1 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-Q X Quarterly Report Pursuant to Section 13 or 15(d) of the Securities and Exchange Act of 1934 For the quarterly period ended March 31, 2000, or __ Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the Transition Period from ________ to _________ Commission File No. 0-17000 COMMERCIAL NATIONAL FINANCIAL CORPORATION (Exact name of registrant as specified in its charter) Michigan 38-2799780 (State of Incorporation) (IRS Employer Identification No.) 101 North Pine River Street, Ithaca, Michigan 48847 (address of principal executive offices) (ZIP Code) Registrant's telephone number, including area code: (517) 875-4144 Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES _____X______ NO ______________ Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Class Outstanding at April 28, 2000 Common Stock 3,206,718 No Par Value 2 COMMERCIAL NATIONAL FINANCIAL CORPORATION INDEX PART I FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Balance Sheets as of March 31, 2000 and December 31, 1999 (Page 3) Consolidated Statements of Income for the three months ended March 31, 2000 and March (Page 4) 31, 1999 Consolidated Statements of Changes in Shareholders' Equity for the periods ended (Page 5) March 31, 2000 and March 31, 1999 Consolidated Statements of Cash Flows for the three months ended March 31, 2000 and (Page 6) March 31, 1999 Notes to Consolidated Financial Statements (Page 7-10) Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Page 11-15) PART II OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K a) Exhibit 23-Consent of Independent Accountants (Page 18) Exhibit 27-Financial Data Schedule (Page 19) b) Reports on Form 8-K (Page 16) SIGNATURES (Page 17) 2 3 COMMERCIAL NATIONAL FINANCIAL CORPORATION CONSOLIDATED BALANCE SHEETS March 31, December 31, 2000 1999 --------- ------------ (Unaudited) ASSETS Cash and due from banks $ 7,574,499 $ 7,419,093 Federal funds sold 2,800,000 1,250,000 ------------- ------------- Total cash and cash equivalents 10,374,499 8,669,093 Securities available for sale 18,452,707 17,746,753 Securities held to maturity (fair value $8,898,948 - March 31, 2000; $8,940,714 - December 31, 1999) 8,811,750 8,813,986 Federal Home Loan Bank stock, at cost 1,391,300 1,391,300 Loans receivable, net of allowance for loan losses $2,880,962-March 31, 2000; $2,792,293 - December 31, 1999 154,644,516 149,674,589 Premises and equipment, net 2,638,903 2,694,511 Accrued interest receivable and other assets 2,071,716 2,031,782 ------------- ------------- Total assets $ 198,385,391 $ 191,022,014 ============= ============= LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities Deposits Noninterest-bearing demand $ 18,130,952 $ 18,535,251 Interest-bearing demand 25,748,916 26,639,403 Savings 44,694,542 41,271,920 Time 64,212,839 60,757,458 ------------- ------------- Total deposits 152,787,249 147,204,032 Securities sold under agreements to repurchase 5,741,031 4,689,557 Other borrowings 455,915 2,190,639 Federal Home Loan Bank advances 18,500,000 16,500,000 Accrued expenses and other liabilities 1,597,356 1,473,253 ------------- ------------- Total liabilities 179,081,551 172,057,481 Shareholders' equity Common stock and paid in capital, no par value: 5,000,000 shares authorized; shares issued and outstanding March 31, 2000 - 3,201,329 and December 31, 1999 - 3,189,025 20,080,279 19,946,643 Retained earnings (deficit) (588,590) (830,339) Accumulated other comprehensive income/(loss), net of tax (187,849) (151,771) ------------- ------------- Total shareholders' equity 19,303,840 18,964,533 ------------- ------------- Total liabilities and shareholders' equity $ 198,385,391 $ 191,022,014 ============= ============= See accompanying notes 3 4 COMMERCIAL NATIONAL FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF INCOME (Unaudited) For Three Months Ended March 31, 2000 1999 ---- ---- Interest and dividend income Loans receivable, including fees $3,322,181 $2,839,137 Taxable securities 228,519 233,288 Nontaxable securities 143,150 165,183 Federal funds sold 41,941 30,732 Federal Home Loan Bank stock dividends 27,674 27,445 Interest on other deposits 8,179 6,927 ---------- ---------- Total interest and dividend income 3,771,644 3,302,712 Interest expense Deposits 1,238,459 1,095,995 Securities sold under agreements to repurchase 68,756 77,615 Federal Home Loan Bank advances 236,089 164,696 Other 8,825 4,547 ---------- ---------- Total interest expense 1,552,129 1,342,853 Net interest income 2,219,515 1,959,859 Provision for loan losses 90,000 90,000 ---------- ---------- Net interest income after provision for loan losses 2,129,515 1,869,859 Noninterest income Service charges and fees 104,744 109,824 Net gains on loan sales 14,111 82,636 Receivable financing fees 74,673 66,505 Other 50,915 68,535 ---------- ---------- Total