1 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1998 Commission file number 0-7818 INDEPENDENT BANK CORPORATION - -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) Michigan 38-2032782 - -------------------------------------------------------------------------------- (State or jurisdiction of (I.R.S. Employer Identification Incorporation or Organization) Number) 230 West Main Street, P.O. Box 491, Ionia, Michigan 48846 - -------------------------------------------------------------------------------- (Address of principal executive offices) (616) 527-9450 - -------------------------------------------------------------------------------- (Registrant's telephone number, including area code) NONE - -------------------------------------------------------------------------------- Former name, address and fiscal year, if changed since last report. Indicate by check mark whether the registrant (1) has filed all documents and reports required to be filed by Sections 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 November 12, 1998 - ---------------------------------- -------------------------------------------- Common stock, par value $1 7,375,282 2 INDEPENDENT BANK CORPORATION AND SUBSIDIARIES INDEX Page Number(s) --------- PART I - Financial Information Item 1. Consolidated Statements of Financial Condition September 30, 1998 and December 31, 1997 2 Consolidated Statements of Operations Three- and nine-month periods ended September 30, 1998 and 1997 3 Consolidated Statements of Cash Flows Nine-month periods ended September 30, 1998 and 1997 4 Consolidated Statements of Shareholders' Equity Nine-month periods ended September 30, 1998 and 1997 5 Notes to Interim Consolidated Financial Statements Three- and nine-month periods ended September 30, 1998 and 1997 6-7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 8-18 Item 3. Quantitative and Qualitative Disclosures about Market Risk 18 PART II- Other Information Item 6. Exhibits & Reports on Form 8-K 19 3 Part I. INDEPENDENT BANK CORPORATION AND SUBSIDIARIES Consolidated Statements of Financial Condition September 30, December 31, 1998 1997 ---------------- ---------------- Assets (unaudited) ---------------- ---------------- Cash and due from banks $ 30,453,000 $ 30,371,000 Securities available for sale 103,380,000 110,769,000 Securities held to maturity (Fair value of $20,173,000 at September 30, 1998; $23,354,000 at December 31, 1997) 19,427,000 22,525,000 Federal Home Loan Bank stock, at cost 12,589,000 12,489,000 Loans held for sale 32,392,000 21,754,000 Loans Commercial and agricultural 228,273,000 199,098,000 Real estate mortgage 434,188,000 416,689,000 Installment 134,916,000 128,391,000 ---------------- ---------------- Total Loans 797,377,000 744,178,000 Allowance for loan losses (9,256,000) (7,670,000) ---------------- ---------------- Net Loans 788,121,000 736,508,000 Property and equipment, net 24,895,000 21,067,000 Accrued income and other assets 33,162,000 28,334,000 ---------------- ---------------- Total Assets $ 1,044,419,000 $ 983,817,000 ================ ================ Liabilities and Shareholders' Equity Deposits Non-interest bearing $ 96,075,000 $ 88,546,000 Savings and NOW 353,410,000 339,594,000 Time 327,453,000 272,340,000 ---------------- ---------------- Total Deposits 776,938,000 700,480,000 Federal funds purchased 24,650,000 28,000,000 Other borrowings 143,016,000 167,185,000 Guaranteed preferred beneficial interests in Company's subordinated debentures 17,250,000 17,250,000 Accrued expenses and other liabilities 14,574,000 11,386,000 ---------------- ---------------- Total Liabilities 976,428,000 924,301,000 ---------------- ---------------- Shareholders' Equity Preferred stock, no par value--200,000 shares authorized; none outstanding Common stock, $1.00 par value--14,000,000 shares authorized; issued and outstanding: 7,375,282 shares at September 30, 1998 and 4,586,733 shares at December 31, 1997 7,375,000 4,587,000 Capital surplus 37,518,000 30,011,000 Retained earnings 21,058,000 23,243,000 Accumulated other comprehensive income 2,040,000 1,675,000 ---------------- ---------------- Total Shareholders' Equity 67,991,000 59,516,000 ---------------- ---------------- Total Liabilities and Shareholders' Equity $ 1,044,419,000 $ 983,817,000 ================ ================ See notes to interim consolidated financial statements. 2 4 Consolidated Statements of Operations Three Months Ended Nine Months Ended September 30, September 30, 1998 1997 1998 1997 ------------- -------------- -------------- -------------- (unaudited) (unaudited) ---------------------------- ----------------------------- Interest Income Interest and fees on loans $ 19,709,000 $ 17,173,000 $ 57,238,000 $ 47,937,000 Securities Taxable 1,230,000 1,895,000 4,047,000 6,318,000 Tax-exempt 727,000 682,000 1,941,000 2,002,000 Other investments 278,000 251,000 777,000 745,000 ------------- -------------- ------------- -------------- Total Interest Income 21,944,000 20,001,000 64,003,000 57,002,000 ------------- -------------- ------------- -------------- Interest Expense Deposits 6,630,000 5,699,000 18,581,000 16,749,000 Other borrowings 2,897,000 3,298,000 9,001,000 8,895,000 ------------- -------------- ------------- -------------- Total Interest Expense 9,527,000 8,997,000 27,582,000 25,644,000 ------------- -------------- ------------- -------------- Net Interest Income 12,417,000 11,004,000 36,421,000 31,358,000 Provision for loan losses 915,000 461,000 2,218,000 1,103,000 ------------- -------------- ------------- -------------- Net Interest Income After Provision for Loan Losses 11,502,000 10,543,000 34,203,000 30,255,000 ------------- -------------- ------------- -------------- Non-interest Income Service charges on deposit accounts 1,066,000 822,000 2,869,000 2,273,000 Net gains on asset sales Real estate mortgage loans 1,219,000 587,000 3,174,000 1,423,000 Securities 92,000 145,000 166,000 Other income 1,421,000 660,000 3,517,000 1,961,000 ------------- -------------- ------------- -------------- Total Non-interest Income 3,706,000 2,161,000 9,705,000 5,823,000 ------------- -------------- ------------- -------------- Non-interest Expense Salaries and employee benefits 6,689,000 5,178,000 19,030,000 14,857,000 Occupancy, net 850,000 700,000 2,301,000 2,046,000 Furniture and fixtures 621,000 608,000 1,870,000 1,656,000 Other expenses 3,445,000 3,019,000 10,104,000 8,239,000 ------------- -------------- ------------- -------------- Total Non-interest Expense 11,605,000 9,505,000 33,305,000 26,798,000 ------------- -------------- ------------- -------------- Income Before Federal Income Tax 3,603,000 3,199,000 10,603,000 9,280,000 Federal income tax expense 1,021,000 924,000 3,049,000 2,677,000 ------------- -------------- ------------- -------------- Net Income $ 2,582,000 $ 2,275,000 $ 7,554,000 $ 6,603,000 ============= ============== ============= ============== Net Income Per Share Basic $ .35 $ .32 $ 1.03 $ .92 Diluted .35 .31 1.02 .91 Dividends Per Common Share Declared $ .124 $ .112 $ .371 $ .336 Paid .124 .112 .365 .328 See notes to interim consolidated financial statements. 3 5 INDEPENDENT BANK CORPORATION AND SUBSIDIARIES Consolidated Statements of Cash Flows Nine months ended September 30, 1998 1997 --------------- -------------- (unaudited) ------------------------------ Net Income $ 7,554,000 $ 6,603,000 --------------- ------------ Adjustments to Reconcile Net Income to Net Cash from Operating Activities Proceeds from sales of loans held for sale 199,546,000 69,684,000 Disbursements for loans held for sale (207,010,000) (72,698,000) Provision for loan losses 2,218,000 1,103,000 Deferred loan fees 187,000 454,000 Depreciation and amortization of premiums and accretion of discounts on securities and loans 3,328,000 3,064,000 Net gains on sales of securities (145,000) (166,000) Net gains on sales of real estate mortgage loans (3,174,000) (1,423,000) (Increase) decrease in accrued income and other assets (3,722,000) 652,000 Increase in accrued expenses and other liabilities 3,209,000 327,000 --------------- ------------ Total Adjustments (5,563,000) 997,000 --------------- ------------ Net Cash from Operating Activities 1,991,000 7,600,000 --------------- ------------ Cash Flow from Investing Activities Proceeds from the sale of securities available for sale 4,882,000 49,844,000 Proceeds from the maturity of securities available for sale 5,477,000 2,702,000 Proceeds from the maturity of securities held to maturity 1,970,000 2,756,000 Principal payments received on securities available for sale 15,742,000 8,479,000 Principal payments received on securities held to maturity 1,223,000 562,000 Purchases of securities available for sale (18,328,000) (47,283,000) Portfolio loans purchased (29,758,000) Principal payments on portfolio loans purchased 12,264,000 2,572,000 Portfolio loans made to customers, net of principal payments received (66,253,000) (83,705,000) Acquisition of business, less cash received 1,459,000 Acquisition of branches, less cash received 16,168,000 Capital expenditures (5,225,000) (3,892,000) --------------- ------------ Net Cash from Investing Activities (30,621,000) (97,723,000) --------------- ------------ Cash Flow from Financing Activities Net increase in total deposits 58,147,000 8,599,000 Net increase (decrease) in short-term borrowings (11,134,000) 18,635,000 Proceeds from Federal Home Loan Bank advances 60,115,000 87,000,000 Payments of Federal Home Loan Bank advances (75,000,000) (48,000,000) Retirement of long-term debt (1,500,000) (1,500,000) Dividends paid (2,674,000) (2,356,000) Proceeds from issuance of common stock 758,000 525,000 --------------- ------------ Net Cash from Financing Activities 28,712,000 62,903,000 --------------- ------------ Net Increase (Decrease) in Cash and Cash Equivalents 82,000 (27,220,000) Cash and Cash Equivalents at Beginning of Period 30,371,000 50,631,000 --------------- ------------ Cash and Cash Equivalents at End of Period $ 30,453,000 $ 23,411,000 =============== ============ Cash paid during the period for Interest $ 26,465,000 $ 25,919,000 Income taxes 4,000,000 2,743,000 Transfer of loans to other real estate 399,000 344,000 See notes to interim consolidated financial statements 4 6 INDEPENDENT BANK CORPORATION AND SUBSIDIARIES Consolidated Statements of Shareholders' Equity Nine months ended September 30, 1998 1997 -------------- -------------- (unaudited) ------------------------------ Balance at beginning of period $ 59,516,000 $ 51,836,000 Net income 7,554,000 6,603,000 Cash dividends declared (2,727,000) (2,413,000) Issuance of common stock 3,283,000 1,148,000 Net change in unrealized gain on securities available for sale, net of related tax effect (note 4) 365,000 427,000 -------------- -------------- Balance at end of period $ 67,991,000 $ 57,601,000 ============== ============== See notes to interim consolidated financial statements. 