SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
X Quarterly Report Pursuant to Section 13 or 15(d) of the
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Securities and Exchange Act of 1934
For the quarterly period ended June 30, 2003, or
Transition Report Pursuant to Section 13 or 15(d) of the
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Securities Exchange Act of 1934
For the Transition Period from to
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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: (989) 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 by check mark whether the registrant is an accelerated filer (as
defined in rule 12b-2 of the Exchange Act).
YES NO X
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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 August 11, 2003
----- ------------------------------
Common Stock 3,843,223
No Par Value
INDEX
PART I FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of June 30, 2003 (unaudited) and December 31, 2002 (Page 3)
Consolidated Statements of Income and Other Comprehensive Income (unaudited) for
the three and six months ended June 30, 2003 and June 30, 2002 (Page 4)
Consolidated Statements of Changes in Shareholders' Equity (unaudited) for the
three months ended June 30, 2003 and June 30, 2002 (Page 5)
Consolidated Statements of Cash Flows (unaudited) for the six months ended (Page 6)
June 30, 2003 and June 30, 2002
Notes to Consolidated Financial Statements (unaudited) (Page 7-9)
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Page 10-14)
Item 3. Quantitative and Qualitative Disclosures about Market Risk (Page 14-15)
Item 4. Controls and Procedures (Page 16)
PART II OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders (Page 17)
Item 6. Exhibits and Reports on Form 8-K (Page 17-24)
SIGNATURES (Page 18)
COMMERCIAL NATIONAL FINANCIAL CORPORATION
CONSOLIDATED BALANCE SHEETS
June 30, December 31,
2003 2002
---- ----
(Unaudited)
ASSETS
Cash and due from banks $ 5,172,367 $ 8,784,826
Federal funds sold 6,825,000 6,850,000
Other interest bearing deposits 1,761,536 3,634,988
------------- -------------
Total cash and cash equivalents 13,758,903 19,269,814
Securities available for sale 25,232,553 21,345,896
Securities held to maturity (fair value $3,592,976 -
June 30, 2003; $4,911,696 - December 31, 2002) 3,404,808 4,689,025
Federal Home Loan Bank stock, at cost 1,668,800 1,647,000
Gross loans receivable 182,655,801 184,448,296
Allowance for loan losses (2,271,715) (2,783,234)
------------- -------------
Net loans receivable 180,384,086 181,665,062
Bank owned life insurance 3,322,481 3,231,374
Premises and equipment, net 3,866,534 3,687,151
Accrued interest receivable and other assets 4,128,649 2,715,261
------------- -------------
Total assets $ 235,766,814 $ 238,250,583
============= =============
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities
Deposits
Noninterest-bearing demand $ 21,094,790 $ 21,495,410
Interest-bearing demand 29,485,059 29,872,655
Savings 62,431,221 59,432,935
Time 53,873,561 55,258,479
------------- -------------
Total deposits 166,884,631 166,059,479
Securities sold under agreements to repurchase 15,162,721 14,266,239
Other short-term borrowings 441,984 491,840
Federal Home Loan Bank advances 28,420,749 32,807,086
Accrued expenses and other liabilities 1,109,132 921,967
------------- -------------
Total liabilities 212,019,217 214,546,611
Shareholders' equity
Common stock and paid-in-capital, no par value: 5,000,000 shares
authorized; shares issued and outstanding
June 30, 2003 - 3,825,799 and December 31,
2002 - 3,801,421 23,548,479 23,255,499
Retained earnings (deficit) (298,372) 3,908
Accumulated other comprehensive income, net of tax 497,490 444,565
------------- -------------
Total shareholders' equity 23,747,597 23,703,972
------------- -------------
Total liabilities and shareholders' equity $ 235,766,814 $ 238,250,583
============= =============
See accompanying notes
3
COMMERCIAL NATIONAL FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (Unaudited)
Three Months Six Months
Ended June 30, Ended June 30,
2003 2002 2003 2002
---- ---- ---- ----
Interest and dividend income
Loans, including fees $ 3,125,574 $ 3,185,954 $ 6,219,668 $ 6,303,430
Taxable securities 183,544 203,522 363,162 412,468
Nontaxable securities 99,804 118,375 206,804 249,092
Federal funds sold 27,245 11,492 67,029 40,572
Federal Home Loan Bank stock dividends 20,358 21,679 44,358 42,263
Interest on other deposits 6,087 3,447 10,415 8,576
----------- ----------- ----------- -----------
Total interest and dividend income 3,462,612 3,544,469 6,911,436 7,056,401
Interest expense
Deposits 645,281 862,783 1,340,932 1,775,738
Securities sold under agreements to repurchase 39,441 37,755 85,436 68,914
Federal Home Loan Bank advances 386,290 378,072 798,353 762,015
Other 668 1,103 1,419 3,307
----------- ----------- ----------- -----------