noninterest income 244,443 327,500 Noninterest expenses Salaries and employee benefits 737,839 672,864 Occupancy and equipment 255,301 249,336 FDIC insurance 7,548 5,583 Printing, postage and supplies 68,322 70,581 Professional and outside services 83,986 80,754 Other 246,513 228,703 ---------- ---------- Total noninterest expense 1,399,509 1,307,821 ---------- ---------- Income before income tax expense 974,449 889,538 Income tax expense 284,000 247,600 ---------- ---------- Net income $ 690,449 $ 641,938 ========== ========== Per share information Basic earnings $ 0.22 $ 0.20 Diluted earnings $ 0.21 $ 0.20 Dividends declared $ 0.14 $ 0.14 See accompanying notes 4 5 COMMERCIAL NATIONAL FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY Periods ended March 31, 2000 (Unaudited) and December 31, 1999 Accumulated Common Other Stock and Retained Comprehensive Total Paid in Earnings Income Shareholders' Capital (deficit) Net of Tax Equity - ------------------------------------------------------------------------------------------------------------------------- Balance at December 31, 1998 $ 17,525,466 $ (8,483) $ 143,119 $ 17,660,102 Comprehensive income: Net income 2,730,872 2,730,872 Net change in unrealized gains/(losses) on securities available for sale (444,669) (444,669) Reclassification adjustment for gains/(losses) recognized in income (2,134) (2,134) Tax effect 151,913 151,913 --------- ------------ Total other comprehensive income (294,890) (294,890) ------------ Total comprehensive income 2,435,982 ------------ Cash dividends declared, $.55 per share (1,730,590) (1,730,590) Payment of 5% stock dividend 1,822,372 (1,822,138) 234 Issued under dividend reinvestment program 686,391 686,391 Issued under stock option plan 159,062 159,062 Issued under employee benefit plan 41,795 41,795 Repurchase and retirement of 22,938 shares (288,443) (288,443) ------------- ---------- --------- ------------ Balance at December 31, 1999 19,946,643 (830,339) (151,771) 18,964,533 Comprehensive income: Net income 690,449 690,449 Net change in unrealized gains/(losses) on securities available for sale (54,663) (54,663) Reclassification adjustment for gains/(losses) recognized in income - - Tax effect 18,585 18,585 --------- ------------ Total other comprehensive income (36,078) (36,078) ------------ Total comprehensive income 654,371 Cash dividends declared, $.14 per share (448,700) (448,700) Issued under dividend reinvestment program 173,247 173,247 Issued under stock option plan 13,655 13,655 Issued under employee benefit plan 38,953 38,953 Repurchase and retirement of 6,793 shares (92,219) (92,219) ------------ ---------- --------- ------------ Balance at March 31, 2000 $ 20,080,279 $ (588,590) $(187,849) $ 19,303,840 ============ ========== ========= ============ See accompanying notes 5 6 COMMERCIAL NATIONAL FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) For Three Months Ended March 31, 2000 1999 ---- ---- Cash flows from operating activities Net income $ 690,449 $ 641,938 Adjustments to reconcile net income to net cash from operating activities Provision for loan loss 90,000 90,000 Net gains on loan sales (14,111) (82,636) Originations of loans held for sale (427,509) (3,967,938) Proceeds from sales of loans held for sale 578,620 4,019,351 Depreciation, amortization and accretion 141,731 180,133 Net change in accrued interest receivable and other assets (6,563) (205,088) Net change in accrued expenses and other liabilities 124,103 (647,520) ------------ ------------ Net cash from operating activities 1,176,720 28,240 Cash flows from investing activities Purchases of securities available for sale (1,840,718) (2,515,863) Proceeds from maturities of securities available for sale 1,075,000 -- Proceeds from maturities of securities held to maturity -- 1,716,600 Purchases of securities held to maturity -- -- Net change in loans (5,213,953) (2,258,644) Purchases of premises and equipment, net (76,546) (147,578) ------------ ------------ Net cash from investing activities (6,056,217) (3,205,485) Cash flow from financing activities Net change in deposits 5,583,217 (2,025,387) Net change in securities sold under agreements to repurchase 1,051,474 774,032 Net change in U.S. Treasury demand notes (1,734,724) (1,195,368) Federal Home Loan Bank advances 8,000,000 -- Federal Home Loan Bank repayments (6,000,000) (1,000,000) Repurchase of common stock shares (92,219) (83,700) Dividends paid and fractional shares (448,700) (428,813) Proceeds from sale of common stock 225,855 198,971 ------------ ------------ Net cash from financing activities 6,584,903 (3,760,265) ------------ ------------ Net change in cash and cash equivalents 1,705,406 (6,937,510) Cash and cash equivalents, at beginning of year 8,669,093 12,555,428 ------------ ------------ Cash and cash equivalents, at end of period $ 