5 7 NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (unaudited) 1. In the opinion of management of the Registrant, the accompanying unaudited consolidated financial statements contain all the adjustments (consisting only of normal recurring accruals) necessary to present fairly the consolidated financial condition of the Registrant as of September 30, 1998 and December 31, 1997, and the results of operations for the nine-month periods ended September 30, 1998 and 1997. 2. Management's assessment of the allowance for loan losses is based on an evaluation of the loan portfolio, recent loss experience, current economic conditions and other pertinent factors. Loans on non-accrual status, past due more than 90 days, or restructured amounted to $6,592,000 at September 30, 1998, and $5,386,000 at December 31, 1997. (See Management's Discussion and Analysis of Financial Condition and Results of Operations). 3. The provision for income taxes represents federal income tax expense calculated using annualized rates on taxable income generated during the respective periods. 4. The Registrant adopted Statement of Financial Accounting Standards, No. 130, "Reporting Comprehensive Income", (SFAS #130) effective January 1, 1998. SFAS #130 establishes standards for reporting and displaying comprehensive income and its components, including but not limited to unrealized gains and losses on securities available for sale. Prior period amounts have been reclassified in the financial statements. Comprehensive income for the three-month and the nine-month periods ending September 30 follows: Three months ended Nine months ended September 30, September 30, 1998 1997 1998 1997 ------------- ------------- ------------- ------------- Net income $ 2,582,000 $ 2,275,000 $ 7,554,000 $ 6,603,000 Net change in unrealized gain on securities available for sale, net of related tax effect 487,000 482,000 365,000 427,000 ------------- ------------- ------------- ------------- Comprehensive income $ 3,069,000 $ 2,757,000 $ 7,919,000 $ 7,030,000 ============= ============= ============= ============= 5. The Financial Accounting Standards Board adopted Statement of Financial Accounting Standards, No. 131, "Disclosures about Segments of an Enterprise and Related Information", (SFAS #131) in June 1997. SFAS 131 establishes standards for the way public entities report information about operating segments in their financial statements. This statement is effective for annual reporting for 1998 calendar year entities. Although this statement applies to interim financial statements, interim reporting is not required in the initial year of application. 6 8 NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued) (unaudited) 6. A reconciliation of basic and diluted earnings per share for the three-month and the nine-month periods ending, September 30 follows: Three months ended Nine months ended September 30, September 30, 1998 1997 1998 1997 ------------- -------------- ------------- ------------- Basic earnings per share Net income $ 2,582,000 $ 2,275,000 $ 7,554,000 $ 6,603,000 ============= ============== ============= ============= Shares outstanding 7,373,000 7,195,000 7,330,000 7,181,000 ============= ============== ============= ============= Per share amount $ .35 $ .32 $ 1.03 $ .92 ============= ============== ============= ============= Diluted earnings per share Net income $ 2,582,000 $ 2,275,000 $ 7,554,000 $ 6,603,000 ============= ============== ============= ============= Shares outstanding 7,373,000 7,195,000 7,330,000 7,181,000 Effect of dilutive securities - stock options 77,000 111,000 86,000 93,000 ------------- -------------- ------------- ------------- 7,450,000 7,306,000 7,416,000 7,274,000 ============= ============== ============= ============= Per share amount $ .35 $ .31 $ 1.02 $ .91 ============= ============== ============= ============= 7. The results of operations for the nine-month period ended September 30, 1998, are not necessarily indicative of the results to be expected for the full year. 7 9 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's discussion and analysis of financial condition and results of operations contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from those projected in such forward-looking statements. The following section presents additional information that may be necessary to assess the financial condition and results of operations of the Registrant and its subsidiary banks (the "Banks"). This section should be read in conjunction with the consolidated financial statements contained elsewhere in this report as well as the Registrant's 1997 Annual Report on Form 10-K. FINANCIAL CONDITION SUMMARY Assets totaled $1,044.4 million at September 30, 1998. The $60.6 million increase from $983.8 million at December 31, 1997, principally reflects increases in total loans as well as loans held for sale. (See "Non-interest income.") The increase in total assets was funded with a $76.5 million increase in deposits as well as an increase in shareholders' equity. Loans, excluding loans held for sale ("Portfolio Loans") totaled $797.4 million at September 30, 1998. An increase in commercial and agricultural loans account for 55% of $53.2 million increase in Portfolio Loans during the nine-month period. The increase in such loans may be partially attributed to customer dislocation associated with the consolidation of competing banks with larger regional banking holding companies. Deposits totaled $776.9 million and $700.5 million at September 30, 1998 and December 31, 1997, respectively. The