000 for the three months ended September 30, 2005, is an increase of 74.9% over non-interest expense of $3,576,000 for the three months ended September 30, 2004. This level of increase in non-interest expense for the quarter was for the same reasons cited above. On a pro-forma basis, non-interest expense increased by $124,000 or 2.0% during the three months ended September 30, 2005 compared to the three months ended September 30, 2004, with the largest increase in furniture and equipment expense, which was up by 14.0%. In Management's opinion, this low rate of increase in non-interest expense on a pro-forma basis is indicative of the cost savings which the Company is realizing as a result of the FNB Bankshares acquisition.
Income Taxes
Income taxes on operating earnings increased to $3,770,000 for the first nine months of 2005 from $2,470,000 for the same period a year ago. The increase is in line with the increase in pre-tax income.
Page 16
Average Daily Balance Sheets
The following table shows the Company's average daily balance sheets for the nine-month periods ended September 30, 2005 and 2004.
| For nine months ended | For quarters ended |
September 30, | September 30, |
In thousands of dollars | 2005 | 2004 | 2005 | 2004 |
Assets | | | | |
Cash and due from banks | $20,904 | $12,140 | $25,586 | $13,123 |
Interest-bearing deposits | 459 | 599 | 656 | 405 |
Investments | | | | |
U.S. Treasury securities & government agency securities | 64,771 | 60,781 | 66,390 | 61,750 |
Obligations of states and political subdivisions | 51,254 | 34,288 | 55,004 | 35,406 |
Other securities | 42,376 | 42,043 | 42,073 | 40,836 |
Total investments | 158,401 | 137,112 | 163,467 | 137,992 |
Loans held for sale | 420 | 100 | 520 | 100 |
Loans | | | | |
Commercial | 280,383 | 146,206 | 297,901 | 149,751 |
Consumer | 34,745 | 26,042 | 35,432 | 26,082 |
State and municipal | 22,226 | 10,767 | 21,508 | 13,928 |
Real estate | 355,336 | 242,884 | 372,307 | 252,611 |
Total loans | 692,690 | 425,899 | 727,148 | 442,372 |
Allowance for loan losses | (6,525) | (4,417) | (6,529) | (4,520) |
Net loans | 686,165 | 421,482 | 720,619 | 437,852 |
Fixed assets | 16,501 | 8,950 | 16,849 | 8,877 |
Other assets | 18,397 | 10,416 | 19,662 | 10,588 |
Goodwill | 26,430 | 125 | 27,961 | 125 |
Total assets | $927,677 | $590,924 | $975,320 | $609,062 |
Liabilities and shareholders' equity | | | | |
Deposits | | | | |
Demand | $57,802 | $28,277 | $64,869 | $30,180 |
NOW | 105,713 | 54,932 | 113,018 | 57,795 |
Money market | 112,502 | 81,107 | 115,752 | 81,786 |
Savings | 111,832 | 64,412 | 117,229 | 65,890 |
Certificates of deposit | 115,686 | 76,279 | 131,687 | 77,755 |
Certificates of deposit over $100,000 | 130,297 | 83,331 | 171,654 | 87,464 |
Total deposits | 633,832 | 388,338 | 714,209 | 400,870 |
Borrowed funds | 187,342 | 148,718 | 151,067 | 153,889 |
Other liabilities | 8,848 | 4,868 | 8,966 | 4,853 |
Total liabilities | 830,022 | 541,924 | 874,242 | 559,612 |
Common stock | 98 | 74 | 98 | 77 |
Additional paid-in capital | 46,208 | 2,750 | 47,912 | 3,777 |
Retained earnings | 49,687 | 43,762 | 51,588 | 43,651 |
Unrealized gain/loss on AFS | 1,662 | 2,414 | 1,480 | 1,945 |
Total shareholders' equity | 97,655 | 49,000 | 101,078 | 49,450 |
Total liabilities and shareholders' equity | $927,677 | $590,924 | $975,320 | $609,062 |
Page 17
Value of Assets Acquired
On January 14, 2005, the Company completed the FNB acquisition. In its 2004 Strategic Plan, the Company identified certain markets in which it would consider future growth opportunities, including the area served by FNB Bankshares. Management expects that the products and services available in the FNB Bankshares market area will be enhanced as a result of the combination of the two companies, and this will also provide a larger capacity to lend money and a stronger overall funding base. It is expected that the combined entity will realize cost savings from redundant expenses, such as regulatory fees, audit costs, legal costs, and outsourced costs which the company has experienced in the period since the transaction closed.