Total interest expense 1,071,680 1,279,713 2,226,140 2,609,974
Net interest income 2,390,932 2,264,756 4,685,296 4,446,427
Provision for loan losses 1,230,000 167,000 1,350,000 287,000
------------ ----------- ----------- -----------
Net interest income after provision for loan losses 1,160,932 2,097,756 3,335,296 4,159,427
Noninterest income
Service charges and fees 117,151 118,120 234,409 224,932
Net gains on loan sales 260,121 38,179 541,131 93,872
Receivable financing fees 43,225 46,647 84,426 83,738
Net security gains - 4,168 - 27,565
Other 15,990 113,260 104,103 203,763
----------- ----------- ----------- -----------
Total noninterest income 436,487 320,374 964,069 633,870
Noninterest expense
Salaries and employee benefits 929,527 805,584 1,833,669 1,625,715
Occupancy and equipment 319,674 223,574 622,493 445,715
FDIC insurance 6,882 8,178 14,184 16,413
Printing, postage and supplies 66,764 65,064 137,931 138,837
Professional and outside services 104,508 90,154 192,259 194,361
Other 273,046 256,818 516,315 491,654
----------- ----------- ----------- -----------
Total noninterest expense 1,700,401 1,449,372 3,316,851 2,912,695
----------- ----------- ----------- -----------
Income before income tax expense (102,982) 968,758 982,514 1,880,602
Income tax expense (benefit) (105,400) 291,200 214,000 539,300
----------- ----------- ----------- -----------
Net income $ 2,418 $ 677,558 $ 768,514 $ 1,341,302
=========== =========== =========== ===========
Net change in unrealized gains on securities available for sale $ 103,547 $ 188,243 $ 80,189 $ 89,392
Reclassification adjustment for (gains) recognized in income - (4,168) - (27,565)
Tax effects (35,205) (62,586) (27,264) (21,021)
----------- ----------- ----------- -----------
Total comprehensive income $ 70,760 $ 799,047 $ 821,439 $ 1,382,108
=========== =========== =========== ===========
Per share information
Basic earnings $ - $ 0.18 $ 0.20 $ 0.35
Diluted earnings $ - $ 0.18 $ 0.20 $ 0.35
Dividends declared $ 0.14 $ 0.13 $ 0.28 $ 0.27
See accompanying notes
4
COMMERCIAL NATIONAL FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
Six Months ended June 30, 2003 and June 30, 2002 (Unaudited)
Accumulated
Shares Common Other
Issued Stock and Retained Comprehensive Total
and Paid in Earnings Income/(Loss), Shareholders'
Outstanding Capital (Deficit) Net of Tax Equity
- ----------------------------------------------------------------------------------------------------------------------------
Balance at January 1, 2002 3,725,085 $ 22,104,910 $ (416,257) $ 375,625 $ 22,064,278
Comprehensive income:
Net income 1,341,302 1,341,302
Net change in unrealized gains/(losses) on
securities available for sale 89,392 89,392
Reclassification adjustment for gains
recognized in income (27,565) (27,565)
Tax effects (21,021) (21,021)
------------
Total comprehensive income 1,382,108
Cash dividends declared, $.27 per share (1,003,304) (1,003,304)
Issued under dividend reinvestment program 43,341 406,127 406,127
Issued under stock option plans 6,939 47,690 47,690
Issued under employee benefit plan 3,880 39,713 39,713
Repurchase and retirement of shares (4,570) (51,793) (51,793)
---------- ------------ ----------- ---------- ------------
Balance at June 30, 2002 3,774,675 $ 22,546,647 $ (78,259) $ 416,431 $ 22,884,819
========== ============ =========== ========== ============
============================================================================================================================
Balance at January 1, 2003 3,801,421 $ 23,255,499 $ 3,908 $ 444,565 $ 23,703,972
Comprehensive income:
Net income 768,514 768,514
Net change in unrealized gains/(losses) on
securities available for sale 80,189 80,189
Tax effects (27,264) (27,264)
------------
Total comprehensive income 821,439
Cash dividends declared, $.28 per share (1,070,794) (1,070,794)
Issued under dividend reinvestment program 34,086 409,032 409,032
Issued under stock option plans 48 318 318
Issued under employee benefit plan 3,370 40,956 40,956
Repurchase and retirement of shares (13,126) (157,326) (157,326)
---------- ------------ ----------- ---------- ------------
Balance at June 30, 2003 3,825,799 $ 23,548,479 $ (298,372) $ 497,490 $ 23,747,597
========== ============ =========== ========== ============
See accompanying notes
5
COMMERCIAL NATIONAL FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
Six Months Ended
June 30,
2003 2002
---- ----
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 768,514 $ 1,341,302
Adjustments to reconcile net income to net
cash from operating activities
Provision for loan losses 1,350,000 287,000
Net gains on loan sales (541,131) (93,872)
Originations of loans held for sale (22,696,920) (4,401,919)
Proceeds from sales of loans held for sale 23,238,051 4,495,791
Gain on sales of securities available for sale - (27,565)
Depreciation, amortization and accretion 343,188 252,216
Net change in accrued interest receivable and other assets (113,237) 1,336,476
