U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] Quarterly Report under Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the quarterly period ended September 30, 2002
[ ] Transition Report under Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the transition period from ____________ to _____________
Commission file number: 0-24159
MIDDLEBURG FINANCIAL CORPORATION
(Exact Name of Registrant as Specified in its Charter)
Virginia 54-1696103
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
111 West Washington Street
Middleburg, Virginia 20117
(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code (703) 777-6327
Indicate by check mark whether the registrant: (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Exchange Act 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
--- ---
Indicate the number of shares outstanding of each of the issuer's
classes of common stock, as of the latest practicable date:
1,852,682 shares of common stock, par value $5.00 per share,
outstanding as of November 1, 2002
MIDDLEBURG FINANCIAL CORPORATION
INDEX
Part I. Financial Information Page No.
Item 1. Financial Statements
Consolidated Balance Sheets 3
Consolidated Statements of Income 4
Consolidated Statements of Changes in Shareholders'
Equity 5
Consolidated Statements of Cash Flows 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Results of
Operations and Financial Condition 12
Item 3. Quantitative and Qualitative Disclosures About
Market Risk 17
Item 4. Controls and Procedures 18
Part II. Other Information
Item 1. Legal Proceedings 20
Item 2. Change in Securities and Use of Proceeds 20
Item 3. Defaults upon Senior Securities 20
Item 4. Submission of Matters to a Vote of Security Holders 20
Item 5. Other Information 20
Item 6. Exhibits and Reports on Form 8-K 20
Signatures 21
2
PART I. FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
MIDDLEBURG FINANCIAL CORPORATION
Consolidated Balance Sheets
(In Thousands, Except Share Data)
(Unaudited)
September 30, December 31,
2002 2001
------------- ------------
Assets:
Cash and due from banks $ 14,876 $ 10,053
Interest-bearing balances in banks 278 200
Temporary investments:
Federal funds sold 9,000 925
Other money market investments 1,277 1,797
Securities (fair value: September 30, 2002,
$145,743 , December 31, 2001, $124,522 ) 145,452 124,351
Loans held for sale 12,567 6,652
Loans, net of allowances for loan losses of $2,240 in 2002
and $2,060 in 2001 207,278 194,340
Bank premises and equipment, net 11,768 8,069
Other assets 11,704 7,714
--------- ---------
Total assets $ 414,200 $ 354,101
========= =========
Liabilities and Shareholders' Equity
Liabilities:
Deposits:
Non-interest bearing demand deposits 85,784 68,771
Savings and interest-bearing demand deposits 130,752 111,148
Time deposits 99,340 91,812
--------- ---------
Total deposits $ 315,876 $ 271,731
Securities sold under agreements to
repurchase $ 13,386 $ 12,011
Federal Home Loan Bank Advances - 7,000
Long-term debt 31,610 20,805
Trust preferred debt 10,000 10,000
Other liabilities 3,550 2,216
--------- ---------
Total liabilities $ 374,422 $ 323,763
--------- ---------
Shareholders' Equity
Common stock par value $5.00 per
share, authorized 10,000,000 shares;
issued and outstanding at September 30, 2002 - 1,846,607
issued and outstanding at December 31, 2001 - 1,752,258 $ 9,263 $ 8,761
Capital surplus 3,433 741
Retained earnings 24,272 21,084
Accumulated other comprehensive income (loss) 2,810 (248)
--------- ---------
Total shareholders' equity $ 39,778 $ 30,338
--------- ---------
Total liabilities and shareholders' equity $ 414,200 $ 354,101
========= =========
See Accompanying Notes to Consolidated Financial Statements.
3
MIDDLEBURG FINANCIAL CORPORATION
Consolidated Statements of Income
(In Thousands, Except Per Share Data)
Unaudited Unaudited
------------------------------------------
For the Nine Months For the Quarter
Ended September 30, Ended September 30,
2002 2001 2002 2001
--------- --------- -------- ---------
Interest Income
Interest and fees on loans $ 12,153 $ 12,197 $ 4,131 $ 4,149
Interest on investment securities
Taxable 3 17 1 5
Exempt from federal income taxes 183 226 58 72
Interest on securities available for sale
Taxable 3,998 2,157 1,391 784
Exempt from federal income taxes 1,182 1,199 389 407
Dividends 179 208 39 65
Interest on federal funds sold and other 67 169 20 37
--------- -------- --------- ---------
Total interest income $ 17,765 $ 16,173 $ 6,029 $ 5,519
--------- -------- --------- ---------
Interest Expense
Interest on deposits $ 3,188 $ 4,519 $ 1,019 $ 1,479
Interest on long-term debt 1,153 759 173 294
Interest on short-term borrowings 587 798 446 192
--------- -------- --------- ---------
Total interest expense $ 4,928 $ 6,076 $ 1,638 $ 1,965
--------- -------- --------- ---------
Net interest income $ 12,837 $ 10,097 $ 4,391 $ 3,554
Provision for loan losses 225 225 75 75
--------- -------- --------- ---------
Net interest income after provision
for loan losses $ 12,612 $ 9,872 $ 4,316 $ 3,479
--------- -------- --------- ---------
Other Income
Trust and investment advisory fee income $ 1,934 $ 976 $ 796 $ 319
Service charges on deposit accounts 1,344 1,063 522 352
Net gains (losses) on securities
available for sale (78) 312 (31) 66
Fees on loans held for sale 1,310 1,028 564 454
Other operating income 472 451 179 129
--------- -------- --------- ---------
Total other income $ 4,982 $ 3,830 $ 2,030 $ 1,320
--------- -------- --------- ---------
Other Expense
Salaries and employee benefits $ 6,618 $ 5,189 $ 2,487 $ 1,761
Net occupancy expense of premises 1,245 872 495 291
Other operating expenses 2,707 2,215 986 823
Advertising 327 224 89 54
--------- -------- --------- ---------
Total other expense $ 10,897 $ 8,500 $ 4,057 $ 2,929
--------- -------- --------- ---------
Income before income taxes $ 6,697 $ 5,202 $ 2,289 $ 1,870
Income taxes 1,855 1,322 647 481
--------- -------- --------- ---------
Net income $ 4,842 $ 3,880 $ 1,642 $ 1,389
========= ======== ========= =========
Earnings per weighted average share:
Earnings per share, basic $ 2.68 $ 2.22 $ 0.89 $ 0.79
Earnings per share, diluted $ 2.61 $ 2.18 $ 0.87 $ 0.77
Dividends per share $ 0.90 $ 0.75 $ 0.30 $ 0.25
See Accompanying Notes to Consolidated Financial Statements.
