UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2005
or
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934.
FOR THE TRANSITION PERIOD FROM ________ TO ________
Commission File Number: 000-26099
FARMERS & MERCHANTS BANCORP
(Exact name of registrant as specified in its charter)
DELAWARE 94-3327828
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
111 W. Pine Street, Lodi, California 95240
(Address of principal Executive offices) (Zip Code)
Registrant's telephone number, including area code (209) 367-2300
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 [X] No [_]
Number of shares of common stock of the registrant: Par value $0.01, authorized
2,000,000 shares; issued and outstanding 827,463 as of July 31, 2005.
FARMERS & MERCHANTS BANCORP
FORM 10-Q
TABLE OF CONTENTS
___________________________
PART I. - FINANCIAL INFORMATION PAGE
--------------------- ----
ITEM 1 - FINANCIAL STATEMENTS
Consolidated Balance Sheets as of June 30, 2005,
December 31, 2004 and June 30, 2004. 4
Consolidated Statements of Income for the Three Months
and Six Months Ended June 30, 2005 and 2004. 5
Consolidated Statements of Comprehensive (Loss) Income for the Three
Months and Six Months Ended June 30, 2005 and 2004. 6
Consolidated Statements of Changes in Shareholders' Equity for the
Six Months Ended June 30, 2005 and 2004. 7
Consolidated Statement of Cash Flows for the Six
Months Ended June 30, 2005 and 2004. 8
Notes to the Consolidated Financial Statements 9
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS 13
ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 26
ITEM 4 - CONTROLS AND PROCEDURES 29
PART II. - OTHER INFORMATION
-----------------
ITEM 1 - LEGAL PROCEEDINGS 30
ITEM 2 - UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 30
ITEM 3 - DEFAULTS UPON SENIOR SECURITIES 30
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 30
ITEM 5 - OTHER INFORMATION 31
2
ITEM 6 - EXHIBITS 31
SIGNATURES 32
INDEX TO EXHIBITS 32
3
PART I. - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
FARMERS & MERCHANTS BANCORP
CONSOLIDATED BALANCE SHEETS
=========================================================================================
(in thousands) June 30, December 31, June 30,
2005 2004 2004
ASSETS (Unaudited) (Unaudited)
- -----------------------------------------------------------------------------------------
Cash and Cash Equivalents:
Cash and Due From Banks $ 39,723 $ 32,170 $ 32,518
Federal Funds Sold 0 0 6,300
- -----------------------------------------------------------------------------------------
Total Cash and Cash Equivalents 39,723 32,170 38,818
Investment Securities:
Available-for Sale 157,716 185,488 188,022
Held-to-Maturity 111,467 89,952 72,159
- -----------------------------------------------------------------------------------------
Total Investment Securities 269,183 275,440 260,181
- -----------------------------------------------------------------------------------------
Loans 905,412 869,082 842,736
Less: Unearned Income (2,343) (2,174) (2,014)
Less: Allowance for Loan Losses (17,943) (17,727) (17,776)
- -----------------------------------------------------------------------------------------
Loans, Net 885,126 849,181 822,946
- -----------------------------------------------------------------------------------------
Land, Buildings & Equipment 15,913 14,971 11,644
Bank Owned Life Insurance 36,001 35,235 34,462
Interest Receivable and Other Assets 20,184 19,298 19,201
- -----------------------------------------------------------------------------------------
TOTAL ASSETS $ 1,266,130 $ 1,226,295 $ 1,187,252
=========================================================================================
LIABILITIES & SHAREHOLDERS' EQUITY
- -----------------------------------------------------------------------------------------
Deposits:
Demand $ 256,219 $ 273,799 $ 229,809
Interest Bearing Transaction 109,565 108,213 92,439
Savings 288,299 301,225 284,564
Time Deposits 352,075 318,873 361,501
- -----------------------------------------------------------------------------------------
Total Deposits 1,006,158 1,002,110 968,313
- -----------------------------------------------------------------------------------------
Fed Funds Purchased 22,400 0 0
FHLB Borrowings 90,868 80,889 85,909
Subordinated Debentures 10,310 10,310 10,310
Other Liabilities 15,666 16,439 11,788
- -----------------------------------------------------------------------------------------
Total Liabilities 1,145,402 1,109,748 1,076,320
- -----------------------------------------------------------------------------------------
SHAREHOLDERS' EQUITY
Common Stock 8 8 8
Additional Paid In Capital 98,814 82,237 84,218
Retained Earnings 23,762 35,332 30,376
Accumulated Other Comprehensive Loss (1,856) (1,030) (3,670)
- -----------------------------------------------------------------------------------------
TOTAL SHAREHOLDERS' EQUITY 120,728 116,547 110,932
- -----------------------------------------------------------------------------------------
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY $ 1,266,130 $ 1,226,295 $ 1,187,252