Net change in accrued expenses and other liabilities 182,651 (39,105)
------------ ------------
Net cash from operating activities 2,531,116 3,150,324
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of securities available for sale (14,425,946) (1,533,829)
Purchases of FHLB stock (21,800) -
Proceeds from maturities of securities available for sale 10,517,199 3,000,000
Proceeds from maturities of securities held to maturity 1,280,000 2,578,900
Net change in loans (1,492,050) (13,275,506)
Purchases of premises and equipment (411,571) (390,860)
------------ ------------
Net cash from investing activities (4,554,168) (9,621,295)
CASH FLOW FROM FINANCING ACTIVITIES
Net change in deposits 825,152 (1,549,218)
Net change in securities sold under agreements to repurchase 896,482 3,988,463
Net change in U.S. Treasury demand notes (49,856) 431,735
Proceeds from Federal Home Loan Bank advances - 5,000,000
Repayment of Federal Home Loan Bank advances (4,386,337) (4,209,995)
Repurchase and retirement of shares of common stock (63,028) (51,793)
Dividends paid and fractional shares (1,066,280) (996,407)
Proceeds from sale of common stock 356,008 493,530
------------ ------------
Net cash from financing activities (3,487,859) 3,106,315
------------ ------------
Net change in cash and cash equivalents (5,510,911) (3,364,656)
Cash and cash equivalents, at beginning of period 19,269,814 14,347,325
------------ ------------
CASH AND CASH EQUIVALENTS, AT END OF PERIOD $ 13,758,903 $ 10,982,669
============ ============
Cash paid during the period for
Interest $ 2,250,080 $ 2,676,056
Federal income taxes 684,000 610,000
See accompanying notes
6
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
accounting principles generally accepted in the United States of America for
complete presentation of financial statements. In management's opinion, 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 June 30, 2003 and
December 31, 2002 and the results of its operations for the three and six months
ending June 30, 2003 and June 30, 2002. The results for the three and six months
ended June 30, 2003 are not necessarily indicative of the results expected for
the full year.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of
Commercial National Financial Corporation (CNFC), Commercial Bank (Bank) and
CNFC Financial Services, Inc. and CNFC Mortgage Corporation, both wholly owned
subsidiaries of the Bank. All material intercompany accounts and transactions
have been eliminated in consolidation.
Nature of Operations, Industry Segments and Concentrations of Credit Risk
CNFC 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 CNFC's chief
decision-makers monitor the revenue stream of various products and services,
operations are managed and financial performance is evaluated on a
corporation-wide basis. Accordingly, management considers all of the CNFC's
banking operations 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 surrounding these
communities. The Bank serves these markets through nine offices located in
Gratiot, Isabella and Montcalm Counties in Michigan.
Use of Estimates
To prepare financial statements in conformity with accounting principles
generally accepted in the United States of America, 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. The allowance for loan losses and fair values of securities and other
financial instruments are particularly subject to change.
STOCK COMPENSATION Employee compensation expense under stock options is reported
using the intrinsic value method. No stock-based compensation cost is reflected
in net income as all options granted had an exercise price equal to or greater
than the market price of the underlying common stock at date of grant. The
following table illustrates the effect on net income and earnings per share if
expense was measured using the fair value recognition provisions of SFAS No.
123, Accounting for Stock-Based Compensation Expense.
7
COMMERCIAL NATIONAL FINANCIAL CORPORATION
Quarter to Date Year to Date
June 30, 2003 June 30, 2002 June 30, 2003 June 30, 2002
- ---------------------------------------------------------------------------------------------------------
Net income as reported $ 2,418 $ 677,558 $ 768,514 $ 1,341,302
Stock-based compensation expense (28,470) (15,943) (53,361) (28,922)
- --------------------------------------------------------------------------------------------------------
Proforma net income $ (26,052) $ 661,615 $ 715,153 $ 1,312,380
========================================================================================================
Basic earnings per share as reported $ .00 $ .18 $ .20 $ .35
Proforma basic earnings per share $ (.01) $ .18 $ .19 $ .35
Diluted earnings per share as reported $ .00 $ .18 $ .20 $ .35
Proforma diluted earnings per share $ (.01) $ .17 $ .18 $ .34
The pro forma effects are computed using option pricing models, using the
following weighted-average assumptions as of the grant date.