4
MIDDLEBURG FINANCIAL CORPORATION
Consolidated Statement of Changes in Shareholders' Equity
For the Nine Months ended September 30, 2002 and 2001
(In Thousands)
(Unaudited)
Accumulated
Other
Common Capital Retained Comprehensive Comprehensive
Stock Surplus Earnings Income (Loss) Income Total
--------- -------- -------- ------------ ----------- -------
Balances - December 31, 2000 $ 8,696 $ 556 $ 17,616 $ 403 $ - $27,271
Comprehensive Income
Net income 3,880 3,880 -
Issuance of common shares in stock
option plan (13,011 shares) 65 185 250
Other comprehensive income
net of tax:
Unrealized gain on available for
sale securities (net of tax $452) 873
Reclassification adjustment for
gains realized in net income (net of tax $106) (206)
-------
Other comprehensive income (net of tax $346) 667 667 667
-------
Total comprehensive income $ 4,547
=======
Cash dividends declared (1,311) (1,311)
------- ------- --------- -------- --------
Balances - September 30, 2001 $ 8,761 $ 741 $ 20,185 $ 1,070 $26,877
======= ======= ========= ========= =======
Balances - December 31, 2001 $ 8,761 $ 741 $ 21,084 $ (248) $ - $30,338
Net income 4,842 4,842 4,842
Issuance of common stock (100,424 shares) 502 2,692 3,194
Other comprehensive income net of tax:
Unrealized gains on available for sale
securities (net of tax $1,548) 3,007
Reclassification adjustment for
losses realized in net income (net of tax $27) 51
----------
Other comprehensive income (net of tax $1,575) 3,058 3,058 3,058
----------
Total comprehensive income $ 7,900
Cash dividends declared (1,654) ========== (1,654)
------- ------- --------- -------- --------
Balances - September 30, 2002 $ 9,263 $ 3,433 $ 24,272 $ 2,810 $39,778
======= ======= ========= ========= =======
See Accompanying Notes to Consolidated Financial Statements.
5
MIDDLEBURG FINANCIAL CORPORATION
Consolidated Statements of Cash Flows
(In Thousands)
Unaudited
For the Nine Months Ended
----------------------------------
September 30, September 30,
2002 2001
----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 4,842 $ 3,880
Adjustments to reconcile net income to net cash provided by (used in)
operating activities
Provision for loan losses 225 225
Depreciation and amortization 866 564
Net (gains) losses on securities available for sale 78 (312)
Net (gains) losses on sales of equipment (3) 3
Discount accretion and premium amortization on securities, net (76) (105)
Originations of loans held for sale (85,297) (64,035)
Proceeds from sales of loans held for sale 79,382 55,356
Decrease (increase) in other assets 126 (2,136)
Increase in other liabilities 51 1,149
----------- --------
Net cash provided by (used in) operating activities $ 194 $ (5,411)
----------- --------
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from maturity, principal paydowns and calls on investment
securities $ 896 987
Proceeds from maturity, principal paydowns and
calls of securities available for sale 11,147 5,984
Proceeds from sale of securities available for sale 19,572 20,426
Purchase of securities available for sale (48,084) (42,335)
Purchase of subsidiary (1,240) -
Net (increase) in loans (14,163) (17,459)
Proceeds from sale of bank premises and equipment 31 34
Purchases of bank premises and equipment (4,379) (1,552)
------------ ---------
Net cash (used in) investing activities $ (36,220) $ (33,915)
------------ ---------
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in demand deposits, NOW accounts, and savings accounts $ 29,482 $ 19,506
Net increase in certificates of deposits 14,663 13,794
Proceeds from Federal Home Loan Bank advances 87,000 49,100
Payment on Federal Home Loan Bank advances (94,000) (44,100)
Proceeds from long term debt 11,000 -
Payments on long-term debt (195) (430)
Cash dividends paid (1,538) (1,238)
Issuance of common stock 695 250
Increase (decrease) in securities sold under agreement to repurchase 1,375 (557)
----------- ---------
Net cash provided by financing activities $ 48,482 $ 36,325
----------- ---------
Increase (decrease) in cash and cash equivalents $ 12,456 $ (3,001)
CASH AND CASH EQUIVALENTS
Beginning $ 12,975 $ 17,147
=========== =========
Ending $ 25,431 $ 14,146
=========== =========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash payments for:
Interest paid 5,118 4,596
Income taxes 1,774 1,567
SUPPLEMENTAL DISCLOSURES FOR NON-CASH
INVESTING AND FINANCING ACTIVITIES
Unrealized gain on securities available for sale 4,633 1,013
Stock issuance for purchase of subsidiary 2,500 -
Note receivable forgiven in connection with purchase of subsidiary 1,000 -
Exercise of option to purchase subsidiary 1,200 -
See Accompanying Notes to Consolidated Financial Statements.