increase in deposits principally reflects an increase in brokered certificates of deposits ("Brokered CDs") as well as the purchase of two offices from Great Lakes National Bank during the most recent quarter. (See "Deposits and borrowings" and "Acquisitions.") During the nine-month period, federal funds purchased and other borrowings declined by $3.4 million and $24.2 million, respectively. SECURITIES The Banks maintain diversified securities portfolios that include obligations of the U.S. Treasury and government-sponsored agencies as well as securities issued by states and political subdivisions, corporate notes and mortgage-backed securities. Management continually evaluates the Banks' asset/liability management needs and attempts to maintain a portfolio structure that provides sufficient liquidity and cash flow. (See "Asset/liability management.") 8 10 SECURITIES Unrealized Amortized -------------------------- Fair Cost Gains Losses Value --------- ----------- ----------- ---------- (in thousands) Securities available for sale September 30, 1998 $100,289 $3,170 $ 79 $103,380 December 31, 1997 108,231 2,775 237 110,769 Securities held to maturity September 30, 1998 $ 19,427 $ 756 $ 10 $ 20,173 December 31, 1997 22,525 838 9 23,354 The sale of securities available for sale is dependent upon Management's assessment of reinvestment opportunities and the Banks' asset/liability management needs. As a result of such ongoing evaluations, the Banks sold securities with an aggregate market value of approximately $4.9 million during the nine-month period ended September 30, 1998, compared to $49.8 million during the comparable period in 1997. The Banks realized net gains on the sale of such securities totaling $145,000 and $166,000 during the nine months ended September 30, 1998 and 1997, respectively. A portion of the proceeds from the sale or maturity of securities has been utilized to fund increases in Portfolio Loans. SALES OF SECURITIES AVAILABLE FOR SALE Three months ended Nine months ended September 30, September 30, 1998 1997 1998 1997 ---------------- --------------- ---------------- ---------------- Proceeds $23,422,000 $4,882,000 $49,844,000 =============== =============== =============== =============== Gross gains $120,000 $145,000 $234,000 Gross losses (28,000) (68,000) --------------- --------------- --------------- --------------- Net Gains (losses) $ 92,000 $145,000 $166,000 =============== =============== =============== =============== ASSET QUALITY Management believes that the Registrant's decentralized structure provides important advantages in serving the credit needs of the Banks' principal lending markets. Although the Management and Board of Directors of each Bank retain authority and responsibility for credit decisions, each of the Banks has adopted uniform underwriting standards. Further, the Registrant's loan committee and the centralization of commercial loan credit services as well as loan review functions promote compliance with such established underwriting standards. The centralization of retail loan services also provides for consistent service quality and facilitates compliance with consumer protection laws and regulations. In addition to the communities served by the Banks' branch networks, principal lending markets include nearby communities and metropolitan areas. Subject to established underwriting criteria, the Banks also participate in commercial lending transactions with certain non-affiliated banks and purchase residential real estate mortgage loans from third-party originators. 9 11 Non-performing loans totaled $6,592,000 at September 30, 1998, compared to $5,386,000 at December 31, 1997. Residential real estate mortgage loans account for approximately 65% of the $1,206,000 increase in non-performing loans. Management does not believe that the increase in non-performing loans at September 30, 1998, reflects a material increase in credit risk associated with Portfolio Loans. NON-PERFORMING ASSETS September 30, December 31, 1998 1997 ---------------- ----------------- Non-accrual loans $4,588,000 $3,298,000 Loans 90 days or more past due and still accruing interest 1,837,000 1,904,000 Restructured loans 167,000 184,000 --------------- ---------------- Total non-performing loans 6,592,000 5,386,000 Other real estate 655,000 331,000 --------------- ---------------- Total non-performing assets $7,247,000 $5,717,000 =============== ================ As a percent of Portfolio Loans Non-performing loans 0.83 % 0.72 % Non-performing assets 0.91 0.77 Allowance for loan losses as a percent of Portfolio Loans 1.16 1.03 Allowance for loan losses as a percent of non-performing loans 140 142 Impaired loans totaled approximately $3,700,000 at September 30, 1998. At that same date, certain impaired loans with a balance of approximately $1,600,000, had specific allocations of the allowance for loan losses calculated in accordance with Statement of Financial Accounting Standards #114 totaling approximately $300,000. The Banks' average investment in impaired loans was approximately $3,600,000, for the nine-month period ending September 30, 1998. Cash receipts on impaired loans on non-accrual status are generally applied to the principal balance. Interest recognized on impaired loans for that nine-month period was approximately $95,000. Loans charged against the allowance for loan losses, net of recoveries, totaled $632,000 during the nine months ended September 30, 1998, compared to $734,000 during the comparable period of 1997. Annualized net loan losses were equal to .12% and .15% of average loans during the respective nine-month periods of 1998 and 1997. 