10,374,499 $ 5,617,918 ============ ============ Cash paid during the period for Interest $ 1,545,931 $ 1,379,642 Federal income taxes 100,000 333,000 See accompanying notes 6 7 COMMERCIAL NATIONAL FINANCIAL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Note 1-Summary of Significant Accounting Policies Basic Presentation The accompanying unaudited condensed consolidated financial statements were prepared in accordance with Rule 10-01 of regulation S-X and the instructions for Form 10-Q and, therefore, do not include all disclosures required by generally accepted accounting principles for complete presentation of financial statements. In the opinion of management, the condensed consolidated financial statements contain all adjustments (consisting of normal recurring accruals) necessary to present fairly the financial condition of Commercial National Financial Corporation as of March 31, 2000 and December 31, 1999, and the results of its operations for the three months ending March 31, 2000 and March 31, 1999. The results for the three months ended March 31, 2000 are not necessarily indicative of the results expected for the full year. Principals of Consolidation The accompanying consolidated financial statements include the accounts of Commercial National Financial Corporation (CNFC), Commercial Bank (Bank) and CNFC Financial Services, Inc., a wholly owned subsidiary of the Bank. All material intercompany accounts and transactions have been eliminated in consolidation. Nature of Operations, Industry Segments and Concentrations of Credit Risk The Corporation is a one-bank holding company, which conducts limited business activities. The Bank performs the majority of business activities. The Bank provides a full range of banking services to individuals, agricultural businesses, commercial businesses and light industries located in its service area. It maintains a diversified loan portfolio, including loans to individuals for home mortgages, automobiles and personal expenditures, and loans to business enterprises for current operations and expansion. The Bank offers a variety of deposit products, including checking, savings, money market, individual retirement accounts and certificates of deposit. While the Corporation's chief decision-makers monitor the revenue stream of various Corporate products and services, operations are managed and financial performance is evaluated on a Corporation-wide basis. Accordingly, all of the Corporation's banking operations are considered by management to be aggregated into one operating segment. The principal markets for the Bank's financial services are the Michigan communities in which the Bank is located and the areas immediately surrounding these communities. The Bank serves these markets through seven offices located in Gratiot and Montcalm Counties in Michigan. Use of Estimates To prepare financial statements in conformity with generally accepted accounting principles, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and future results could differ. The allowance for loan losses and fair values of securities and other financial instruments are particularly subject to change. Cash Flow Reporting Cash and cash equivalents include cash on hand, demand deposits with other financial institutions and federal funds sold. Cash flows are reported net for customer loan and deposit transactions, securities sold under agreements to repurchase with original maturity of 90 days or less and U.S. Treasury demand notes. Securities Securities are classified as held to maturity and carried at amortized cost when management has the positive intent and ability to hold them to maturity. Securities are classified as available for sale when they might be sold before maturity. Securities available for sale are carried at fair value, with net unrealized holding gains and losses reported separately in other comprehensive income, net of tax. Trading securities are bought principally for sale in the near term, and are reported at fair value with unrealized gains and losses included in earnings. Securities are written down to fair value when a decline in fair value is not temporary. CNFC did not classify securities for trading at any time during 2000 or 1999. 