=========================================================================================
<FN>
The accompanying notes are an integral part of these unaudited consolidated financial
statements
4
FARMERS & MERCHANTS BANCORP
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
=============================================================================================
(in thousands) Three Months Six Months
Ended June 30, Ended June 30,
2005 2004 2005 2004
- ---------------------------------------------------------------------------------------------
INTEREST INCOME
Interest & Fees on Loans $ 15,134 $ 11,983 $ 28,570 $ 23,656
Federal Funds Sold 14 8 56 60
Securities:
Taxable 1,834 2,028 3,729 3,754
Non-taxable 835 546 1,555 1,140
- ---------------------------------------------------------------------------------------------
Total Interest Income 17,817 14,565 33,910 28,610
- ---------------------------------------------------------------------------------------------
INTEREST EXPENSE
Interest Bearing Transaction 19 15 38 29
Savings 327 251 653 507
Time Deposits 1,956 1,263 3,611 2,585
Interest on Borrowed Funds 860 782 1,449 1,498
Interest on Subordinated Debentures 157 103 297 208
- ---------------------------------------------------------------------------------------------
Total Interest Expense 3,319 2,414 6,048 4,827
- ---------------------------------------------------------------------------------------------
NET INTEREST INCOME 14,498 12,151 27,862 23,783
Provision for Loan Losses 0 350 0 725
- ---------------------------------------------------------------------------------------------
NET INTEREST INCOME AFTER
PROVISION FOR LOAN LOSSES 14,498 11,801 27,862 23,058
- ---------------------------------------------------------------------------------------------
NON-INTEREST INCOME
Service Charges on Deposit Accounts 1,111 1,269 2,145 2,458
Net (Loss) Gain on Sale of Investment Securities (17) 106 144 747
Credit Card Merchant Fees 520 453 980 837
Increase in Cash Surrender Value of Life Insurance 395 389 766 809
Other 1,014 1,218 1,890 2,128
- ---------------------------------------------------------------------------------------------
Total Non-Interest Income 3,023 3,435 5,925 6,979
- ---------------------------------------------------------------------------------------------
NON-INTEREST EXPENSE
Salaries & Employee Benefits 7,105 5,785 13,410 11,838
Occupancy 480 391 1,010 850
Equipment 486 538 961 978
Credit Card Collection Assessment 374 311 693 562
Other Operating 1,912 1,705 3,582 3,200
- ---------------------------------------------------------------------------------------------
Total Non-Interest Expense 10,357 8,730 19,656 17,428
- ---------------------------------------------------------------------------------------------
NET INCOME BEFORE TAXES 7,164 6,506 14,131 12,609
Provision for Taxes 2,575 2,402 5,111 4,603
- ---------------------------------------------------------------------------------------------
NET INCOME $ 4,589 $ 4,104 $ 9,020 $ 8,006
=============================================================================================
EARNINGS PER SHARE $ 5.52 $ 4.90 $ 10.85 $ 9.55
=============================================================================================
<FN>
The accompanying notes are an integral part of these consolidated financial statements
5
FARMERS & MERCHANTS BANCORP
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (UNAUDITED)
===============================================================================================================================
(in thousands) For Three Months For Six Months
Ended June 30, Ended June 30,
2005 2004 2005 2004
- -------------------------------------------------------------------------------------------------------------------------------
NET INCOME $ 4,589 $ 4,104 $ 9,020 $ 8,006
OTHER COMPREHENSIVE INCOME (LOSS) -
UNREALIZED (LOSSES) GAINS ON DERIVATIVE INSTRUMENTS:
Unrealized holding (losses) gains arising during the period, net
of income tax effects of $(3) and $(11) for the quarters ended
June 30, 2005 and 2004, respectively, and $(3) and $64
for the six months ended June 30, 2005 and 2004, respectively. (4) (16) (4) 88
Less: Reclassification adjustment for realized losses included in net
income, net of related income tax effects of $0 and $(33) for the
quarters ended June 30, 2005 and 2004, respectively, and $(3) and
$(65) for the six months ended June 30, 2005 and 2004, respectively. - (45) (4) (89)
UNREALIZED GAINS (LOSSES) ON SECURITIES:
Unrealized holding gains (losses) arising during the period, net of
income tax effects of $505 and $(2,825) for the quarters ended
June 30, 2005 and 2004, respectively, and of $(593) and $(1,943)
for the six months ended June 30, 2005 and 2004, respectively. 695 (3,892) (818) (2,677)
Less: Reclassification adjustment for realized gains (losses) included
in net income, net of related income tax effects of $7 and $(44)
for the quarters ended June 30, 2005 and 2004, respectively, and of
$0 and $(314) for the six months ended June 30, 2005 and 2004, 10 (61) - (433)
respectively.