Quarter to Date Year to Date
June 30, 2003 June 30, 2002 June 30, 2003 June 30, 2002
- ---------------------------------------------------------------------------------------------------------
Risk-free interest rate 3.57% 4.08% 3.57% 4.08%
Expected option life 10.00 9.45 10.00 9.45
Expected stock price volatility 21.10 40.83 21.10 40.83
Dividend yield 4.31% 4.70% 4.31% 4.70%
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.
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.
Comprehensive Income
Comprehensive income consists of net income and other comprehensive income
(loss). Other comprehensive income (loss) 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.
Reclassifications
Some items in the prior year financial statements have been reclassified to
conform with the current year presentation.
Newly Issued But Not Yet Effective Accounting Standards
New accounting standards on asset retirement obligations, restructuring
activities and exit costs, operating leases, and early extinguishment of debt
were issued in 2002. The new accounting standards were adopted in 2003, and did
not have a material impact on Commercial'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 periods ended is
presented below. Stock options representing 147,981 and 129,360 shares of common
stock were not considered in computing diluted earnings per share for the three
and six month periods in 2002 and 2003 because they were antidilutive.
8
COMMERCIAL NATIONAL FINANCIAL CORPORATION
Three months ended Six Months ended
JUNE 30, June 30, JUNE 30, June 30,
2003 2002 2003 2002
- -------------------------------------------------------------------------------------------------------------------------
BASIC EARNINGS PER SHARE:
Net income available to common shareholders $ 2,418 $ 677,558 $ 768,514 $ 1,341,302
Weighted-average common shares outstanding for
basic earnings per share 3,825,228 3,767,524 3,825,228 3,737,524
- -------------------------------------------------------------------------------------------------------------------------
BASIC EARNINGS PER SHARE $ .00 $ .18 $ .20 $ .35
=========================================================================================================================
DILUTED EARNINGS PER SHARE:
Net income available to common shareholders $ 2,418 $ 677,558 $ 768,514 $ 1,341,302
Weighted-average common shares outstanding for basic
earnings per share 3,825,228 3,767,524 3,825,228 3,767,524
Add:
Dilutive effect of assumed exercise of stock options 41,058 38,646 41,058 38,646
- -------------------------------------------------------------------------------------------------------------------------
Weighted-average common and dilutive additional potential
common shares outstanding 3,866,286 3,806,170 3,866,286 3,806,170
=========================================================================================================================
DILUTED EARNINGS PER SHARE $ .00 $ .18 $ .20 $ .35
=========================================================================================================================
9
COMMERCIAL NATIONAL FINANCIAL CORPORATION
ITEM 2: MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
FINANCIAL CONDITION
Summary
The historically low interest rate environment continued to provide incentive
for residential real estate customers to refinance their residential mortgage.
The Bank originated and sold $22,697,000 in loans during the first six months of
2003 compared to $4,402,000 during the same period in 2002. A weak local economy
has also negatively affected the demand for business loans, which have decreased
$7.1 million since December 31, 2002.
Savings account balances increased $3.0 million and repurchase agreement
balances increased $.9 million compared to December 31, 2002 balances. The
effect of increased mortgage loan sales, lower business loan totals, and
increased short term deposits contributed to increased liquidity. Management has
attempted to reduce liquidity through the scheduled repayment of FHLB advances,
and by reducing dependence on network and jumbo certificate of deposits. FHLB
totals decreased $4,386,000 and certificate of deposits decreased $1,385,000.
The combined effect of the factors listed above was to reduce total assets from
$238,251,000 at December 31, 2002 to $235,767,000 at June 30, 2003.
Accrued interest receivable and other assets increased by $1,413,000 compared to
December 31, 2002 balance primarily caused by the transfer of $1,500,000 in
loans to foreclosed assets. This asset was associated with a loan identified as
a non-accrual loan at December 31, 2002.
During the quarter ending June 30, 2003 CNFC opened a full service office in Mt.
Pleasant, Michigan. The office location is leased under an operating lease.
Therefore, the office opening has had minimal impact on the balance sheet.
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, with minimal losses.
Management believes 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 provides adequate short and medium term sources
of liquidity. At a minimum the Bank has the following available to meet
short-term liquidity needs: $8,319,000 in available FHLB advances and $9,000,000
in short term federal funds 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.