6
MIDDLEBURG FINANCIAL CORPORATION
Notes to Consolidated Financial Statements
For the Nine Months Ended September 30, 2002 and 2001
(Unaudited)
Note 1.
In the opinion of management, the accompanying unaudited financial
statements contain all adjustments (consisting of only normal recurring
accruals) necessary to present fairly the financial position as of September 30,
2002 and the results of operations and changes in cash flows for the three and
nine months ended September 30, 2002 and 2001. The statements should be read in
conjunction with the Notes to Consolidated Financial Statements included in the
Company's Annual Report on Form 10-KSB for the year ended December 31, 2001. The
results of operations for the three-month and nine-month periods ended September
30, 2002 and 2001 are not necessarily indicative of the results to be expected
for the full year.
Note 2. Securities
Securities being held to maturity as of September 30, 2002 are
summarized as follows:
---------------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Market
Cost Gains (Losses) Value
---------------------------------------------------------
(In Thousands)
Obligations of states and
political subdivisions $ 4,592 $ 291 $ - $ 4,883
Mortgaged backed securities 54 - - 54
-------- ---------- ------- ---------
$ 4,646 $ 291 $ - $ 4937
======== ========== ======= =========
7
Securities available for sale as of September 30, 2002 are summarized
below:
------------------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Market
Cost Gains (Losses) Value
------------------------------------------------------------
(In Thousands)
U.S. Treasury securities
and obligations of U.S.
government corporations
and agencies $ 249 26 $ - $ 275
Corporate securities 2,224 77 (35) 2,266
Obligations of states and
political subdivisions 31,444 1,721 - 33,165
Mortgaged backed securities 89,216 2,673 (6) 91,883
Other 13,411 177 (371) 13,217
--------- --------- --------- ---------
$ 136,544 $ 4,674 $ (412) $ 140,806
========= ========= ========= =========
Note 3.
The consolidated loan portfolio is composed of the following:
--------------------------------
September 30, December 31,
2002 2001
-------------------------------
(In Thousands)
Commercial, financial and agricultural $ 21,493 $ 22,993
Real estate construction 19,821 24,174
Real estate mortgage 156,537 137,332
Installment loans to individuals 11,667 11,901
Total loans 209,518 196,400
Less: Allowance for loan losses 2,240 2,060
Loans, net $207,278 $194,340
The Company had $633,000 in non-performing assets at September 30,
2002.
8
Note 4. Allowance for Loan Losses
The following is a summary of transactions in the allowance for loan
losses:
----------------------------------
September 30, December 31,
2002 2001
----------------------------------
----------------------------------
(In Thousands)
Balance at January 1 $ 2,060 $ 1,804
Provision charged to operating expense 225 300
Recoveries 16 39
Charge offs (61) (83)
------- -------
Balance at the end of the period $ 2,240 $ 2,060
======= =======
Note 5. Earnings Per Share
The following tables show the weighted average number of shares used in
computing earnings per share and the effect on the weighted average number of
shares of potential dilutive common stock. Potential dilutive common stock has
no effect on income available to common shareholders.
For the Nine Months Ended
September 30, 2002 September 30, 2001
Per share Per share
Shares Amount Shares Amount
----------------------------------------------------------
Basic EPS 1,810,048 $ 2.68 1,744,013 $ 2.22
------- ---------
Effect of dilutive
securities:
stock options 44,787 36,075
--------- ---------
Diluted EPS 1,854,835 $ 2.61 1,780,088 $ 2.18
========= ======= ========= =========
For the Quarter Ended
September 30, 2002 September 30, 2001
Per share Per share
Shares Amount Shares Amount
----------------------------------------------------------
Basic EPS 1,852,602 $ 0.89 1,752,258 $ 0.79
========== ==========
Effect of dilutive
securities:
stock options 32,225 44,332
--------- ---------
Diluted EPS 1,884,827 $ 0.87 1,796,590 $ 0.77
==========================================================
9
Note 6. Derivative Financial Instruments
Interest rate swap agreements:
During May 2000, the Company entered into two agreements to assume
variable market-indexed interest payments in exchange for fixed-rate interest
payments (interest rate swaps). The agreements matured on May 15, 2002. The
notional principal amount of interest rate swaps outstanding during the contract
period was $8,525,000. The original term to maturity was 24 months. The
weighted-average fixed payment rate received was 7.0% during the life of the
agreement period. Variable interest payments were based on three-month LIBOR.
The effect of these agreements was to transform fixed rate liabilities to
variable rate liabilities. The net income from these agreements was $169,774 for
the nine-month period ended September 30, 2002, which was charged to income as
it accrued.
Note 7. Recent Accounting Pronouncements
In April 2002, the Financial Accounting Standards Board issued
Statement 145, Rescission of FASB No. 4, 44, and 64, Amendment of FASB Statement
No. 13, and Technical Corrections. This Statement rescinds FASB Statement No. 4,
Reporting Gains and Losses from Extinguishment of Debt, and an amendment of that
Statement, FASB Statement No. 64, Extinguishments of Debt Made to Satisfy
Sinking-Fund Requirements. This Statement also rescinds FASB Statement No. 44,
Accounting for Intangible Assets of Motor Carriers. This Statement amends FASB
Statement No. 13, Accounting for Leases, to eliminate an inconsistency between
the required accounting for sale-leaseback transactions and the required
accounting for certain lease modifications that have economic effects that are
similar to sale-leaseback transactions. This Statement also amends other
existing authoritative pronouncements to make various technical corrections,
clarify meanings, or describe their applicability under changed conditions. The
provisions of this Statement related to the rescission of Statement 4 shall be
applied in fiscal years beginning after May 15, 2002. The provisions of this
Statement related to Statement 13 are effective for transactions occurring after
May 15, 2002, with early application encouraged.