10 12 ALLOWANCE FOR LOAN LOSSES Nine months ended September 30, 1998 1997 --------------- -------------- Balance at beginning of period $7,670,000 $6,960,000 Additions (deduction) Provision charged to operating expense 2,218,000 1,103,000 Recoveries credited to allowance 497,000 455,000 Loans charged against the allowance (1,129,000) (1,189,000) -------------- ------------- Balance at end of period $9,256,000 $7,329,000 ============== ============= Net loans charged against the allowance to average Portfolio Loans (annualized) 0.12% 0.15% Management's assessment of the allowance for loan losses is based on the composition of the loan portfolio, an evaluation of specific credits, historical loss experience as well as the level of non-performing and impaired loans. (See "Provision for loan losses.") Application of Management's established methodology resulted in an allocation of 39% of the allowance for loan losses to specific loans and loan portfolios at September 30, 1998. In addition, Management allocated an amount equal to approximately 4% of the allowance to reflect potential credit risk associated with the Year 2000 issue. (See "Year 2000.") At December 31, 1997, 45% of the allowance was allocated to specific loans and loan portfolios. There was no consideration of risk relating to the Year 2000 issue at that date. ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES September 30, 1998 December 31, 1997 --------------------------------- --------------------------------- Percent of Percent of Allowance Loans to Allowance Loans to Amount Total Loans Amount Total Loans -------------- ---------------- -------------- ---------------- Commercial and agricultural $2,511,000 28.6% $2,200,000 26.8% Real estate mortgage 353,000 54.5 322,000 56.0 Installment 760,000 16.9 892,000 17.2 Unallocated(1) 5,632,000 4,256,000 ------------- ---------------- -------------- ---------------- Total $9,256,000 100.0% $7,670,000 100.0% ============== ================ ============== ================ (1)Unallocated includes $350,000 that has been separately allocated in consideration of the Year 2000 issue DEPOSITS AND BORROWINGS The Banks' competitive position within many of the markets served by the branch networks limits the ability to materially increase deposits without adversely impacting the weighted-average cost of core deposits. Accordingly, Management employs pricing tactics that are intended to enhance the value of core deposits and the Banks' have implemented funding strategies that incorporate other borrowings and Brokered CDs to finance a portion of the Portfolio Loans. The use of such alternate sources of funds is also an integral part of the Banks' asset/liability management efforts. Other borrowed funds, principally advances from the Federal Home Loan Bank (the "FHLB"), decreased to $143.0 million at September 30, 1998, from $167.2 million at December 31, 1997. 11 13 To diversify the Banks' funding sources, the Banks also employ Brokered CDs. Brokered CDs totaled $47.7 million and $14.4 million at September 30, 1998 and December 31, 1997, respectively. September 30, 1998 December 31, 1997 -------------------------------- --------------------------------- Average Average Average Average Amount Maturity Rate Amount Maturity Rate ------ -------- ---- ------ -------- ----- Brokered CDs $47,710 1.2 years 5.56% $14,375 0.1 years 5.91% Fixed rate FHLB advances 90,569 2.4 years 5.73 78,954 1.3 years 5.98 Variable rate FHLB advances 43,500 0.8 years 5.61 67,000 1.0 years 5.74 LIQUIDITY AND CAPITAL RESOURCES Effective management of the Registrant's capital resources is critical to Management's mission to create value for the Registrant's shareholders. To profitably deploy capital within existing markets, the Banks have implemented balance sheet management strategies that combine effective loan origination efforts with disciplined funding strategies. (See "Asset/liability management."). Although the Banks' balance sheet management strategies provide profitable opportunities to leverage the balance sheet, Management believes that its acquisition strategy may provide greater value to the Registrant's shareholders. The Registrant's cost of capital is also an important factor in creating shareholder value. Accordingly, the Registrant's capital structure includes unsecured debt and Preferred Securities. CAPITALIZATION September 30, December 31, 1998 1997 ------------------ ----------------- Unsecured debt $10,500,000 $12,000,000 Preferred Securities 17,250,000 17,250,000 Shareholders' Equity Preferred stock, no par value Common Stock, par value $1.00 per share 7,375,000 4,587,000 Capital surplus 37,518,000 30,011,000 Retained earnings 21,058,000 23,243,000 Accumulated other comprehensive income 2,040,000 1,675,000 ----------- ----------- Total shareholders' equity 67,991,000 59,516,000 ----------- ----------- Total capitalization $95,741,000 $88,766,000 =========== =========== Shareholders' equity totaled $68.0 million at September 30, 1998. In addition to the retention of earnings, the $8.5 million increase from $59.5 million at December 31, 1997, reflects the issuance of common stock in conjunction with the purchase of First Home Financial, Inc. as well as various equity-based incentive compensation plans. (See "Acquisitions.") Shareholders' equity was equal to 6.51% of total assets at September 30, 1998, compared to 6.05% at December 31, 1997. 