Asset Quality
At June 30, 2003 CNFC has identified $2,589,000 of loans as non-performing. This
compares to $6,025,000 at December 31, 2002. The $2,589,000 in non-accrual loans
represents four business relationships and their related entities. All
non-accrual loans are considered impaired and the allowance for loan loss
allocated to these loans is $1,385,000. Of the $3,436,000 decrease in
non-performing loans, $1,500,000 was transferred to repossessed assets and other
real estate during the first quarter and an additional $1,666,000 was charged
off during the second quarter. The remaining $270,000 decrease was the result of
principal reduction either because of loan payments, or improved financial
condition.
10
COMMERCIAL NATIONAL FINANCIAL CORPORATION
June 30, 2003 December 31, 2002
------------- -----------------
Total loans $ 182,655,801 $ 184,448,296
Non-accrual loans $ 2,589,399 $ 5,676,390
Accruing loans past due 90 days or more - -
Restructured Loans (non accrual) - 348,520
- -------------------------------------------------------------------------------------------------
Total non-performing loans 2,589,399 6,024,910
Repossessed assets and other real estate 1,548,948 120,970
- -------------------------------------------------------------------------------------------------
Total non-performing assets $ 4,138,347 $ 6,145,880
=================================================================================================
Total non-performing loans as a
percentage of total loans 1.42% 3.33%
=================================================================================================
Allowance for loan loss as a percentage of
non-performing loans 87.73% 46.20%
=================================================================================================
Total non-performing assets as a percentage of
total assets 1.76% 2.58%
=================================================================================================
Allowance for Loan Loss
- -----------------------
Three Months Ended Three Months Ended Six Months Ended Six Months Ended
June 30, 2003 June 30, 2002 June 30, 2003 June 30, 2002
- ------------------------------------------------------------------------------------------------------------------------
Beginning balance $ 2,909,709 $ 2,718,824 $ 2,783,234 $ 2,586,025
Loan charge-offs (1,874,357) (3,225) (1,945,362) (11,222)
Loan recoveries 6,363 14,394 83,843 35,190
- ------------------------------------------------------------------------------------------------------------------------
Net loan recoveries/(charge-offs) (1,867,994) 11,169 (1,861,519) 23,968
Provision for loan losses 1,230,000 167,000 1,350,000 287,000
- ------------------------------------------------------------------------------------------------------------------------
Ending balance $ 2,271,715 $ 2,896,993 $ 2,271,715 $ 2,896,993
========================================================================================================================
Average loan balance $ 181,690,000 $ 179,285,000 $ 181,230,000 $ 175,173,000
Percentage of net charge-offs
as a percentage of average loans (1.02)% 0.00% (1.03)% .00%
The allowance for loan losses was 1.24% of total loans at June 30, 2003 and
1.51% at December 31, 2002. Management systematically evaluates the adequacy of
the allowance such that the balance is commensurate with the performance of the
loan portfolio.
For purposes of evaluating the adequacy of the allowance, the performance of the
loan portfolio is divided into four classifications: non-classified, watch,
substandard-not impaired, and substandard-impaired. Management has subdivided
the classifications of non-classified and watch into the following categories of
loans: residential, consumer and business loans.
Non-classified loans are loans that are viewed as homogeneous categories. These
loans are generally current and performing as agreed. Commercial establishes a
reserve on these categories of non-classified loans using the last three year
historical charge-off experience.
Watch credits are loans that management has identified as having some change
that requires additional loan officer monitoring. These loans are generally
paying as agreed, however, the ability to meet debt obligations, while adequate,
has deteriorated. These loans are not considered impaired within the definition
of FAS 114 and 118 and are viewed as homogeneous categories.
11
COMMERCIAL NATIONAL FINANCIAL CORPORATION
Substandard-impaired and substandard-not impaired loans are business loans that
management reviews for impairment under FAS 114 and 118. Management reviews
these loans individually for impairment using either the present value of
expected cash flow or the value of collateral. Loans not considered impaired are
grouped as a homogenous category. A reserve is established on this category
using historical loss experience. A specific reserve is calculated for each loan
identified as impaired, however, the total allowance is available for any loan.
The residential real estate loan portfolio has experienced net recoveries during
the last three calendar years of $45,000. The consumer loan portfolio has
experienced net recoveries of $8,000 during the last three calendar years.
Despite a slowing economy, the consumer and residential real estate portfolios
continue to perform at levels consistent with prior years.