The total value of the transaction was $47,955,000, and all of the voting equity interest of FNB was acquired in the transaction. As required under GAAP, the purchase price was allocated to assets acquired and liabilities assumed at the date of acquisition. The excess of purchase price over the fair value of net tangible and identified intangible assets acquired was recorded as goodwill, which totaled $27,835,000 and included $972,000 for direct expenses to consummate the transaction. The majority of the $1,830,000 difference between actual goodwill booked and the $26,005,000 of goodwill which Management estimated in the Company's December 31, 2004 financial statements was due to deferred income taxes.
There have been no changes in the opening balance sheet since the end of the first quarter. The following table shows the fair value of assets and liabilities recorded on the Company's balance sheet from the FNB acquisition, including the associated goodwill in the transaction:
In thousands of dollars | January 14, 2005 |
Assets | |
Cash and due from banks | $6,963 |
Investments | 26,562 |
Loans held for sale (fair value approximates cost) | 591 |
Loans | 185,357 |
Less: allowance for loan losses | (2,164) |
Net loans | 183,193 |
Bank premises and equipment | 7,767 |
Goodwill | 27,835 |
Other assets | 9,311 |
Total Assets | $262,222 |
Liabilities & Shareholders' Equity | |
Deposits | $192,860 |
Borrowed funds | 17,044 |
Other liabilities | 4,362 |
Total liabilities | 214,266 |
Shareholders' equity | 47,956 |
Total Liabilities & Shareholders' Equity | $262,222 |
Page 18
Investments
The Company's investment portfolio increased by $36.6 million or 28.9% to $163.4 million between December 31, 2004, and September 30, 2005. At September 30, 2005, the Company's available-for-sale portfolio had an unrealized gain, net of taxes, of $1.1 million. Between September 30, 2004 and September 30, 2005, the Company's investment portfolio increased by $26.2 million or 19.1%. This growth was the result of the FNB acquisition.
On a pro-forma basis, the Company's investment portfolio increased by $9.4 million or 6.1% during the first nine months of 2005. Year-over-year, the investment portfolio declined by $1.8 million or 1.1% on a pro-forma basis, the result of the decline in investments on the FNB balance sheet to fund loan growth.
Loans
Loans grew by $261.3 million or 54.6% during the first nine months of 2005. The growth in commercial loans was $137.8 million or 87.3% and municipal loans increased $7.2 million or 52.7%. The residential mortgage portfolio increased by $85.2 million or 39.7%, and home equity lines of credit grew $20.3 million or 31.3% year-to-date. The majority of this growth was due to the FNB acquisition. Between September 30, 2004 and September 30, 2005, the loan portfolio increased $278.1 million or 60.5%, as a result of strong customer demand and the FNB acquisition
On a pro-forma basis, the loan portfolio increased by $75.1 million or 11.3% during the nine months ended September 30, 2005. Year-over-year, the loan portfolio increased by $94.4 million or 14.6% on a pro-forma basis, the result of strong loan growth seen by the Company in both the Mid-Coast and Down East Maine regions.
Allowance for Loan Losses
The allowance for loan losses represents the amount available for credit losses inherent in the Company's loan portfolio. Loans are charged off when they are deemed uncollectible, after giving consideration to factors such as the customer's financial condition, underlying collateral and guarantees, as well as general and industry economic conditions.