In June 2002, the Financial Accounting Standards Board issued Statement
146, Accounting for Costs Associated with Exit or Disposal Activities. This
Statement addresses financial accounting and reporting for costs associated with
exit or disposal activities and nullifies Emerging Issues Task Force (EITF)
Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits
and Other Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring)." The standard requires companies to recognize costs associated
with exit or disposal activities when they are incurred rather than at the date
of a commitment to an exit or disposal plan. The provisions of this Statement
are effective for exit or disposal activities that are initiated after December
31 2002, with early application encouraged.
The Financial Accounting Standards Board issued Statement No. 147,
Acquisitions of Certain Financial Institutions, an Amendment of FASB Statements
No. 72 and 144 and FASB Interpretation No. 9 in October 2002. FASB Statement No.
72, Accounting for Certain Acquisitions of Banking or Thrift Institutions, and
FASB Interpretation No. 9, Applying APB Opinions No. 16 and 17, When a Savings
and Loan Association or a Similar Institution Is Acquired in a Business
Combination Accounted for by the Purchase Method, provided interpretive guidance
on the application of the purchase method to acquisitions of financial
institutions. Except for transactions between two or more mutual enterprises,
this Statement removes acquisitions of financial institutions from the scope of
both Statement 72 and Interpretation 9 and requires that those transactions be
accounted for in accordance with FASB Statements No. 141, Business Combinations,
and No. 142, Goodwill and Other Intangible Assets. Thus, the requirement in
paragraph 5 of Statement 72 to recognize (and subsequently amortize) any excess
of the fair value of liabilities assumed over the fair value of tangible and
identifiable intangible assets
10
acquired as an unidentifiable intangible asset no longer applies to acquisitions
within the scope of this Statement. In addition, this Statement amends FASB
Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived
Assets, to include in its scope long-term customer-relationship intangible
assets of financial institutions such as depositor- and borrower-relationship
assets and credit cardholder intangible assets. Consequently, those intangible
assets are subject to the same undiscounted cash flow recoverability test and
impairment loss recognition and measurement provisions that Statement 144
requires for other long-lived assets that are held and used.
Paragraph 5 of this Statement, which relates to the application of the
purchase method of accounting, is effective for acquisitions for which the date
of acquisition is on or after October 1, 2002. The provisions in paragraph 6
related to accounting for the impairment or disposal of certain long-term
customer-relationship intangible assets are effective on October 1, 2002.
Transition provisions for previously recognized unidentifiable intangible assets
in paragraphs 8-14 are effective on October 1, 2002, with earlier application
permitted.
This Statement clarifies that a branch acquisition that meets the
definition of a business should be accounted for as a business combination,
otherwise the transaction should be accounted for as an acquisition of net
assets that does not result in the recognition of goodwill.
The transition provisions state that if the transaction that gave rise
to the unidentifiable intangible asset was a business combination, the carrying
amount of that asset shall be reclassified to goodwill as of the later of the
date of acquisition or the date Statement 142 was first applied (fiscal years
beginning after December 15, 2001). Any previously issued interim statements
that reflect amortization of the unidentifiable intangible asset subsequent to
the Statement 142 application date shall be restated to remove that amortization
expense. The carrying amounts of any recognized intangible assets that meet the
recognition criteria of Statement 141 that have been included in the amount
reported as an unidentifiable intangible asset and for which separate accounting
records have been maintained shall be reclassified and accounted for as assets
apart from the unidentifiable intangible asset and shall not be reclassified to
goodwill. The adoption of theses standards will not have a material impact on
the company's financial statements.
Note 8. Acquisition of Subsidiary
On August 9, 1999, the Company purchased one percent of the issued and
outstanding capital stock of Gilkison Patterson Investment Advisors, Inc.
("GPIA"), an investment advisory firm based in Alexandria, Virginia. The Company
also acquired the right to purchase all of the remaining authorized, issued and
outstanding shares of GPIA capital stock on or after July 1, 2001. This option
was extended through June 30, 2002. On April 1, 2002, the Company completed the
acquisition of GPIA. The terms of the transaction include a total purchase price
of $6 million, which included 59,874 shares ($2.5 million value) of the
Company's common stock issued to the shareholders of GPIA. Based on a purchase
price valuation, the Company allocated approximately 61% of the purchase price
to identified intangibles with a weighted-average life of 12.5 years. The
remaining 39% of the purchase price has been treated as goodwill.
11
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
Critical Accounting Policies
The financial condition and results of operations presented in the
Consolidated Financial Statements, accompanying Notes to the Consolidated
Financial Statements and management's discussion and analysis are, to a large
degree, dependent upon the accounting policies of Middleburg Financial
Corporation (the "Company"). The selection and application of these accounting
policies involve judgments, estimates, and uncertainties that are susceptible to
change.
Presented below is discussion of those accounting policies that
management believes are the most important (Critical Accounting Policies) to the
portrayal and understanding of the Company's financial condition and results of
operations. These Critical Accounting Policies require management's most
difficult, subjective and complex judgments about matters that are inherently
uncertain. In the event that different assumptions or conditions were to
prevail, and depending upon the severity of such changes, the possibility of
materially different financial condition or results of operations is a
reasonable likelihood. See also Note 1 of the Notes to Consolidated Financial
Statements in the Company's Annual Report on Form 10-KSB for the year ended
December 31, 2002 (the "Form 10-KSB").