7 8 COMMERCIAL NATIONAL FINANCIAL CORPORATION Gains and losses on sales are determined using the amortized cost of the specific security sold. Interest and dividend income, adjusted by amortization of purchase premiums and discounts, is included in earnings. Loans Held for Sale Loans held for sale are reported at the lower of cost or market value in the aggregate. Net unrealized losses are recorded in a valuation allowance by charges to income. Loans Receivable Loans receivable are reported at the principal balance outstanding, net of unearned interest, deferred loan fees and costs, and an allowance for loan losses. Interest income is reported on the interest method and includes amortization of net deferred loan fees and costs over the loan term. Interest income is not reported when full loan repayment is in doubt, typically when payments are past due over 90 days, unless the loan is both well secured and in the process of collection. Payments received on such loans are reported as principal reductions. Allowance for Loan Losses The allowance for loan losses is a valuation allowance for probable credit losses, increased by the provision for loan losses and decreased by charge-offs less recoveries. Estimating the risk of loss and the amount of loss on any loan is necessarily subjective. Accordingly, management estimates the allowance balance required based on past loan loss experience, known and inherent risks in the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management's judgment, should be charged-off. A problem loan is charged-off by management as a loss when deemed uncollectible, although collection efforts continue and future recoveries may occur. Loan impairment is reported when full payment under the loan terms is not expected. Impairment is evaluated in total for smaller-balance loans of similar nature such as residential mortgage and consumer loans and on an individual loan basis for other loans. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan's existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Loans are evaluated for impairment when payments are delayed, typically 90 days or more, or when it is probable that all principal and interest amounts will not be collected according to the original terms of the loan. Premises and Equipment Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed using a combination of straight-line and accelerated methods with useful lives ranging from 10 to 40 years for buildings and improvements, and 3 to 10 years for furniture and equipment. These assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. Maintenance, repairs and minor alterations are charged to current operations as expenditures occur. Major improvements are capitalized. Servicing Rights Servicing rights represent both purchased rights and the allocated value of servicing rights retained on loans sold. Servicing rights are expensed in proportion to, and over the period of, estimated net servicing revenues. Impairment is evaluated based on the fair value of the rights, using groupings of the underlying loans as to interest rates and then, secondarily, as to geographic and prepayment characteristics. Any impairment of a grouping is reported as a valuation allowance. Excess servicing receivable is reported when a loan sale results in servicing in excess of normal amounts and is expensed over the life of the servicing on the interest method. Other Real Estate Owned Real estate properties acquired in collection of a loan receivable are recorded at fair value at acquisition. Any reduction to fair value from the carrying value of the related loan is accounted for as a loan loss. After acquisition, a valuation allowance reduces the reported amount to the lower of the initial amount or fair value less costs to sell. Expenses, gains and losses on disposition, and changes in the valuation allowance are reported in other expense. 8 9 COMMERCIAL NATIONAL FINANCIAL CORPORATION Goodwill and Identified Intangibles Goodwill is the excess of purchase price over identified net assets in business acquisitions. Goodwill is expensed on the straight-line method over no more than 25 years. Identified intangibles represent the value of depositor relationships purchased and are expensed on accelerated methods over 10 years. Goodwill and identified intangibles are assessed for impairment based on estimated undiscounted cash flows, and written down if necessary. Securities Sold Under Agreements to Repurchase All of these liabilities represent amounts advanced by various customers and are secured by securities owned, as they are not covered by general deposit insurance. Employee Benefits A benefit plan with 401(k) features cover substantially all employees. The plan allows participant compensation deferrals. The amount of any Corporation matching contribution is based solely on the discretion of the board of directors. Historically, the Corporation has matched up to 6% of such deferrals at 100%. Expense for employee compensation under stock option plans is reported only if options are granted below market price at grant date. Income Taxes Income tax expense is the sum of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax consequences of temporary differences between the carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. Earnings and Dividends Per Share Basic earnings per common share is based on net income divided by the weighted average number of common shares outstanding during the period. Diluted