Adequacy of the allowance for loan losses is determined using a consistent, systematic methodology, which analyzes the risk inherent in the loan portfolio. In addition to evaluating the collectibility of specific loans when determining the adequacy of the allowance for loan losses, Management also takes into consideration other factors such as changes in the mix and size of the loan portfolio, historic loss experience, the amount of delinquencies and loans adversely classified, and economic trends. The adequacy of the allowance for loan losses is assessed by an allocation process whereby specific loss allocations are made against certain adversely classified loans, and general loss allocations are made against segments of the loan portfolio which have similar attributes. The Company’s historical loss experience, industry trends, and the impact of the local and regional economy on the Company’s borrowers, were considered by Management in determining the adequacy of the allowance for loan losses.
The allowance for loan losses is increased by provisions charged against current earnings. Loan losses are charged against the allowance when management believes that the collectibility of the loan principal is unlikely. Recoveries on loans previously charged off are credited to the allowance. While Management uses available information to assess possible losses on loans, future additions to the allowance may be necessary based on increases in non-performing loans, changes in economic conditions, growth in loan portfolios, or for other reasons. Any future additions to the allowance would be recognized in the period in which they were determined to be necessary. In addition, various regulatory agencies periodically review the Company’s allowance for loan losses as an integral part of their examination process. Such agencies may require the Company to record additions to the allowance based on judgments different from those of Management.
Credit quality of the commercial portfolios is quantified by a corporate credit rating system designed to parallel regulatory criteria and categories of loan risk. Individual loan officers monitor their loans to ensure appropriate rating assignments are made on a timely basis. Risk ratings and quality of the commercial loan portfolio are also assessed on a regular basis by an independent loan review consulting firm. An ongoing portfolio trend analyses and individual credit reviews to evaluate loan risk and compliance with corporate lending policies are also performed. The level of allowance allocable to each group of risk-rated loans is then determined by applying a loss factor that estimates the amount of probable loss in each category. The assigned loss factor for each risk rating is based upon Management’s assessment of historical loss data, portfolio characteristics, economic trends, overall market conditions and past experience.
Page 19
Consumer loans, which include residential mortgages, home equity loans/lines, and direct/indirect loans, are generally evaluated as a group based on product type and on the basis of delinquency data and other credit data available due to the large number of such loans and the relatively small size of individual credits. Allocations for these loan categories are principally determined by applying loss factors that represent Management’s estimate of inherent losses. In each category, inherent losses are estimated based upon Management’s assessment of historical loss data, portfolio characteristics, economic trends, overall market conditions and past experience. In addition, certain loans in these categories may be individually risk-rated if considered necessary by Management.
The other method used to allocate the allowance for loan losses entails the assignment of reserve amounts to individual loans on the basis of loan impairment. Certain loans are evaluated individually and are judged to be impaired when Management believes it is probable that the Company will not collect all of the contractual interest and principal payments as scheduled in the loan agreement. Under this method, loans are selected for evaluation based on internal risk ratings or non-accrual status. A specific reserve is allocated to an individual loan when that loan has been deemed impaired and when the amount of a probable loss is estimable on the basis of its collateral value, the present value of anticipated future cash flows, or its net realizable value. At September 30, 2005, impaired loans with specific reserves totaled $1,707,000 (all of these loans were on non-accrual status) and the amount of such reserves were $598,000.
All of these analyses are reviewed and discussed by the Directors' Loan Committee, and recommendations from these processes provide Management and the Board of Directors with independent information on loan portfolio condition. As a result of these analyses, the Company has concluded that the level of the allowance for loan losses was adequate as of September 30, 2005. As of that date, the balance of $6,474,000 was 0.88% of total loans, compared to 0.99% at December 31, 2004 and 1.02% at September 30, 2004. Loans considered to be impaired according to SFAS 114/118 totaled $2,996,000 at September 30, 2005, compared to $1,601,000 at December 31, 2004. The portion of the allowance for loan losses allocated to impaired loans at September 30, 2005, was $598,000 compared to $228,000 at December 31, 2004.