- -------------------------------------------------------------------------------------------------------------------------------
TOTAL OTHER COMPREHENSIVE INCOME (LOSS) 701 (4,014) (826) (3,111)
- -------------------------------------------------------------------------------------------------------------------------------
COMPREHENSIVE INCOME $ 5,290 $ 90 $ 8,194 $ 4,895
===============================================================================================================================
<FN>
The accompanying notes are an integral part of these consolidated financial statements
6
FARMERS & MERCHANTS BANCORP
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (UNAUDITED)
========================================================================================================================
(in thousands except share data) ACCUMULATED
COMMON ADDITIONAL OTHER TOTAL
SHARES COMMON PAID-IN RETAINED COMPREHENSIVE SHAREHOLDERS'
OUTSTANDING STOCK CAPITAL EARNINGS INCOME (LOSS) EQUITY
- ------------------------------------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 2003 763,274 $ 8 $ 72,506 $ 37,650 $ (559) $ 109,605
- ------------------------------------------------------------------------------------------------------------------------
Net Income - - 8,006 - 8,006
Cash Dividends Declared on -
Common Stock - - (2,235) - (2,235)
5% Stock Dividend 37,429 - 12,838 (12,838) - -
Cash Paid in Lieu of Fractional
Shares Related to Stock Dividend - - (207) - (207)
Redemption of Stock (3,141) - (1,126) - - (1,126)
Unrealized Gains on
Derivitive Instruments (1) (1)
Changes in Net Unrealized Gain (Loss)
on Securities Available for Sale - - - (3,110) (3,110)
- ------------------------------------------------------------------------------------------------------------------------
BALANCE, JUNE 30, 2004 797,562 $ 8 $ 84,218 $ 30,376 $ (3,670) $ 110,932
========================================================================================================================
- ------------------------------------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 2004 792,722 $ 8 $ 82,237 $ 35,332 $ (1,030) $ 116,547
========================================================================================================================
Net Income - - 9,020 - 9,020
Cash Dividends Declared on -
Common Stock - - (2,659) - (2,659)
5% Stock Dividend 38,995 - 17,641 (17,641) - -
Cash Paid in Lieu of Fractional
Shares Related to Stock Dividend - - (290) - (290)
Redemption of Stock (2,130) - (1,064) - - (1,064)
Unrealized Gain (Loss) on
Derivitive Instruments (8) (8)
Changes in Net Unrealized Gain (Loss)
on Securities Available for Sale - - - (818) (818)
- ------------------------------------------------------------------------------------------------------------------------
BALANCE, JUNE 30, 2005 829,587 $ 8 $ 98,814 $ 23,762 $ (1,856) $ 120,728
========================================================================================================================
<FN>
The accompanying notes are an integral part of these consolidated financial statements
7
FARMERS & MERCHANTS BANCORP
CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED) Six Months Ended
===============================================================================================
(in thousands) June 30, June 30,
2005 2004
- -----------------------------------------------------------------------------------------------
OPERATING ACTIVITIES:
Net Income $ 9,020 $ 8,006
Adjustments to Reconcile Net Income to Net
Cash Provided by Operating Activities:
Provision for Loan Losses 0 725
Depreciation and Amortization 742 778
Provision for Deferred Income Taxes 0 (360)
Net Amortization of Investment Security Premium & Discounts 326 529
Net Gain on Sale of Investment Securities (144) (747)
Net Gain on Sale of Property & Equipment 0 (125)
Increase in Interest Receivable and Other Assets (1,068) (1,099)
(Decrease) Increase in Interest Payable and Other Liabilities (773) 415
- -----------------------------------------------------------------------------------------------
Net Cash Provided by Operating Activities 8,103 8,122
INVESTING ACTIVITIES:
Securities Available-for-Sale:
Purchased (11,235) (52,321)
Sold, Matured or Called 37,449 83,042
Securities Held-to-Maturity:
Purchased (26,710) (37,706)
Matured or Called 5,161 3,577
Net Loans Originated or Acquired (36,442) (34,059)
Principal Collected on Loans Previously Charged Off 497 74
Net Additions to Premises and Equipment (1,684) (1,262)
Proceeds from Sale of Property & Equipment 0 174
- -----------------------------------------------------------------------------------------------
Net Cash Used by Investing Activities (32,964) (38,481)
FINANCING ACTIVITIES:
Net (Decrease) Increase in Demand, Interest-Bearing Transaction,
and Savings Accounts (29,154) 10,927
Increase in Time Deposits 33,202 53,037
Net Increase (Decrease) in Federal Funds Purchased 22,400 (1,000)