earnings per common share shows the diluted effect of any additional potential common shares. Earnings and dividends per common share are restated for all stock splits and stock dividends. On July 21, 1999 the board of directors of the Corporation approved a 3 for 1 stock split payable on September 1, 1999 to shareholders of record on August 8, 1999. All earnings per common share and dividends per common share have been restated to reflect this stock split. Stock Dividends Dividends issued in stock are reported by transferring the market value of the stock issued from retained earnings to common stock and additional paid-in capital. Fractional shares are paid in cash for all stock dividends. Comprehensive Income Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes the change in unrealized appreciation and depreciation on securities available for sale, net of tax, which is also recognized as a separate component of shareholders' equity. Financial Instruments with Off-Balance-Sheet Risk The Corporation, in the normal course of business, makes commitments to make loans, which are not recorded in the financial statements. Fair Values of Financial Instruments Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed separately. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates. The fair value estimates of existing on-and off-balance-sheet financial instruments does not include the value of anticipated future business or values of assets and liabilities not considered financial instruments. Reclassifications Some items in the prior year financial statements have been reclassified to conform with the current year presentation. 9 10 COMMERCIAL NATIONAL FINANCIAL CORPORATION Recent Accounting Pronouncements SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS No. 137, requires derivative instruments be carried at fair value on the balance sheet. The statement continues to allow derivative instruments to be used to hedge various risks and sets forth specific criteria to be used to determine when hedge accounting can be used. The statement also provides for offsetting changes in fair value or cash flows of both the derivative and the hedged asset or liability to be recognized in earnings in the same period; however, any changes in fair value or cash flow that represent the ineffective portion of a hedge are required to be recognized in earnings and cannot be deferred. For derivative instruments not accounted for as hedges, changes in fair value are required to be recognized in earnings. The adoption of SFAS No. 133 as amended becomes effective beginning January 1, 2001 and is not expected to have a material impact on the Company's financial position or results of operations. Note 2 - Earnings Per Share A reconciliation of the numerators and denominators of the basic earnings per share and diluted earnings per share computations for the years ended is presented below: MARCH 31, 2000 MARCH 31, 1999 - ---------------------------------------------------------------------------------------------------------------- BASIC EARNINGS PER SHARE: Net income available to common shareholders $ 690,449 $ 641,938 ================================================================================================================ Weighted-average common shares outstanding for basic earnings per share 3,201,674 3,143,041 ================================================================================================================ BASIC EARNINGS PER SHARE $ .22 $ 0.20 ================================================================================================================ DILUTED EARNINGS PER SHARE: Net income available to common shareholders $ 690,449 $ 641,938 ================================================================================================================ Weighted-average common shares outstanding for basic earnings per share 3,201,674 3,143,041 Add: Dilutive effect of assumed exercise of stock options 20,568 14,903 - ---------------------------------------------------------------------------------------------------------------- Weighted-average common and dilutive additional potential common shares outstanding 3,222,242 3,157,944 ================================================================================================================ DILUTED EARNINGS PER SHARE $ .21 $ .20 ================================================================================================================ 10 11 COMMERCIAL NATIONAL FINANCIAL CORPORATION ITEM 2: MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Financial Condition Total assets at March 31, 2000 increased to $198,385,000 from the $191,022,000 at December 31, 1999. Total loans were $157,525,000 as of March 31, 2000. This represents a $5,058,000 or 3.3% increase from December 31, 1999 balance of $152,467,000. The increase in loans