In Management's opinion, the level of the Company's allowance for loan losses is adequate. Although the allowance is lower as a percentage of loans than many peers, the Bank's loan portfolio has a higher percentage of residential mortgage loans than peers, and the overall credit quality of the portfolio and historically low level of chargeoffs support this.
On a pro-forma basis, the allowance for loan losses decreased by $245,000 or 3.6% in the first nine months of 2005. This was the result of limited additional provision to the allowance due to the analysis of credit quality in the loan portfolio and the level of loan chargeoffs during the period.
Deposits
During the first nine months of 2005, deposits increased by $385.5 million or 104.2% over December 31, 2004. Core deposits (demand, NOW, savings and money market accounts) increased by $192.8 million or 80.9% in the first nine months of 2005. During the same period, certificates of deposit increased $192.3 million or 144.6%. Between September 30, 2004, and September 30, 2005, deposits grew by 88.1%, or $353.8 million. Demand deposits grew $32.8 million, NOW accounts $67.2 million, savings $49.3 million, and money market accounts $33.8 million, while certificates of deposit increased $170.5 million. The majority of the growth, both year-to-date and year-over-year, was due to the FNB acquisition and in certificates of deposit, primarily from wholesale and brokered sources. The Company also saw good growth in core deposits in the first nine month of 2005, although this growth was at lower levels than with wholesale and brokered sources of funding.
On a pro-forma basis, deposits grew by $195.8 million or 35.0% during the first nine months of 2005. This growth was in certificate of deposits, primarily from wholesale and brokered sources.
Page 20
Borrowed Funds
The Company's funding includes borrowings from the Federal Home Loan Bank of Boston, the Federal Reserve System, and repurchase agreements, enabling it to grow its balance sheet and, in turn, grow its revenues. They may also be used to carry out interest rate risk management stategies, and are increased to replace or supplement other sources of funding, including core deposits and certificates of deposit. During the nine months ended September 30, 2005, borrowed funds decreased by $80.6 million or 38.9% from December 31, 2004. Between September 30, 2004 and September 30, 2005, borrowed funds decreased $45.8 million or 26.6%.
On a pro-forma basis, borrowed funds decreased by $101.6 million or 44.5% during the first nine months of 2005. This was the result of growth in wholesale and brokered sources, as noted above. Year-over-year, borrowed funds decreased $59.9 million or 32.1%.
Shareholders' Equity
Shareholders' equity as of September 30, 2005 was $101.8 million, compared to $52.8 million as of December 31, 2004. The Company's strong earnings performance in the first nine months of 2005, net of dividends paid, added to shareholders' equity, in addition to the significant increase from the FNB acquisition. The net unrealized gain on available-for-sale securities, presented in accordance with SFAS 115, decreased by $0.8 million from December 31, 2004, as a result of a recent rise in interest rates and by maturing securities replaced at lower yields.
On April 27, 2004, the Company's Board of Directors declared a three-for-one split of the Company's common stock payable in the form of a 200% stock dividend to shareholders of record on May 12, 2004, with a payment date of June 1, 2004. All share and per share data included in the consolidated financial statements and elsewhere in this report have been restated to reflect the stock split.
In 2005, a cash dividend of 13.5 cents per share was declared in the third quarter compared to 11.5 cents in the third quarter of 2004. The dividend payout ratio was 39.71% in the third quarter of 2005 compared to 38.33% in the third quarter of 2004.
In determining future dividend payout levels, the Board of Directors carefully analyzes capital requirements and earnings retention, as set forth in the Company's Dividend Policy. The ability of the Company to pay cash dividends to its shareholders depends on receipt of dividends from its subsidiary, the Bank. The subsidiary may pay dividends to its parent out of so much of its net profits as the Bank's directors deem appropriate, subject to the limitation that the total of all dividends declared by the Bank in any calendar year may not exceed the total of its net profits of that year combined with its retained net profits of the preceding two years. The amount available for dividends in 2005 is this year's net income plus $9.7 million.