However, the business portfolio has not performed as well. During the quarter,
management identified additional collateral deficiency for a loan relationship
previously identified as impaired. In addition, management charged-off
$1,868,000 during the quarter. Approximately $1,735,000 was related to one
borrower also previously identified as impaired, however, the amount charged-off
exceeded the previously identified exposure related to this loan. These two
events, incorporated into management's allowance for loan loss methodology
resulted in a $1,230,000 provision for loan loss during the quarter.
Capital Resources
CNFC's capital ratios continue to exceed regulatory guidelines for a "well
capitalized" institution. It is management's intent to maintain capital ratios
in excess of the minimum required to be well capitalized. A summary of CNFC's
capital ratios follows:
Minimum Required to be
Well Capitalized Under Minimum Required
June 30, December 31, Prompt Corrective Action for Capital
2003 2002 Regulations Adequacy Purposes
- --------------------------------------------------------------------------------------------------------------
Total capital to
risk weighted assets 14.5% 14.2% 10.0% 8.0%
Tier 1 capital to
risk weighted assets 13.3% 13.0% 6.0% 4.0%
Tier 1 capital to
average assets 9.7% 10.0% 5.0% 4.0%
RESULTS OF OPERATIONS
Summary
Net income for the quarter ended June 30, 2003 was $2,000, a decrease of
$675,000 compared to the same period in 2002. There are three primary factors
that affected the decrease in net income: a $1,063,000 increase in the provision
for loan loss, a $116,000 or 36.2% increase in non-interest income caused by
continued strong level of sales of residential real estate loans to the
secondary market, and a $251,000 or 17.3% increase in non-interest expense
caused by the additional overhead to support our new facilities in Greenville
and Mt. Pleasant, Michigan and the addition of staff in our business loan
processing department.
Net Interest Income
The following table illustrates the effect that changes in rates and balances of
interest-earning assets and interest-bearing liabilities had on tax-equivalent
net interest income for the three and six months ending June 30, 2003 and 2002.
12
COMMERCIAL NATIONAL FINANCIAL CORPORATION
Three Months Ending June 30, Six Months Ending June 30,
2003 2002 2003 2002
---- ---- ---- ----
Interest Income (tax equivalent) $ 3,574,006 $ 3,677,418 $ 7,136,836 $ 7,316,630
Interest Expense 1,071,678 1,279,713 2,226,139 2,609,974
------------ ------------- ------------- -------------
Net Interest Income $ 2,502,328 $ 2,397,705 $ 4,910,697 $ 4,706,656
============ ============= ============= =============
Average Balances
Interest-earning Assets $224,495,461 $ 210,289,753 $ 225,288,866 $ 208,938,575
Interest-bearing Liabilities 193,030,080 178,026,591 193,547,969 177,402,209
------------ ------------- ------------- -------------
Net Differential $ 31,465,381 $ 32,263,162 $ 31,740,897 $ 31,536,366
============ ============= ============= =============
Average Yields/Rates (annualized)
Yield on Earning Assets 6.39% 7.01% 6.39% 7.06%
Rate Paid on Liabilities 2.23% 2.88% 2.32% 2.97%
----- ----- ----- -----
Interest Spread 4.16% 4.13% 4.07% 4.09%
===== ===== ===== =====
Net Interest Margin 4.47% 4.57% 4.40% 4.54%
===== ===== ===== =====
The change in tax equivalent net interest income is attributable to the
following:
Three Months Ending Six Months Ending
June 30, 2003 June 30, 2003
Balance Rate Inc/(Dec) Balance Rate Inc/(Dec)
------- ---- --------- ------- ---- ---------
Interest Earning
Assets $ 90,910 $ (194,322) $ (103,412) $ 275,168 $ (454,962) $ (179,794)
Interest Bearing
Liabilities 48,861 (256,898) (208,037) 125,934 (509,769) (383,835)
-------- ---------- ---------- --------- ---------- ----------
Net Interest Income $ 42,049 $ 62,576 $ 104,625 $ 149,234 $ 54,807 $ 204,041
======== ========== ========== ========= ========== ===========
The $105,000 increase in tax-equivalent net interest income for the three months
ending June 30, 2003 resulted from a 10 basis point decrease in margin offset by
a $14,206,000 increase in average earning assets.
Since June 30, 2002 the Federal Reserve lowered the Federal funds target rate by
50 basis points in November of 2002 and 25 basis points in June of 2003. The
decrease in short term interest rates negatively impacted margin in the short
run. Also negatively impacting margin is the interest not earned and collected
on non-accrual loans.
The factors affecting the $ 204,000 increase in net interest income for the six
months ending June 30, 2003 are similar to those described above for the three
months ending June 30, 2003.
Noninterest Income
Noninterest income for the three months ending June 30, 2003 was $436,000. This
represents a $116,000 or 36.2% increase over the same period in 2002.