was primarily a result of demand for business loans and management's decision to portfolio an increasing number of residential mortgage loans. Investment securities also increased to $28,656,000 at March 31, 2000 compared to $27,952,000 at December 31, 1999. Deposits increased $5,583,000 or 3.8% during the period. Total deposits at March 31, 2000 were $152,787,000 compared to $147,204,000 at December 31, 1999. Included in the deposit total are certificates of deposit obtained through an online certificate of deposit network. The Bank is accessing this source of funding more frequently and regularly. The participants in this network are primarily banks, credit unions, and savings and loans. Rates are posted on an electronic bulletin board available to participants in the network. Certificate of deposits gathered through this method are generally less than 1 year in term and are in increments of $100,000 or less. Federal Home Loan Bank (FHLB) advances increased to $18,500,000 from $16,500,000 at December 31, 1999. Liquidity Management defines liquidity as the ability to fund appropriate levels of credit worthy loans, meet the immediate cash withdrawal requirements of depositors, and maintain access to sufficient resources to meet unexpected contingencies at a reasonable cost and or with minimum losses. While loan growth continues, the Bank's retail deposit base has not increased at the same rate. As discussed above, the Bank continues to attract deposits through the online service discussed above. The loan to deposit ratio calculated on March 31, 2000 ending balances was 103.1% compared to 103.6% at December 31, 1999. Management is confident that the combination of available FHLB advances, Federal funds lines of credit, the available for sale investment portfolio, and our ability to sell mortgage loans and the government guaranteed portion of commercial loans provides adequate short and medium term sources of liquidity. At a minimum the Bank has the following available to meet short-term liquidity needs: $6,500,000 in available FHLB advances and $9,000,000 in short term lines of credit with correspondent banks. CNFC also needs cash to pay dividends to its shareholders. The primary source of cash is the dividends paid to CNFC by the Bank. Management believes that cash from operations is sufficient to supply the cash needed to continue paying a reasonable dividend. CNFC also has a $1,500,000 line of credit with a correspondent institution, which is renewed annually. Asset Quality and the Allowance for Loan Loss The allowance for loan losses was 1.83% of total loans at March 31, 2000 the same as December 31, 1999. At March 31, 2000 approximately $932,000 is classified as non-accrual. This balance relates to a single business relationship. Management is evaluating this relationship for potential loss exposure, and is in the process of restructuring the affected loans. Management has specifically identified a portion of the allowance for loan losses in the event that a portion of the loan is charged off. Year to date recoveries totaled $11,000 compared to charge-offs of $12,000. During the quarter the Bank expensed a provision of $90,000 to the allowance compared to $90,000 during the same period in 1999. Management continues to systematically evaluate the adequacy of the allowance such that the balance is commensurate with the performance of the loan portfolio, loan growth, general market conditions and other relevant factors. 11 12 COMMERCIAL NATIONAL FINANCIAL CORPORATION Capital Resources CNFC's capital ratios continue to exceed regulatory guidelines for a "well capitalized" institution. A summary of CNFC's capital ratios follows: March 31, December 31, Minimum Required to be Well 2000 1999 Capitalized Under Prompt --------- ------------ Corrective Action Regulations ----------------------------- Total capital to risk weighted assets 14.0% 14.3% 10.0% ==== ==== ==== Tier 1 capital to risk weighted assets 12.8% 13.0% 6.0% ==== ==== ==== Tier 1 capital to average assets 10.0% 10.0% 5.0% ==== ==== ==== Results of Operations Net income for the quarter ended March 31, 2000 was $690,000, an increase of $48,000, or 7.5% compared to the same period in 1999. A 13.2% increase in net interest income generated by strong loan demand is the primary contributing factor to the increase in net income. Offsetting the increase in net interest income is a 25.3% decrease in non-interest income and a 7.0% increase in non-interest expense. The factors affecting these changes are discussed in the following paragraphs. Net Interest Income The following table illustrates the effect that changes in rates and volumes of interest-earning assets and interest-bearing liabilities had on net interest income for the three months ending March 31, 2000 and 1999. Three Months Ending March 31, 2000 1999 ---- ---- Interest Income (tax equivalent) $ 3,928,470 $ 3,469,424 Interest Expense 1,552,129 1,342,853 ------------ ------------ Net Interest Income $ 2,376,341 $ 2,126,571 Average Volume Interest-earning Assets $186,819,659 $170,930,157 Interest-bearing Liabilities 154,857,490 140,835,882 ------------ ------------ Net Differential $ 31,962,169 $ 30,094,275 ============ ============ Average Yields/Rates Yield on Earning Assets 8.43% 8.23% Rate Paid on Liabilities 4.02% 3.87% ---- ---- Interest Spread 4.41% 4.36% ==== ==== Net Interest Margin 5.10% 5.05% ==== ==== 12 13 COMMERCIAL NATIONAL FINANCIAL CORPORATION The change in net interest income is attributable to the following: Three Months Ending March 31, 2000 Volume Rate Inc/(Dec) ------ ---- --------- Interest Earning Assets $ 398,360 $ 60,685 $459,045 Interest Bearing Liabilities 165,130 44,145 209,275 --------- -------- --------- Net Interest Income $ 233,230 $ 16,540 $249,770 ========= ======== ======== The increase in net interest income for the three months ending March 31, 2000 is due to an increase in earning assets and an increase in margin. Net interest margin for the three months ending March 31, 2000 increased to 5.10% compared to 5.05% for the three months ending March 31, 1999. Average earning assets for the three months ending March 31, 2000 increased $15,890,000 compared to the same period in 1999. During 1999, the Federal Reserve increased the Fed Funds rate three times, each time by 25 basis points. The Federal Reserve has increased the Fed Funds rate twice during the first quarter of 2000. This results in an almost immediate increase in the Bank's prime lending rate. The interest rate on a significant portion of the Bank's commercial loan portfolio is tied to the prime-lending rate. Therefore, the Bank receives an immediate short-term benefit to the increase in prime. In general, local deposit interest rates do not respond as quickly to changes in the prime lending rate. However, the cost of certificates of deposits gathered on the electronic network, and FHLB advances are more sensitive to general changes in interest rates. These funding sources have become more expensive and over time will offset some of the short-term increase in net interest income. Non-interest Income Non-interest income for the three months ending March 31, 2000 was $244,000. This represents a $83,000 or 25.4% decrease over the same period in 1999. Rising interest rates has all but eliminated the mortgage refinance activity. This has significantly reduced the number of mortgage loans originated and, as a result, has also reduced the gain on sale of mortgage loans. Also, management has elected to portfolio a larger number of residential real estate mortgage loans that previously would have been sold to the secondary market. Non-interest Expense Non-interest expense for the three months ending March 31, 2000 totaled $1,400,000. This represents a $92,000 or 7.0% increase over the same period in 1999. Salary and benefit expense for the three months ending March 31, 2000 totaled $738,000 compared to $673,000 an increase of $65,000 or 9.7%. The increase reflects normal base salary increases, market adjustments and an 8.0% increase in the cost of medical insurance. The increase in medical cost reflects normal increases effective August of 1999. Management anticipates a similar increase during 2000. The Bank is experiencing wage pressure as the area unemployment rate remains low. The Bank is competing for staff with a large area casino and newly opened prisons. These organizations have increased the base pay scale for entry level employees. The increase in salary and benefit expense accounts for 70.1% of the increase in non-interest expenses. Quantitative and Qualitative Disclosures about Market Risk Commercial's primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk. All of the Corporation's transactions are denominated in U.S. dollars with no specific foreign exchange exposure. The Corporation has a limited exposure to commodity prices related to agricultural loans. Any impacts that changes in foreign exchange rate and commodity prices would have on interest rates are assumed to be insignificant. Interest rate risk ("IRR") is the exposure of a banking organization's financial condition to adverse movements in interest rates. Accepting this risk can be an important source of profitability and 13 14 COMMERCIAL NATIONAL FINANCIAL CORPORATION stockholder value, however, excessive levels of IRR could pose a significant threat to the Corporation's earnings and capital base. Accordingly, effective risk management that maintains IRR at prudent levels is essential to the Corporation's safety and soundness. Evaluating a financial institution's exposure to changes in interest rates includes assessing both the adequacy of the management process used to control IRR and the organization's