12 14 CAPITAL RATIOS September 30, 1998 December 31, 1997 ------------------------ ---------------------- Equity capital 6.51% 6.05% Average shareholders equity to average assets(1) 6.39 5.95 Tier 1 leverage (tangible equity capital) 6.26 6.02 Tier 1 risk-based capital 8.76 8.76 Total risk-based capital 10.01 9.91 (1) Based on year to date average balances for the respective periods ASSET/LIABILITY MANAGEMENT Interest rate risk is created by differences in the pricing characteristics of the Banks' assets and liabilities. Options embedded in certain financial instruments, including caps on adjustable-rate loans as well as borrowers' rights to prepay fixed-rate loans also create interest rate risk. Management employs simulation analyses to evaluate potential changes in the Bank's net interest income and market value of portfolio equity that result from changes in interest rates. Such analyses further anticipate the changes in the rate of prepayment on certain assets and premature withdrawals of certificates of deposits that will accompany changes in interest rates. At September 30, 1998, each of the Banks was within established parameters for interest-rate risk. The asset/liability management efforts of the Registrant and the Banks are further intended to identify and evaluate opportunities to structure the balance sheet in a manner that is consistent with Management's mission to maintain profitable financial leverage within established risk parameters. Accordingly, Management's evaluation of business opportunities and alternate strategies carefully consider the likely impact on the Bank's risk profile as well as the anticipated contribution to earnings. The marginal cost of funds is a principal consideration in the implementation of the Bank's balance sheet management strategies, but such evaluations further consider interest rate and liquidity risk as well as other pertinent factors. Management has determined that the retention of certain real estate mortgage loans, generally 15- and 30-year fixed rate obligations, is inconsistent with its goal to maintain profitable leverage or the Banks' interest-rate risk profiles. Accordingly, the majority of such loans are sold to mitigate exposure to changes in interest rates. Adjustable-rate and balloon real estate mortgage loans may often be profitably funded within established risk parameters. The retention of such loans has been a principal focus of the Banks' balance sheet management strategies. (See "Non-interest income.") Derivative financial instruments are employed to reduce the cost of alternate funding sources and to manage the Banks' exposure to changes in interest rates. At September 30, 1998 and December 31, 1997, the Company employed interest rate caps, collars and swaps with a notional amount of $74.0 million and $38.0 million, respectively. Derivative financial instruments at September 30, 1998, are set forth below. DERIVATIVE FINANCIAL INSTRUMENTS NOTIONAL AVERAGE CAP FLOOR FIXED ANNUAL AMORTIZED FAIR TYPE AMOUNT MATURITY STRIKE STRIKE PAY COST COST VALUE - --------------------------------------------------------------------------------------------------------------------------- (dollars in thousands) Interest rate caps $26,500 1.5 years 6.70% .26% $110 $10 Interest rate collars 10,000 1.9 6.42 5.71% (182) Interest rate swaps 37,500 3.6 5.56% (707) 13 15 RESULTS OF OPERATIONS SUMMARY Net income totaled $2,582,000 and $2,275,000 during the three months ended September 30, 1998 and 1997, respectively. During the nine-month periods of 1998 and 1997, net income totaled $7,554,000 and $6,603,000, respectively. The double-digit increases in earnings during these periods are principally the result of increases in net interest income and non-interest income. Such increases in revenue were, however, partially offset by increases in non-interest expense, the provision for loan losses and federal income tax expense. Key performance ratios for the nine-month periods ended September 30, 1998 and 1997, are set forth below. KEY PERFORMANCE RATIOS Three months Nine months ended September 30, ended September 30, 1998 1997 1998 1997 -------------------------- ---------------------------- Net income to Average assets 0.99% 0.94% 1.00% 0.95% Average equity 15.32 15.83 15.71 16.14 Earnings per common share Basic $.35 $.32 $1.03 $.92 Diluted .35 .31 1.02 .91 Cash basis income to(A) Average tangible assets 1.15% 1.09% 1.16% 1.11% Average tangible equity 24.58 25.99 24.84 27.30 Cash basis income per share(A) Basic $.40 $.36 $1.17 $1.05 Diluted .40 .35 1.15 1.03 (A) Cash basis financial data exclude intangible assets and the related amortization expense NET INTEREST INCOME Tax equivalent net interest income totaled $12,823,000 and $37,528,000 during the three- and nine-months periods ended September 30, 1998, respectively. Increases in tax equivalent net interest income from the comparable periods of 1997 are principally the result of increases in average earning assets as well as an increase in loan fees. 14 16 NET INTEREST INCOME AND SELECTED RATIOS Three months Nine months ended September 30, ended September 30, 1998 1997 1998 1997 ----------- ------------ ----------- ------------ Average earning assets (in thousands) $963,886 $887,567 $935,736 $857,049 Tax equivalent net interest income 12,823 11,361 37,528 32,049 As a percent of average earning assets Tax equivalent interest income 9.23 % 9.10 % 9.29 % 9.05 % Interest expense 3.92 4.02 3.94 4.00 Tax