Allowance for Loan Losses
The Company monitors and maintains an allowance for loan losses to
absorb an estimate of probable losses inherent in the loan and lease portfolio.
The Company maintains policies and procedures that address the systems of
controls over the following areas of maintenance of the allowance: the
systematic methodology used to determine the appropriate level of the allowance
to provide assurance they are maintained in accordance with accounting
principles generally accepted in the United States of America; the accounting
policies for loan charge-offs and recoveries; the assessment and measurement of
impairment in the loan and lease portfolio; and the loan grading system.
The Company evaluates various loans individually for impairment as
required by Statement of Financial Accounting Standard (SFAS) No. 114,
Accounting by Creditors for Impairment of a Loan, and SFAS No. 118, Accounting
by Creditors for Impairment of a Loan - Income Recognition and Disclosures.
Loans evaluated individually for impairment include non-performing loans, such
as loans on non-accrual, loans past due by 90 days or more, restructured loans
and other loans selected by management. The evaluations are based upon
discounted expected cash flows or collateral valuations. If the evaluation shows
that a loan is individually impaired, then a specific reserve is established for
the amount of impairment. If a loan evaluated individually is not impaired, then
the loan is assessed for impairment under SFAS No. 5, Accounting for
Contingencies (SFAS 5), with a group of loans that have similar characteristics.
For loans without individual measures of impairment, the Company makes
estimates of losses for groups of loans as required by SFAS 5. Loans are grouped
by similar characteristics, including the type of loan, the assigned loan grade
and the general collateral type. A loss rate reflecting the expected loss
inherent in a group of loans is derived based upon estimates of default rates
for a given loan grade, the predominant collateral type for the group and the
terms of the loan. The resulting estimate of losses for groups of loans are
adjusted for relevant environmental factors and other conditions of the
portfolio of loans and leases, including: borrower and industry concentrations;
levels and trends in delinquencies, charge-offs and recoveries; changes in
underwriting standards and risk selection; level of experience, ability and
depth of lending management; and national and local economic conditions.
12
The amount of estimated impairment for individually evaluated loans and
groups of loans is added together for a total estimate of loans and lease
losses. This estimate of losses is compared to the allowance for loan and lease
losses of the Company as of the evaluation date and, if the estimate of losses
is greater than the allowance, an additional provision to the allowance would be
made. If the estimate of losses is less than the allowance, the degree to which
the allowance exceeds the estimate is evaluated to determine whether the
allowance falls outside a range of estimates. If the estimate of losses is below
the range of reasonable estimates, the allowance would be reduced by way of a
credit to the provision for loan losses. The Company recognizes the inherent
imprecision in estimates of losses due to various uncertainties and variability
related to the factors used, and therefore a reasonable range around the
estimate of losses is derived and used to ascertain whether the allowance is too
high. If different assumptions or conditions were to prevail and it is
determined that the allowance is not adequate to absorb the new estimate of
probable losses, an additional provision for loan losses would be made, which
amount may be material to the Consolidated Financial Statements.
Valuation of Derivatives
The Company maintains an overall interest rate risk management strategy
that incorporates the use of derivative financial instruments. The Company has
used derivative financial instruments only for asset/liability management
through the hedging of a specific transaction or position, and not for trading
or speculative purposes.
Management believes that the risk associated with using derivative
financial instruments to mitigate interest rate risk sensitivity is minimal and
should not have any material unintended impact on the Company's financial
condition or results of operations. See further information regarding
derivatives in Note 6 (page 9) of the Notes to Consolidated Financial
Statements in the Company's Form 10-KSB.
Intangibles and Goodwill
The Company has approximately $7.1 million in intangible assets and
goodwill at September 30, 2002, an increase of $6.1 million since December 31,
2001. The increase is associated with the April 1, 2002 acquisition of Gilkison
Patterson Investment Advisors, Inc. ("GPIA"), a registered investment advisor.
In connection with this investment, a purchase price valuation (using FAS 141
and 142 as a guideline) was completed to determine the appropriate allocation to
identified intangibles. The valuation concluded that approximately 42% of the
purchase price was related to the acquisition of customer relationships with an
amortizable life of 15 years. Another 19% of the purchase price was allocated to
a non-compete agreement with an amortizable life of 7 years. The remainder of
the purchase price has been allocated to goodwill.
The purchase price allocation process requires management estimates and
judgment as to expectations for the life span of various customer relationships
as well as the value that key members of management add to the success of the
Company. For example, customer attrition rates were determined based upon
assumptions that the past five years may predict the future. If the actual
attrition rates, among other assumptions, differed from the estimates and
judgments used in the purchase price allocation, the amounts recorded in the
financial statements could result in a possible impairment of the intangible
assets and goodwill or require an acceleration in the amortization expense.
In addition, FAS 142 requires that goodwill be tested annually using a
two-step process. The first step is to identify a potential impairment. The
second step measures the amount of the impairment loss, if any. Processes and
procedures have been identified for the two-step process.
13
When the Company completes its ongoing review of the recoverability of
intangible assets and goodwill, factors that are considered important to
determining whether an impairment might exist include loss of customers acquired
or significant withdrawals of the assets currently under management and/or early
retirement or termination of key members of management. Any changes in the key
management estimates or judgments could result in an impairment charge, and such
a charge could have an adverse effect on the Company's financial condition and
results of operations.
Financial Summary
Net income for the nine months ended September 30, 2002 increased 24.8%
to $4.8 million or $2.60 per diluted share compared to $3.9 million or $2.18 per
diluted share for the first nine months of 2001. Annualized returns on average
assets and equity for the nine months ended September 30, 2002 were 1.7% and
18.3%, respectively, compared to 1.7% and 17.5% for the same period in 2001.