Regulatory leverage capital ratios for the Company were 7.67% and 8.03% at September 30, 2005 and December 31, 2004, respectively. The Company had a tier one risk-based capital ratio of 10.81% and tier two risk-based capital ratio of 11.78% at September 30, 2005, compared to 11.62% and 12.71%, respectively, at December 31, 2004. These are comfortably above the standards to be rated "well-capitalized" by regulatory authorities -- qualifying the Company for lower deposit-insurance premiums.
On January 20, 2005, the Company announced that its Board of Directors had authorized the repurchase of up to 250,000 shares of the Company's common stock or approximately 2.5% of the outstanding shares. The Company expects such repurchases to be effected from time to time, in the open market, in private transactions or otherwise, during a period of up to 24 months. The amount and timing of shares to be purchased will be subject to market conditions and will be based on several factors, including the price of the Company's stock and the level of stock issuances under the Company's employee stock plans. No assurance can be given as to the specific timing of the share repurchases or as to whether and to what extent the share repurchase will be consummated.
As of September 30, 2005, the Company had repurchased 162,188 shares under the new repurchase plan at an average price of $17.09.
Page 21
Non-Performing Assets
At September 30, 2005, loans on non-accrual status totaled $2.9 million, which compares to non-accrual loans of $1.6 million as of December 31, 2004. In addition to loans on non-accrual status at September 30, 2005, loans past due 90 days or more and accruing (calculated on a constant 30-day month basis) totaled $408,000 which compares to $281,000 as of December 31, 2004. The Company continues to accrue interest on these loans because it believes collection of the interest is reasonably assured. The majority of the increase in non-performing assets in the third quarter of 2005 was the result of the FNB acquisition.
Off-Balance Sheet Financial Instruments
No material off-balance sheet risk exists that requires a separate liability presentation.
Sale of Loans
No recourse obligations have been incurred in connection with the sale of loans.
Contractual Obligations
The following table sets forth the contractual obligations of the Company as of September 30, 2005:
In thousands of dollars | Total | Less than 1 year | 1-3 years | 3-5 years | More than 5 years |
Borrowed funds | $126,647 | $84,938 | $14,000 | $15,000 | $12,709 |
Operating leases | 686 | 119 | 338 | 171 | 58 |
Certificates of deposit | 325,361 | 260,038 | 51,692 | 13,508 | 123 |
Total | $452,694 | $345,095 | $66,030 | $28,679 | $12,890 |
Commitments to extend credit and unused lines of credit | $159,917 | $159,917 | $- | $- | $- |
Liquidity Management
As of September 30, 2005 the Bank had primary sources of liquidity of $182.2 million. It is Management's opinion this is adequate. In its Asset/Liability policy, the Bank has guidelines for liquidity. The Company is not aware of any recommendations by the regulatory authorities which, if they were to be implemented, would have a material effect on the Company's liquidity, capital resources or results of operations.
Forward-Looking Statements
Certain disclosures in Management's Discussion and Analysis of Financial Condition and Results of Operations contain certain forward-looking statements (as defined in the Private Securities Litigation Reform Act of 1995). In preparing these disclosures, Management must make assumptions, including, but not limited to, the level of future interest rates, prepayments on loans and investment securities, required levels of capital, needs for liquidity, and the adequacy of the allowance for loan losses. These forward-looking statements may be subject to significant known and unknown risks uncertainties, and other factors, including, but not limited to, those matters referred to in the preceding sentence.
Although First National Lincoln Corporation believes that the expectations reflected in such forward-looking statements are reasonable, actual results may differ materially from the results discussed in these forward-looking statements. 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 republish revised forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Readers are also urged to carefully review and consider the various disclosures made by the Company which attempt to advise interested parties of the facts which affect the Company's business.
Page 22
Item 3 – Quantitative and Qualitative Disclosures About Market Risk
Market-Risk Management
Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates. First National Lincoln Corporation's market risk is composed primarily of interest rate risk. The Bank's Asset/Liability Committee (ALCO) is responsible for reviewing the interest rate sensitivity position of the Company and establishing policies to monitor and limit exposure to interest rate risk. All guidelines and policies established by ALCO have been approved by the Board of Directors.