Net gain on loan sales increased from $38,000 to $260,000. The Bank continued to
experience significant refinancing activity. For the three months ending June
30, 2003, the Bank originated and sold $22,697,000 in residential real estate
loans. This compares to $4,402,000 for the three months ended June 30, 2002.
At the end of each quarter, management values the value of mortgage servicing
rights. The low interest rate environment has allowed home owners to refinance
residential real estate loans several times during the last two years. The
resulted in a deterioration in the value of mortgage servicing rights booked at
the time of loan sales to the secondary market. At June 30, 2003, CNFC recorded
a $148,000 valuation to recognize that the market value for mortgage servicing
rights was less than the unamortized cost.
13
COMMERCIAL NATIONAL FINANCIAL CORPORATION
The factors affecting the $330,000 increase in noninterest income for the six
months ending June 30, 2003 are similar to those described above for the three
months ending June 30, 2003.
Noninterest Expense
Noninterest expense for the three months ending June 30, 2003 totaled
$1,700,000. This represents a $251,000 or 17.3% increase over the same period in
2002.
Salary and benefit expense for the three months ending June 30, 2003 totaled
$930,000 compared to $806,000 for the same period in 2002, an increase of
$124,000 or 15.4%. Increased staffing for the new Greenville and Mt. Pleasant
offices and the business loan processing department are the primary reason for
the increase. Full time equivalent employees increased from 74 at June 30, 2002
to 85 at June 30, 2003.
Occupancy and equipment increased $96,100 or 43.0% compared to the same period
in 2002. Costs associated with operating the new Greenville and Mt. Pleasant
offices contributed to the increase expense.
Professional fees for the quarter ending June 30, 2003 increased $14,000 or
15.9% compared to the same period in 2002. Search fees for lending staff for our
Mt. Pleasant office contributed to the increase.
The factors affecting the $404,000 increase in noninterest expense for the six
months ending June 30, 2003 are similar to those described above for the three
months ending June 30, 2003.
ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Commercial's primary market risk exposure is interest rate risk and, to a lesser
extent, liquidity risk. Commercial's transactions are denominated in U.S.
dollars with no specific foreign exchange exposure. Also, Commercial 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 movements in interest rates. Accepting this risk can be an
important source of profitability and stockholder value; however, excessive
levels of IRR could pose a threat to earnings and capital. Accordingly,
effective risk management that maintains IRR at prudent levels is essential to
Commercial's safety and soundness. Evaluating the quantitative level of IRR
exposure requires the assessment of 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.
Commercial's Asset/Liability Committee ("Committee") is responsible for managing
this process.
Commercial derives the majority of income from the excess of interest collected
over interest paid. The rates of interest earned on its assets and owed on its
liabilities generally are established contractually for a period of time. Since
market interest rates change over time, Commercial is exposed to lower profit
margins (or losses) if it cannot adapt to interest rate changes.
Commercial is also subject to repayment risk when interest rates fall. For
example, mortgage loans and other financial assets may be prepaid by a debtor so
that the debtor may refinance their obligations at lower rates. Prepayment of
assets carrying higher rates reduces interest income and overall asset yields.
Fluctuating interest rates and prepayment risk provide a challenge in managing
the net interest income of the Bank. For example: the Bank may fund a 15 year
fixed rate residential real estate loan with a long term amortizing Federal Home
Loan Bank Advance. In a stable interest rate environment, the Bank can
reasonably predict the net interest income earned. However, if rates fall
significantly, the residential mortgage customer may refinance their mortgage at
a lower rate. The Bank continues to pay the higher rate on the Federal Home Loan
Bank advance, thus eroding net interest income. In an alternative scenario, the
Bank funds the same 15 year fixed rate residential real estate loan with 1 year
certificates of deposits. If rates rise at the end of one year, the Bank will
pay more interest to continue to fund the residential mortgage loan with 1 year
certificates of deposit. The net interest income will be lower in year two than
it was in the first year of the mortgage loan.
14
COMMERCIAL NATIONAL FINANCIAL CORPORATION
An additional challenge management faces in managing net interest income is the
fact that what would maximize net interest income to the Bank may be in conflict
with the customers request for products and services. In the current low
interest rate environment, management has greater concern that interest rates
will rise significantly over time rather than fall. Management would prefer to
offer variable rate loan products that would reprice upward as interest rates
rise. However, our loan customers are generally requesting long term fixed rate
loans. On the funding side, management would like to extend the maturities of
its liabilities to match the loan customers request for longer term fixed rate
loans. However, our deposit customers are reluctant to commit to long term
certificate of deposits.