Total assets for the Company increased to $414.2 million at September
30, 2002 compared to $354.1 million at December 31, 2001, representing an
increase of $60.1 million or 17.0%. Total loans at September 30, 2002 were
$207.3 million, an increase of $13.0 million from the December 31, 2001 balance
of $194.3 million. The Company is located in one of the fastest growing counties
and metropolitan areas in the United States. In addition, the Company has
increased its customer base as a result of increased advertising and
consolidation in the banking industry within its local market. These factors
have contributed to the solid loan and deposit growth experienced over the past
year. However, decreased loan demand and increased loan prepayments as a result
of the current business cycle rather than increased competition hampered loan
growth in the third quarter of 2002.
The investment portfolio increased 17.0% to $145.5 million at September
30, 2002 compared to $124.4 million at December 31, 2001. Deposits increased
$44.2 million to $315.9 million at September 30, 2002 from $271.7 million at
December 31, 2001. Growth in the demand and low interest bearing transactional
accounts of $17.0 million and $19.6 million, respectively, accounts for the
majority of the increase during the first nine months of 2002. While the Company
has experienced significant growth in the balances within the low cost deposit
categories, management believes that the growth is more related to an increase
in the number of accounts and relationships with new clients rather than an
existing client's decision to shift money from personal investments in stocks.
Time deposits increased $7.5 million since December 31, 2001 to $99.3 million.
As of September 30, 2002, the Company had approximately $10.0 million of
municipal deposits that were expected to be withdrawn within the fourth quarter.
Securities sold under agreements to repurchase with commercial checking accounts
increased $1.4 million from $12.0 million at December 31, 2001 to $13.4 million
at September 30, 2002.
Shareholders' equity was $39.8 million at September 30, 2002. This
amount represents an increase of 31.4% from the December 31, 2001 balance of
$30.3 million. The majority of the increase resulted from the shares of common
stock issued by the Company for the acquisition of GPIA on April 1, 2002 and
retained earnings. The company issued 59,874 shares of common stock for the
acquisition. The book value per common share was $21.71 at September 30, 2002
and $17.31 at December 31, 2001.
Net Interest Income
Net interest income is the Company's primary source of earnings and
represents the difference between interest and fees earned on earning assets and
the interest expense paid on deposits and other interest bearing liabilities.
Net interest income totaled $12.8 million for the first nine months of 2002
compared to $10.1 million for the same period in 2001. Average earning assets
increased $70.3 million from $282.6 million at September 30, 2001 to $352.9
million at September 30, 2002. Accordingly, interest income increased 9.8%
compared to the nine month period ended September 30, 2001. The
14
Company continues to experience a majority of its funding growth in its
lower-cost deposit products. Average deposits increased $54.7 million from
$234.0 million at September 30, 2001 to $289.0 million at September 30, 2002.
Increases in lower cost deposit products combined with the lower interest rate
environment resulted in a 18.9% decrease in interest expense for the nine months
ended September 30, 2002 compared to the same period in 2001.
The net interest margin was 5.09% for the nine months ended September
30, 2002 compared to 5.13% for the same period in 2001. The net interest margin
for the third quarter of 2002 declined 23 basis points compared to the second
quarter of 2002. The decline stems from significant prepayments in both the
investment and loan portfolio which are being reinvested in lower yields.
During the third quarter of 2002, net interest income increased
$101,000 to $4.4 million compared to $4.3 million for the second quarter of
2002. The increase in net interest income is attributed to the growth in average
earning assets offset slightly by a decrease in the net interest margin.
Noninterest Income
Noninterest income (excluding net gains (losses) on securities
available for sale) increased 43.8% to $5.1 million for the first nine months of
2002 compared to $3.5 million for the same period in 2001. Noninterest income
increased approximately $246,000 during the third quarter of 2002 compared to an
increase of $158,000 during the third quarter of 2001. Mortgage refinancings and
purchases have remained strong in the local market and have provided significant
volume increases in mortgage fees on loans held for sale. Fees on loans held for
sale increased 27.4% to $1.3 million at September 30, 2002 from $1.0 million at
September 30, 2001. Service charges on deposit accounts for the first nine
months of 2002 totaled $1.3 million compared to $1.1 million for the same period
in 2001, an increase of 26.3%. Commissions and fees from trust and investment
advisory activities were $903,000 for the nine-month period ended September 30,
2002 compared to $976,000 for the same period in 2001. GPIA, the Company's
newest subsidiary, contributed $1.0 million in gross fees to the fees from trust
and investment advisory activities total. Investment advisory fees and trust
fees are based primarily upon the market value of the accounts under management
or administration. Investment advisory fees are the result of a style of
investing that is primarily focused on fixed income products. Trust fees are the
result of a style of investing that is primarily focused on equity products. The
stock market declines have been the only contributor to the decline in trust
fees in 2002.
Noninterest Expense
Total noninterest expense includes employee-related costs, occupancy
and equipment expense and other overhead. Total noninterest expense increased
28.2% to $10.9 million for the first nine months of 2002 compared to $8.5
million for the same period in 2001. During the third quarter of 2002,
noninterest expense increased nearly $347,000. The increase during the same
period in 2001 totaled approximately $101,000. The addition of Gilkison
Patterson Investment Advisors accounts for 31.5% of the total increase in
noninterest expense. Salary and benefit expense increased 29.5% from $4.6
million for the nine months ended September 30, 2001 to $5.9 million for the
nine months ended September 30, 2002. The Company has increased its staffing in
both the business development and operations areas to support the significant
asset growth over the past three years. Commissions paid to employees for fee
related business, such as mortgage originations and investment sales have
increased by $153,000 to $688,000 as a result in the increase in sales volume.