Asset/Liability Management
The primary goal of asset/liability management is to maximize net interest income within the interest rate risk limits set by ALCO. Interest rate risk is monitored through the use of two complementary measures: static gap analysis and earnings simulation modeling. While each measurement has limitations, taken together they represent a reasonably comprehensive view of the magnitude of interest rate risk in the Company, the level of risk through time, and the amount of exposure to changes in certain interest rate relationships.
Static gap analysis measures the amount of repricing risk embedded in the balance sheet at a point in time. It does so by comparing the differences in the repricing characteristics of assets and liabilities. A gap is defined as the difference between the principal amount of assets and liabilities which reprice within a specified time period. The Bank's cumulative one-year gap, at September 30, 2005, 1.59% of total assets. ALCO's policy limit for the one-year gap is plus or minus 20% of total assets. Core deposits with non-contractual maturities are presented based upon historical patterns of balance attrition and pricing behavior which are reviewed at least annually.
The gap repricing distributions include principal cash flows from residential mortgage loans and mortgage-backed securities in the time frames in which they are expected to be received. Mortgage prepayments are estimated by applying industry median projections of prepayment speeds to portfolio segments based on coupon range and loan age.
A summary of the Bank's static gap, as of September 30, 2005 is presented in the following table:
| 0-90 | 90-365 | 1-5 | 5+ |
| Days | Days | Years | Years |
Investment securities at amortized cost | $17,643 | $24,487 | $87,016 | $33,839 |
Loans held for sale | - | - | - | 40 |
Loans | 297,581 | 106,082 | 274,574 | 60,305 |
Other interest-earning assets | 2,500 | - | - | 8,144 |
Non-rate-sensitive assets | 71 | 213 | 1,134 | 49,631 |
Total assets | 317,795 | 130,782 | 362,724 | 151,959 |
Interest-bearing deposits | 250,257 | 92,955 | 65,204 | 347,958 |
Borrowed funds | 79,464 | 5,428 | 14,101 | 27,654 |
Non-rate-sensitive liabilities and equity | 1,281 | 3,843 | 20,496 | 54,619 |
Total liabilities and equity | 331,002 | 102,226 | 99,801 | 430,231 |
Period gap | $(13,207) | $28,556 | $262,923 | $(278,272) |
Percent of total assets | -1.37% | 2.96% | 27.30% | -28.89% |
Cumulative gap (current) | (13,207) | 15,349 | 278,272 | - |
Percent of total assets | -1.37% | 1.59% | 28.89% | 0.00% |
The earnings simulation model forecasts capture the impact of changing interest rates on one-year and two-year net interest income. The modeling process calculates changes in interest income received and interest expense paid on all interest-earning assets and interest-bearing liabilities reflected on the Company's balance sheet. None of the assets used in the simulation are held for trading purposes. The modeling is done for a variety of scenarios that incorporate changes in the absolute level of interest rates as well as basis risk, as represented by changes in the shape of the yield curve and changes in interest rate relationships. Management evaluates the effects on income of alternative interest rate scenarios
Page 23
against earnings in a stable interest rate environment. This analysis is also most useful in determining the short-run earnings exposures to changes in customer behavior involving loan payments and deposit additions and withdrawals.
The Bank's most recent simulation model projects net interest income would increase by approximately 4.90% of stable-rate net interest income if short-term rates affected by Federal Open Market Committee actions fall gradually by two percentage points over the next year, and decrease by approximately 5.92% if rates rise gradually by two percentage points. Both scenarios are well within ALCO's policy limit of a decrease in net interest income of no more than 10.0% given a 2.0% move in interest rates, up or down. Management believes this reflects a reasonable interest rate risk position. In year two, and assuming no additional movement in rates, the model forecasts that net interest income would be higher than that earned in a stable rate environment by 11.66% in a falling-rate scenario and decrease by 9.16% in a rising rate scenario when compared to the year-one base scenario.