Net Increase (Decrease) in Federal Home Loan Bank Advances
Advances 9,979 (26,000)
Paydowns 0 (19)
Cash Dividends (2,949) (2,442)
Stock Redemption (1,064) (1,126)
- -----------------------------------------------------------------------------------------------
Net Cash Provided by Financing Activities 32,414 33,377
Increase (Decrease) in Cash and Cash Equivalents 7,553 3,018
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 32,170 35,800
- -----------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS AS OF JUNE 30, 2005 AND JUNE 30, 2004 $ 39,723 $ 38,818
===============================================================================================
<FN>
The accompanying notes are an integral part of these consolidated financial statements
8
FARMERS & MERCHANTS BANCORP
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
For the six months ended June 30, 2005 and June 30, 2004
1. SIGNIFICANT ACCOUNTING POLICIES
Farmers & Merchants Bancorp (the Company) was organized March 10, 1999. Primary
operations are related to traditional banking activities through its subsidiary
Farmers & Merchants Bank of Central California (the Bank) which was established
in 1916. The Bank's wholly owned subsidiaries include Farmers & Merchants
Investment Corporation and Farmers/Merchants Corp. F & M Bancorp, Inc. was
created in March 2002 to protect the name F & M Bank. Farmers & Merchants
Investment Corporation has been dormant since 1991. Farmers/Merchants Corp. acts
as trustee on deeds of trust originated by the Bank. In December 2003, the
Company formed a wholly owned subsidiary, FMCB Statutory Trust I. FMCB Statutory
Trust I is a non-consolidated subsidiary per generally accepted accounting
principles (GAAP), and was formed for the sole purpose of issuing Trust
Preferred Securities. The following is a summary of the significant accounting
and reporting policies used in preparing the consolidated financial statements.
BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements of the Company have
been prepared in accordance with accounting principles generally accepted in the
United States of America for interim financial information and with the
instructions to Form 10-Q and Article 10 of Regulation S-X. In the opinion of
management, all adjustments (which consist solely of normal recurring accruals)
considered necessary for a fair presentation of the results for the interim
periods presented have been included. These interim consolidated financial
statements should be read in conjunction with the financial statements and
related notes contained in the Company's 2004 Annual Report to Shareholders on
Form 10-K.
The accompanying consolidated financial statements include the accounts of the
Company and the Company's wholly owned subsidiaries, F & M Bancorp, Inc. and the
Bank, along with the Bank's wholly owned subsidiaries, Farmers & Merchants
Investment Corporation and Farmers/Merchants Corp. Significant intercompany
transactions have been eliminated in consolidation. The results of operations
for the six-month period ended June 30, 2005 may not necessarily be indicative
of the operating results for the full year 2005.
Management has determined that since all of the commercial banking products and
services offered by the Company are available in each branch of the bank, all
branches are located within the same economic environment and management does
not allocate resources based on the performance of different lending or
transaction activities, it is appropriate to aggregate the Bank branches and
report them as a single operating segment.
The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions. These estimates and
assumptions affect the reported amounts of assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from these estimates.
9
Certain amounts in the prior years' financial statements and related footnote
disclosures have been reclassified to conform to the current-year presentation.
These reclassifications have no effect on previously reported income.
CASH AND CASH EQUIVALENTS
For purposes of the Consolidated Statements of Cash Flows, the Company has
defined cash and cash equivalents as those amounts included in the balance sheet
captions Cash and Due from Banks, Federal Funds Sold and Securities Purchased
Under Agreements to Resell. Generally, these transactions are for one-day
periods. For these instruments, the carrying amount is a reasonable estimate of
fair value.
INVESTMENT SECURITIES
Investment securities are classified at the time of purchase as held-to-maturity
if it is management's intent and the Company has the ability to hold the
securities until maturity. These securities are carried at cost, adjusted for
amortization of premium and accretion of discount using a level yield of
interest over the estimated remaining period until maturity. Losses, reflecting
a decline in value judged by the Company to be other than temporary, are
recognized in the period in which they become probable.