Commercial's primary tool in measuring interest rate risk is to perform a
simulation analysis. This analysis forecasts the effect of various interest rate
changes on the balance sheet, economic value of equity, net interest income and
net income. One common scenario performed by the Committee is to "shock" the
balance sheet by assuming that Commercial has just experienced an immediate and
parallel shift in the yield curve up or down 200 basis points. The model, using
data and assumptions determined by management, reprice assets and liabilities at
new market rates. The objective of this testing is to determine how the Bank's
net interest income and the economic value of equity are affected by extreme
changes in interest rates. These results are recorded and compared to previous
results. Management performs this calculation quarterly.
The limitation to this methodology is that the interest rate curve rarely shifts
200 basis points immediate and parallel. In addition, a downward 200 basis point
shift in today's interest rate environment is not likely. Management is in the
process of evaluating software that would allow for comparison of alternative
interest rate scenarios, and provide management with better information to
assess alternative funding and investing strategies.
The Table below summarizes the effect a 200 basis point immediate and parallel
shift of the yield curve has on net income. Net income may decrease in both a
falling and rising interest rate environment. In a falling interest rate
environment, management does not have the ability to lower deposit rates 200
basis points to offset a decrease in rates on earning assets. Therefore, if
rates decreased 200 basis points, margin would likely compress resulting in
lower net interest income. In a rising interest rate environment, the duration
of earning assets would most likely extend and money currently invested in short
term liabilities would benefit from the increase in rates. It is possible that
in this scenario, net interest income would also decrease. Though the interest
rate risk associated with a rising interest rate environment has increased,
management believes the risk is still acceptable.
Projected Percentage Change in Net Income
June 30, 2003 December 31, 2002 June 30, 2002
- --------------------------------------------------------------------------------
- -200 basis points (6.98)% (3.50)% (0.03)%
0 basis points 0.00 0.00 0.00
+200 basis points (14.58) (12.22) (4.79)
15
COMMERCIAL NATIONAL FINANCIAL CORPORATION
ITEM 4. CONTROLS AND PROCEDURES
(a) Evaluation of disclosure controls and procedures--Jeffrey S. Barker,
the Corporation's Principal Executive Officer, and Patrick G. Duffy,
the Corporation's Principal Financial Officer, have reviewed and
evaluated the effectiveness of the Corporation's disclosure controls
and procedures (as defined in Rules 240.13a-15(e) and 15d-15(e) under
the Securities Exchange Act of 1934 (the "Exchange Act)) as of a date
within ninety days before the filing date of this quarterly report.
Based on their evaluation, they have concluded that the Corporation's
disclosure controls and procedures are effective, providing them with
material information relating to the Corporation as required to be
disclosed in the reports the Corporation files or submits under the
Exchange Act on a timely basis.
(b) Changes in internal controls--There were no significant changes in the
Corporation's internal controls or in other factors that could
significantly affect the Corporation's disclosure controls and
procedures subsequent to the date of the evaluation, nor were there any
significant deficiencies or material weaknesses in the Corporation's
internal controls.
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.
16
COMMERCIAL NATIONAL FINANCIAL CORPORATION
PART II. OTHER INFORMATION
Item 4 Submission of Matters to a Vote of Security Holders
Commercial National Financial Corporation held its annual meeting of
shareholders on April 22, 2003. A total of 3,316,147 shares were represented in
person or by proxy, or more than 86.9% of the total shares outstanding.
Proposal: Shareholders elected 10 Director nominees named in the Proxy
Statement.
Name For Against
- --------------------------------------------------------------------
Richard F. Abbott 3,308,931 72,160
Jefferson P. Arnold 3,308,931 72,160
Jeffrey S. Barker 3,308,931 72,160
Don J. Dewey 3,308,931 72,160
Patrick G. Duffy 3,308,931 72,160
David A. Ferguson 3,308,931 72,160
Paul B. Luneack 3,308,931 72,160
Kim C. Newson 3,308,407 72,684
Howard D. Poindexter 3,308,931 72,160
Scott E. Sheldon 3,305,107 75,984
ITEM 6 EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
31.1 Certification of Chief Executive Officer
31.2 Certification of Chief Financial Officer
32 Certification of Chief Executive Officer and Chief
Financial Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
(b) Report on Form 8-K
Current report on Form 8-K dated May 30, 2003 filed
with the Security and Exchange Commission on June 3,
2003
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: August 13, 2003 /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
18
10-Q EXHIBIT INDEX
EXHIBIT NO. DESCRIPTION
EX-31.1 Certification of Chief Executive Officer pursuant to Section 302
EX-31.2 Certification of Chief Financial Officer pursuant to Section 302
EX-32 Certification pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002