equivalent net interest income 5.31 5.08 5.35 5.05 Average earning assets as a percent of average assets 92.91 % 92.87 % 93.05 % 92.52 % Free-funds ratio 10.59 % 9.23 % 10.33 % 8.72 % Increases in average earning assets during both the three- and nine-month periods principally reflect implementation of the Banks' balance sheet management strategies. (See "Liquidity and capital resources.") Tax equivalent net interest income was equal to 5.31% and 5.35% of average earning assets during the three- and nine-month periods in 1998, respectively. The increases from the comparable periods of 1997 were principally the result of an increase in loan fees. Such fees totaled $1,629,000 and $1,092,000 during the three months ended September 30, 1998 and 1997, respectively. During the nine-month periods, loan fees totaled $4,536,000 in 1998 and $2,846,000 in 1997. Excluding the impact of such loan fees, tax equivalent net interest income would have been largely unchanged from 1997. Increases in Portfolio Loans as a percent of average earning assets also contributed to the increase in tax equivalent net interest income as a percent of average earning assets. Portfolio Loans comprised 82% of earning assets during the three-month period in 1998 compared to 79% during 1997. During the nine-month periods of 1998 and 1997, Portfolio Loans were equal to 82% and 77% of average earning assets, respectively. PROVISION FOR LOAN LOSSES The provision for loan losses was $915,000 and $2,218,000 during the three- and nine-month periods ended September 30, 1998, respectively. The increase in the provision from the comparable periods in 1997 principally reflects the increase in total loans as well as general economic uncertainty. (See "Asset quality.") NON-INTEREST INCOME Non-interest income totaled $3,706,000 and $9,705,000 during the three- and nine-month periods ended September 30, 1998, respectively. The substantial increases in non-interest income from the comparable periods of 1997 principally reflect increases in net gains on the sale of real estate mortgage loans. The revenues associated with deposit account promotions, the Banks' title insurance agency and First Home Financial, Inc. also contributed to the increase in non-interest income. (See "Acquisitions.") 15 17 Three months ended Nine months ended September 30, September 30, 1998 1997 1998 1997 ---------------------------------- ----------------------------------- Real estate mortgage loans originated $110,373,000 $77,884,000 $360,498,000 $187,419,000 Real estate mortgage loan sales 68,003,000 28,547,000 196,935,000 68,515,000 Real estate mortgage loan servicing rights sold 11,313,000 6,520,000 46,803,000 16,126,000 Net gains on the sale of real estate mortgage loans 1,219,000 587,000 3,174,000 1,423,000 Net gains as a percent of real estate mortgage loans sold 1.79% 2.06% 1.61% 2.08% Net gains on the sale of real estate mortgage loans totaled $1,219,000 and $3,174,000 during the three- and nine-month periods in 1998, respectively. The increases from $587,000 and $1,423,000 during the comparable periods of 1997 principally reflect an increase in loans sold. The decline in net gains as a percent of loans sold may be largely attributed to a decrease in the proportion of loans sold that have been underwritten pursuant to government guarantees. The Banks capitalized approximately $1,111,000 and $340,000 of related servicing rights during the nine-month periods ended September 30, 1998 and 1997, respectively. Amortization of capitalized servicing rights for those periods was $233,000 and $90,000, respectively. The fair value of capitalized servicing rights approximated the book value of $1,491,000 at September 30, 1998, and therefore, no valuation allowance was considered necessary. The capitalized servicing rights relate to approximately $260 million of loans sold and serviced at September 30, 1998. The volume of loans sold is dependent upon the Banks' ability to originate real estate mortgage loans. During the nine months ended September 30, 1998, approximately 60% of such loans represent the refinancing of existing obligations and, accordingly, the volume of loans sold is dependent upon the absolute level of such refinancing activity. The volume of loans sold is also a function of the relative demand for fixed-rate obligations and other loans that the Banks cannot profitably fund within established interest-rate risk parameters. (See "Asset/liability management.") Net gains on real estate mortgage loans are also contingent upon economic and competitive factors as well as the Banks' ability to effectively manage exposure to changes in interest rates. NON-INTEREST EXPENSE Non-interest expense totaled $11,605,000 and $33,305,000 during the three- and nine-month periods ended September 30, 1998. Management estimates that approximately 25% of the increase in non-interest expense from the respective periods in 1997 reflect commissions and other variable costs associated with the increased volumes of real estate mortgage lending. Costs associated with the operation of the Banks' title insurance agency and First Home Financial, Inc. totaled $548,000 and $1,085,000 during the three- and nine-month periods in 1998, respectively. During the corresponding periods of 1997, such costs totaled $99,000 and 245,000, respectively. 