A summary of the Bank's interest rate risk simulation modeling, as of September 30, 2005 is presented in the following table:
| Changes in Net Interest Income | 2005 |
Year 1
| Projected change if rates decrease by 2.0% | +4.90% |
| Projected change if rates increase by 2.0% | -5.92% |
| | | |
Year 2
| Projected change if rates decrease by 2.0% | +11.66% |
| Projected change if rates increase by 2.0% | -9.16% |
| | | |
This dynamic simulation model includes assumptions about how the balance sheet is likely to evolve through time and in different interest rate environments. Loans and deposits are projected to maintain stable balances. All maturities, calls and prepayments in the securities portfolio are assumed to be reinvested in similar assets. Mortgage loan prepayment assumptions are developed from industry median estimates of prepayment speeds for portfolios with similar coupon ranges and seasoning. Non-contractual deposit volatility and pricing are assumed to follow historical patterns. The sensitivities of key assumptions are analyzed annually and reviewed by ALCO.
The information for static gap and changes in net interest income presented in this section pertains to the Bank only and does not include goodwill and a small volume of assets and liabilities owned by the Company and included in its consolidated financial statements as of September 30, 2005. This sensitivity analysis does not represent a Company forecast and should not be relied upon as being indicative of expected operating results. These hypothetical estimates are based upon numerous assumptions including, among others, the nature and timing of interest rate levels, yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, and reinvestment/ replacement of asset and liability cash flows. While assumptions are developed based upon current economic and local market conditions, the Company cannot make any assurances as to the predictive nature of these assumptions, including how customer preferences or competitor influences might change.
Interest Rate Risk Management
A variety of financial instruments can be used to manage interest rate sensitivity. These may include investment securities, interest rate swaps, and interest rate caps and floors. Frequently called interest rate derivatives, interest rate swaps, caps and floors have characteristics similar to securities but possess the advantages of customization of the risk-reward profile of the instrument, minimization of balance sheet leverage and improvement of liquidity. As of September 30, 2005, the Company was not using any derivative instruments for interest rate risk management.
The Company engages an independent consultant to periodically review its interest rate risk position, as well as the effectiveness of simulation modeling and reasonableness of assumptions used. As of September 30, 2005, there were no significant differences between the views of the independent consultant and Management regarding the Company's interest rate risk exposure. Management expects interest rates will continue to rise in the near term and believes that the current level of interest rate risk is acceptable.
Page 24
Item 4: Controls and Procedures
As required by Rule 13a-15 under the Securities Exchange Act of 1934, as of September 30, 2005, the end of the quarter covered by this report, the Company carried out an evaluation under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. In designing and evaluating the Company’s disclosure controls and procedures, the Company and its management recognize that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and the Company’s management necessarily was required to apply its judgment in evaluating and implementing possible controls and procedures. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective at the reasonable assurance level to ensure that information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. There was no change in the Company’s internal control over financial reporting that occurred during the quarter ended September 30, 2005 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. The Company reviews its disclosure controls and procedures, which may include its internal controls over financial reporting on an ongoing basis, and may from time to time make changes aimed at enhancing their effectiveness and to ensure that the Company’s systems evolve with its business.
Page 25
Part II – Other Information
Item 1 – Legal Proceedings
The Company was not involved in any legal proceedings requiring disclosure under Item 103 of Regulation S-K during the reporting period.
Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds
The Company issues shares to the Bank's 401k Investment and Savings Plan pursuant to an exemption from registration under the Securities Act of 1933, as amended (the "Securities Act"), contained in Section 3(a)(11) thereof and Rule 147 promulgated thereunder. During the first nine months of 2005, 24,514 shares were issued pursuant to this Plan, as presented in the following table:
Month | Shares |
January 2005 | 6,088 |
February 2005 | 1,514 |
March 2005 | 560 |
April 2005 | 1,417 |
May 2005 | 11,292 |
June 2005 | 1,099 |
July 2005 | 1,534 |
August 2005 | 457 |
September 2005 | 552 |
| 24,514 |
Item 3 – Default Upon Senior Securities
None.