Net occupancy expense of premises increased $373,000 from $872,000 for the nine
months ended September 30, 2001 to $1.2 million for the nine months ended
September 30, 2002.
15
To better accommodate the Company's expanding employee base, a two
story, 19,000 square foot operations center was constructed and was placed in
service during June 2002. Nearly half of the Company's employees are now working
in the operations center. In addition to the operations and administrative
staff, the center also houses the Company's mortgage banking operations. The
facility is adjacent to the Company's Leesburg, Virginia branch. Approximately
$2.5 million was spent on the land and construction of the operations center.
A second Leesburg branch opened on July 29, 2002 and had $1.0 million
in deposits at September 30, 2002. Approximately $1.6 million was spent on the
land, building and fixtures of this branch.
Allowance for Loan Losses
The allowance for loan losses at September 30, 2002 was $2.2 million
compared to $2.0 million at September 30, 2001. The provision for loan losses
was unchanged at $225,000 for the nine months ended September 30, 2002, and
September 30, 2001. The allowance for loan losses was 1.07% of total loans
outstanding at September 30, 2002 and 1.04% of total loans outstanding at
September 30, 2001. At September 30, 2002, net loan charge offs totaled $45,000,
compared to a net recovery of $1,000 for the same period in 2001. Total loans
past due 90 days or more at September 30, 2002 were approximately $21,000.
Non-performing loans increased to .30% of total loans outstanding at September
30, 2002 compared to .05% at September 30, 2001. Management believes that the
allowance for loan losses is adequate to cover credit losses inherent in the
loan portfolio at September 30, 2002. Loans classified as loss, doubtful,
substandard or special mention are adequately reserved for and are not expected
to have a material impact beyond what has been reserved.
Capital Resources
Shareholders' equity at September 30, 2002 and December 31, 2001 was
$39.8 million and $30.3 million, respectively. Total common shares outstanding
at September 30, 2002 were 1,852,682.
At September 30, 2002 the Company's tier 1 and total risk-based capital
ratios were 14.8% and 15.6%, respectively, compared to 16.4% and 17.3% at
December 31, 2001. The Company's leverage ratio was 9.8% at September 30, 2002
compared to 12.5% at December 31, 2001. The Company's capital structure places
it above the regulatory guidelines, which affords the Company the opportunity to
take advantage of business opportunities while ensuring that it has the
resources to protect against risk inherent in its business.
Forward-Looking Statements
Certain information contained in this discussion may include
"forward-looking statements" within the meaning of Section 27A of the Securities
Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934,
as amended. These forward-looking statements are generally identified by phrases
such as "the Company expects," "the Company believes" or words of similar
import. Such forward-looking statements involve known and unknown risks
including, but not limited to, changes in general economic and business
conditions, interest rate fluctuations, competition within and from outside the
banking industry, new products and services in the banking industry, risk
inherent in making loans such as repayment risks and fluctuating collateral
values, problems with technology utilized by the Company, changing trends in
customer profiles and changes in laws and regulations applicable to the Company.
Although the Company believes that its expectations with respect to the
forward-looking statements are based upon reliable assumptions within the bounds
of its knowledge of its business and operations, there can be no assurance that
actual results, performance or achievements of the Company
16
will not differ materially from any future results, performance or achievements
expressed or implied by such forward-looking statements.
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
Market and Interest Rate Risk
Market risk is the risk of loss in a financial instrument arising from
adverse changes in market rates or prices such as interest rates, foreign
currency exchange rates, commodity prices and equity prices. The Company's
primary market risk exposure is interest rate risk, though it should be noted
that the assets under management by its trust and investment management
subsidiaries for their clients are affected by equity and bond price risk and
are not considered in the asset/liability management process. The ongoing
monitoring and management of this risk is an important component of the
Company's asset/liability management process, which is governed by policies
established by its Board of Directors that are reviewed and approved annually.
The Board of Directors delegates responsibility for carrying out asset/liability
management policies to the Asset/Liability Committee (ALCO) of the Company's
banking subsidiary, Middleburg Bank. In this capacity, ALCO develops guidelines
and strategies that govern the Company's asset/liability management related
activities, based upon estimated market risk sensitivity, policy limits and
overall market interest rate levels and trends.
Interest rate risk represents the sensitivity of earnings to changes in
market interest rates. As interest rates change, the interest income and expense
streams associated with the Company's financial instruments also change,
affecting net interest income, the primary component of the Company's earnings.
ALCO uses the results of a detailed and dynamic simulation model to quantify the
estimated exposure of net interest income to sustained interest rate changes.
While ALCO routinely monitors simulated net interest income sensitivity over a
rolling two-year horizon, it also employs additional tools to monitor potential
longer-term interest rate risk.
The simulation model captures the impact of changing interest rates on
the interest income received and interest expense paid on all assets and
liabilities reflected on the Company's balance sheet. The simulation model is
prepared and updated four times during each year. This sensitivity analysis is
compared to ALCO policy limits, which specify a maximum tolerance level for net
interest income exposure over a one-year horizon, assuming no balance sheet
growth, given both a 100 and 200 basis point (bp) downward shift in interest
rates and a 200 basis point upward shift. A parallel and pro rata shift in rates
over a 12-month period is assumed. The following reflects the range of the
Company's net interest income sensitivity analysis during the nine months ended
September 30, 2002 as well as the fiscal year of 2001 compared to the 10%
Board-approved policy limit.