16 18 ACQUISITIONS On April 17, 1998, the Registrant purchased the outstanding capital stock of First Home Financial, Inc. ("FHF"), an originator of manufactured home loans. FHF operates as a subsidiary of one the Banks and Management expects that the majority of the loans originated by FHF will be sold to non-affiliated banks and finance companies. Aggregate consideration consisted of 72,000 shares of common stock with an aggregate value of $1,783,000. The transaction has been accounted for as a purchase. Goodwill totaled approximately $2.0 million and is being amortized over 15 years. The consolidated results of operation include FHF's revenues and expenses, including the amortization of goodwill, totaling $384,000 and $289,000, respectively, since April 17, 1998. On June 12, 1998, one of the Banks purchased the real and personal property and assumed the deposit liabilities associated with two offices of Great Lakes National Bank. On that date, such deposits totaled $18.3 million and the Bank recorded an intangible asset of $1.3 million which is being amortized over 10 years. STATEMENT OF FINANCIAL ACCOUNTING STANDARDS The Financial Accounting Standards Board adopted Statement of Financial Accounting Standards, No. 133, "Accounting for Derivative Instruments and Hedging Activities", ("SFAS #133") in June 1998. SFAS #133 requires companies to record derivatives on the balance sheet as assets and liabilities measured at fair value. The accounting for increases and decreases in the value of those derivatives will depend upon the use of those derivatives and whether or not they qualify for hedge accounting. This statement is effective for all fiscal quarters of fiscal years beginning after June 15, 1999 with earlier application allowed and is to be applied prospectively. Management has not yet evaluated the impact of the implementation of this statement. YEAR 2000 The Year 2000 issue refers to computer-based operating systems that were originally designed to recognize calendar years by their last two digits. If not corrected, many computer applications may fail or produce erroneous data relating to the year 2000 and beyond. The Registrant initiated the process of preparing its computer-based operating systems for the year 2000 during 1997 and formed a task force to address such issues. The Year 2000 task force has implemented a Year 2000 plan (the "Plan") and reports its progress to the board of directors quarterly. The Plan contains requirements for assessing the impact of the Year 2000 on critical computer-based operating systems and for modifying, replacing and testing such systems so that they will function properly with respect to dates in the year 2000 and thereafter. Additionally, the Banks' have initiated formal discussion with its significant commercial loan customers to determine the extent to which their computer-based operating systems are Year 2000 compliant. 17 19 A significant portion of the Registrant's Year 2000 issue relates to its core data processing application which is provided by a third party service provider, M&I Data Services. The Registrant completed its conversion to M&I Data Services Year 2000 compliant application software during October 1998. The Registrant has not identified any non-compliant systems for which a solution is not available and which would impair the Registrant's business operations. Costs incurred to date have not been material and relate primarily to the replacement of fully depreciated non-compliant personal computer equipment. Furthermore, Management does not anticipate that the costs to make its operating systems Year 2000 compliant will have a material impact on the consolidated financial statements. A significant portion of the costs that will be incurred to make our systems Year 2000 compliant will represent an acceleration of expenditures that would otherwise have been made during subsequent periods to replace or upgrade systems that will become obsolete or otherwise inadequate to meet the Registrant's growing technology needs. Management anticipates that all material non-compliant operating systems will be replaced and that most of the testing of such systems will be completed by December 31, 1998. It is anticipated that the remainder of the testing will be completed during the first quarter of 1999. While the Registrant is not aware of any Year 2000 problems for which a solution is not available, other unanticipated issues could arise and there can be no assurance that actual results will be comparable to expected results. These unanticipated issues may include the ability to identify and correct all relevant computer codes, the availability and cost of trained personnel, the impact of Year 2000 on our customers and other uncertainties. Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. No material changes in the market risk faced by the Registrant has occurred since December 31, 1997. 18 20 Item 6. Exhibits & Reports on Form 8-K (a) Exhibit Number & Description 11. Computation of Earnings per share 27. Financial Data Schedule (b) Reports on Form 8-K During the quarter ended September 30, 1998, there were no reports filed on Form 8-K. 19 21 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. Date November 12, 1998 By s/William R. Kohls -------------------------------- --------------------------------------- William R. Kohls, Principal Financial Officer Date November 12, 1998 By s/James J. Twarozynski -------------------------------- --------------------------------------- James J. Twarozynski, Principal Accounting Officer 20 22 INDEX TO EXHIBITS EXHIBIT NO. DESCRIPTION - ----------- ----------- 11 Computation Of Earnings Per Share 27 Financial Data Schedule