quantitative level of exposure. When assessing the IRR management process, the Corporation seeks to ensure that appropriate policies, procedures, management information systems and internal controls are in place to maintain IRR at prudent levels with consistency and continuity. Evaluating the quantitative level of IRR exposure requires the Corporation to assess the existing and potential future effects of changes in interest rates on its consolidated financial condition, including capital adequacy, earnings, liquidity, and, where appropriate, asset quality. The following table provides information about the Corporation's financial instruments that are sensitive to changes in interest rates as of March 31, 2000. The Corporation had no derivative financial instruments, or trading portfolio, as of that date. The expected maturity date values for loans receivable, mortgage-backed securities, and investment securities were calculated without adjusting the instrument's contractual maturity date for expectations of prepayments. Expected maturity date values for interest-bearing core deposits were not based upon estimates of the period over which the deposits would be outstanding, but rather the opportunity for repricing. Principal/Notional Amount Maturing in: 2000 2001 2002 2003 2004 THEREAFTER TOTAL FAIR VALUE ---- ---- ---- ---- ---- ---------- ----- ----------- Rate Sensitive Assets: Fixed interest rate loans $7,710 $9,609 $11,725 $ 18,835 $16,392 $ 26,408 $ 90,679 $ 88,811 Average interest rate 6.97% 8.23% 8.76% 8.44% 8.29% 7.84% 8.13% Variable interest rate loans 14,788 8,308 4,400 2,246 5,259 31,846 66,847 66,847 Average interest rate 9.66% 9.73% 9.47% 9.77% 9.99% 8.15% 8.97% Fixed interest rate securities 3,455 5,810 4,760 5,690 4,510 3,100 27,325 27,130 Average interest rate 6.39% 5.93% 6.25% 6.24% 6.92% 7.51% 6.45% FHLB stock 1,391 1,391 1,391 Average interest rate 8.00% 8.00% Federal funds sold 2,800 2,800 2,800 Average interest rate 6.25% 6.25% Rate Sensitive Liabilities: Non interest bearing demand 18,131 18,131 18,131 Interest bearing demand 25,749 25,749 25,749 Average interest rate 1.70% 1.70% Savings 44,695 44,695 44,695 Average interest rate 2.70% 2.70% Time deposits 40,525 16,784 3,778 1,988 837 301 64,213 64,520 Average interest rate 4.90% 4.91% 4.56% 4.93% 5.02% 4.99% 4.88% Repurchase agreements 5,741 5,741 5,741 Average interest rate 5.84% 5.84% U.S. treasury demand notes 456 456 456 Average interest rate 5.84% 5.84% Fixed rate FHLB advances 6,000 2,000 - 2,500 - 3,000 13,500 13,037 Average interest rate 6.17% 6.63% 6.18% 6.61% 6.33% Variable rate FHLB advance 3,000 - - - - 2,000 5,000 4,884 Average interest rate 6.32% 7.34% 6.73% 14 15 COMMERCIAL NATIONAL FINANCIAL CORPORATION Forward Looking Statements This discussion and analysis of financial condition and results of operations, and other sections of this report contain forward looking statements that are based on management's beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and about the Corporation itself. Words such as "anticipates", "believes", "estimates", "expects" "forecasts" "intends", "is likely", "plans", "product", "projects", variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties, and assumptions ("Future Factors") that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward looking statements. Furthermore, CNFC undertakes no obligation to update, amend or clarify forward-looking statements, whether as a result of new information, future events, or otherwise. Future Factors include changes in interest rates and interest rate relationships; demand for products and services; the degree of competition by traditional and non-traditional competitors; changes in banking regulations and tax laws; changes in prices, levies, and assessments; the impact of technology, governmental and regulatory policy changes; the outcome of pending and future litigation and contingencies; trends in customer behavior including their ability to repay loans; and vicissitudes of the national and local economies. These are representative of the Future Factors that could cause a difference between an actual outcome and a forward-looking statement. 15 16 COMMERCIAL NATIONAL FINANCIAL CORPORATION PART II. OTHER INFORMATION Item 6 (a) Exhibit 23 Consent of Independent Accountants Exhibit 27 Financial Data Item 6 (b) Reports on Form 8-K None 16 17 COMMERCIAL NATIONAL FINANCIAL CORPORATION 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. Commercial National Financial Corporation (Registrant) Date: May 3, 2000 /S/ Jeffrey S. Barker Jeffrey S. Barker President and Chief Executive Officer /s/ Patrick G. Duffy Patrick G. Duffy Executive Vice President and Chief Financial Officer 17 18 Exhibit Index ------------- Exhibit No. Description - ----------- ----------- 23 Consent of Independent Accountants 27 Financial Data Schedule