Item 4 – Other Information
Page 26
Item 5 – Exhibits
Exhibit 2.1 Agreement and Plan of Merger With FNB Bankshares Dated August 25, 2004, incorporated by reference to Exhibit 2.1 to the Registrant's Form 8-K dated August 25, 2004, filed under item 1.01 on August 27, 2004.
Exhibit 3.1 Conformed Copy of the Registrants Articles of Incorporation, incorporated by reference to Exhibit 3.1 to the Company’s Form 8-K filed under item 5.03 on October 7, 2004.
Exhibit 3.2 Conformed Copy of the Registrant's Bylaws, incorporated by reference to Exhibit 3.2 to the Company’s Form 8-K filed under item 5.03 on October 7, 2004.
Exhibit 10.1(a) FNB Bankshares' Stock Option Plan. incorporated by reference to Exhibit 10.1 to the Company’s Form 8-K filed under item 5.03 on October 7, 2004.
Exhibit 10.1(b) Specimen FNB Bankshares Non-Qualified Stock Option Agreement entered into with Messrs. Rosborough, McKim, Wrobel, Dalrymple and Lay, whose FNB Bankshares options have been converted into options to purchase 5,287, 34,086, 15,275, 11,750 and 21,150 shares of the Registrant's stock, respectively, all at $3.80 per share, incorporated by reference to Exhibit 10.1(b) to the Company’s Form 8-K filed under item 1.01 on January 14, 2005.
Exhibit 10.2(a) Specimen Employment Continuity Agreement entered into with Messrs. McKim, Wroble, Dalrymple and Lay, incorporated by reference to Exhibit 10.2(a) to the Company’s Form 8-K filed under item 1.01 on January 14, 2005.
Exhibit 10.2(b) Specimen Amendment to Employment Continuity Agreement entered into with Messrs. McKim, Wrobel, Dalrymple and Lay, incorporated by reference to Exhibit 10.2(b) to the Company’s Form 8-K filed under item 1.01 on January 14, 2005.
Exhibit 10.3(a) Specimen Split Dollar Agreement entered into with Messrs. McKim, Wrobel, Dalrymple and Lay. For Mr. McKim, the amount of the death benefit is $250,000; for Messrs. Lay, Dalrymple and Wrobel, the death benefit is $150,000. Incorporated by reference to Exhibit 10.3(a) to the Company’s Form 8-K filed under item 1.01 on January 14, 2005.
Exhibit 10.3(b) Specimen Amendment to Split Dollar Agreement entered into with Messrs. McKim, Wrobel, Dalrymple and Lay, incorporated by reference to Exhibit 10.3(b) to the Company’s Form 8-K filed under item 1.01 on January 14, 2005.
Exhibit 31.1 Certification of Chief Executive Officer Persuant to Rule 13A-14(A) of The Securities Exchange Act of 1934
Exhibit 31.2 Certification of Chief Financial Officer Persuant to Rule 13A-14(A) of The Securities Exchange Act of 1934
Exhibit 32.1 Certification of Chief Executive Officer Persuant to 18 U.S.C. Section 1350, As Adopted Persuant to Section 906 of The Sarbanes-Oxley Act of 2002
Exhibit 32.2 Certification of Chief Financial Officer Persuant to 18 U.S.C. Section 1350, As Adopted Persuant to Section 906 of The Sarbanes-Oxley Act of 2002
Page 27
Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
FIRST NATIONAL LINCOLN CORPORATION
/s/ Daniel R. Daigneault
Daniel R. Daigneault
President & Chief Executive Officer
Date: November 9, 2005
/s/ F. Stephen Ward
F. Stephen Ward
Executive Vice President & Chief Financial Officer
Date: November 9, 2005
Page 28