For the Nine Months Ended September 30, 2002
Rate Change Estimated Net Interest Income Sensitivity
----------- -----------------------------------------
High Low Average
---- --- -------
+ 200 bp (2.51%) (1.31%) (2.00%)
- 200 bp 2.62% 2.62% 2.62%
- 100 bp 1.24% 0.81% 1.43%
17
For the Year Ended December 31, 2001
Rate Change Estimated Net Interest Income Sensitivity
----------- -----------------------------------------
High Low Average
---- --- -------
+ 200 bp (2.21%) (.32%) (1.32%)
- 200 bp 3.24% 1.57% 2.44%
Since December 31, 2001, the company's balance sheet has grown by $60.1
million. Deposit inflows provided the funding for the growth in the loan and
securities portfolios. Overall, the Company continues to have minimal interest
rate risks to either falling or rising interest rates. The addition of fixed
rate assets during the first nine months of 2002 has made the Company somewhat
more liability sensitive in the short term, reducing its exposure to falling
rates but slightly increasing the potential exposure to rising rates. Based upon
the first nine months of 2002's simulation, the Company could expect an average
negative impact to net interest income of $340,000 over the next 12 months if
rates rise 200 basis points. If rates were to decline 100 basis points, the
Company could expect an average positive impact to net interest income of
$245,000 over the next 12 months. Likewise, if rates were to decline 200 basis
points, the Company could expect an average positive impact to net interest
income of $440,000 over the next 12 months.
During 2001, the Company was able to test the parameters and
assumptions of its simulation model in light of the 4.75% decrease in short term
rates over 11 months. The simulation model proved to be accurate in its
presentation of a company that benefits from falling interest rates. As
presented in the table above, the Company has had minimal interest rate risks to
either falling or rising interest rates over the past 15 months.
The preceding sensitivity analysis does not represent a forecast and
should not be relied upon as being indicative of expected operating results.
These hypothetical estimates are based upon numerous assumptions, including the
nature and timing of interest rate levels such as yield curve shape, prepayments
on loans and securities, deposit decay rates, pricing decisions on loans and
deposits, reinvestment or replacement of asset and liability cashflows. While
assumptions are developed based upon current economic and local market
conditions, the Company cannot make any assurances about the predictive nature
of these assumptions, including how customer preferences or competitor
influences might change.
Also, as market conditions vary from those assumed in the sensitivity
analysis, actual results will also differ due to factors such as prepayment and
refinancing levels likely deviating from those assumed, the varying impact of
interest rate change, caps or floors on adjustable rate assets, the potential
effect of changing debt service levels on customers with adjustable rate loans,
depositor early withdrawals and product preference changes, and other internal
and external variables. Furthermore, the sensitivity analysis does not reflect
actions that ALCO might take in response to or anticipation of changes in
interest rates.
Item 4. CONTROLS AND PROCEDURES
Within the 90 days prior to the date of this report, the Company
carried out an evaluation, under the supervision and with the participation of
the Company's management, including the Company's Chief Executive Officer and
Chief Financial Officer, of the effectiveness of the design and operation of the
Company's disclosure controls and procedures pursuant to Rule 13a-14 under the
Securities Exchange Act of 1934, as amended. Based upon that evaluation, the
Company's Chief Executive Officer and Chief
18
Financial Officer concluded that the Company's disclosure controls and
procedures are effective in timely alerting them to material information
relating to the Company (including its consolidated subsidiaries) required to be
included in the Company's periodic filings with the Securities and Exchange
Commission. There have been no significant changes in the Company's internal
controls or in other factors that could significantly affect internal controls
subsequent to the date that the Company carried out its evaluation.
In September 2002, the Company completed an upgrade conversion of its
core operating software that had commenced in early 2002. The core operating
software primarily provides customer accounting for deposit and loan
relationships. In addition, the system will serve as a record-keeping tool for
general ledger and accounts payable. The new system provides enhanced
capabilities for the management of the Company's customer relationships. As with
any system-related change, internal processes may need to change or adapt to
retain efficiency. As part of its evaluation of its disclosure controls and
procedures, management continues to evaluate, document and monitor any changes
to internal controls as a result of the core operating software conversion.
19
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
None
Item 2. Change in Securities and Use of Proceeds
None
Item 3. Defaults upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
a) Exhibits
99.1 Statement of Chief Executive Officer and Chief
Financial Officer Pursuant to 18 U.S.C.ss.1350
b) Reports on Form 8-K -- None.
20
SIGNATURES
In accordance with the requirements of the Securities Exchange Act of
1934, as amended, the registrant caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized.
MIDDLEBURG FINANCIAL CORPORATION
(Registrant)
Date: November 14, 2002 /s/ Joseph L. Boling
------------------------------------
Joseph L. Boling
Chairman of the Board & CEO
Date: November 14, 2002 /s/ Alice P. Frazier
------------------------------------
Alice P. Frazier
Executive Vice President & CFO
(Chief Accounting Officer)
21
CERTIFICATIONS
I, Joseph L. Boling, Chief Executive Officer, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Middleburg Financial
Corporation;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent
functions):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 14, 2002
/s/ Joseph L. Boling
---------------------
Joseph L. Boling
Chief Executive Officer
CERTIFICATIONS
I, Alice P. Frazier, Chief Financial Officer, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Middleburg Financial
Corporation;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent
functions):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 14, 2002
/s/ Alice P. Frazier
---------------------
Alice P. Frazier
Chief Financial Officer
EXHIBIT INDEX
Exhibits
99.1 Statement of Chief Executive Officer and Chief Financial
Officer Pursuant to 18 U.S.C.ss.1350