Securities are classified as available-for-sale if it is management's intent, at
the time of purchase, to hold the securities for an indefinite period of time
and/or to use the securities as part of the Company's asset/liability management
strategy. These securities are reported at fair value with aggregate, unrealized
gains or losses excluded from income and included as a separate component of
shareholders' equity, net of related income taxes. Fair values are based on
quoted market prices or broker/dealer price quotations on a specific
identification basis. Gains or losses on the sale of these securities are
computed using the specific identification method. Unrealized losses on these
securities, reflecting a decline in value judged by the Company to be other than
temporary, are recognized in the period in which they become known.
Trading securities, if any, are acquired for short-term appreciation and are
recorded in a trading portfolio and are carried at fair value, with unrealized
gains and losses recorded in non-interest income.
LOANS
Loans are reported at the principal amount outstanding net of unearned discounts
and deferred loan fees. Interest income on loans is accrued daily on the
outstanding balances using the simple interest method. Loan origination fees are
deferred and recognized over the contractual life of the loan as an adjustment
to the yield. Loans are placed on a non-accrual status when the collection of
principal or interest is in doubt or when they become past due for 90 days or
more unless they are both well-secured and in the process of collection. For
this purpose a loan is considered well-secured if it is collateralized by
property having a net realizable value in excess of the amount of the loan or is
guaranteed by a financially capable party. When a loan is placed on non-accrual
status, the accrued and unpaid interest receivable is reversed and charged
against current income, thereafter; interest income is recognized only as it is
collected in cash. Loans placed on a non-accrual status are returned to accrual
status when the loans are paid current as to principal and interest and future
payments are expected to be made in accordance with the contractual terms of the
loan.
A loan is impaired when, based on current information and events, it is probable
that the Company will be unable to collect all amounts due according to the
contractual terms of the loan agreement. When a loan is impaired, the recorded
amount of the loan in the Consolidated Balance Sheets is based on the present
value of expected future cash flows discounted at the loan's effective interest
rate, or the observable or estimated market price of the loan or on the fair
value of the collateral if the loan is collateral dependent. Impaired loans are
placed on a non-accrual status with income reported accordingly. Cash payments
are first applied as a reduction of the principal balance until collection of
the
10
remaining principal and interest can be reasonably assured. Thereafter, interest
income is recognized as it is collected in cash.
ALLOWANCE FOR LOAN LOSSES
As a financial institution which assumes lending and credit risks as a principal
element in its business, the Company anticipates that credit losses will be
experienced in the normal course of business. Accordingly, the allowance for
loan losses is maintained at a level considered adequate by management to
provide for losses that are inherent in the portfolio. The allowance is
increased by provisions charged to operating expense and by recoveries on loans
previously charged-off and reduced by charge-offs. Management employs a
systematic methodology for determining the allowance for loan losses. On a
quarterly basis, management reviews the credit quality of the loan portfolio and
considers many factors in determining the adequacy of the allowance at the
balance sheet date.
The factors evaluated in connection with the allowance may include existing
general economic and business conditions affecting the key lending areas of the
Company, current levels of problem loans and delinquencies, credit quality
trends, collateral values, loan volumes and concentration, seasoning of the loan
portfolio, specific industry conditions, recent loss experience, duration of the
current business cycle, bank regulatory examination results and findings of the
Company's internal credit examiners.
The allowance also incorporates the results of measuring impaired loans as
provided in Statement of Financial Accounting Standards (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". These
accounting standards prescribe the measurement methods, income recognition and
disclosures related to impaired loans, which are discussed more fully in Note 4
to the Consolidated Financial Statements in the Company's 2004 Annual Report to
Shareholders.
While the Company utilizes a systematic methodology in determining its
allowance, the allowance is based on estimates, and ultimate losses may vary
from current estimates. The estimates are reviewed periodically and, as
adjustments become necessary, are reported in earnings in the periods in which
they become probable.
DIVIDENDS
Farmers & Merchants Bancorp common stock is not traded on any exchange. The
shares are primarily held by local residents and are not actively traded.
On April 21, 2005, the Board of Directors declared a 5% stock dividend payable
May 12, 2005, to shareholders of record at the close of business on April 21,
2005. Common stock shareholders of record as of April 21, 2005 received one
share of common stock for every 20 shares of common stock owned. Fractional
shares were not issued. For common stock share lots of less than 20 shares, a
cash dividend in the amount of $22.62 per share was paid in lieu of the stock
dividend.
The Board of Directors of Farmers & Merchants Bancorp declared a cash dividend
on June 7, 2005, in the amount of $3.20 per share, an increase from the $2.80
per share paid last year. The cash dividend was paid on June 30, 2005, to
stockholders of record as of June 17, 2005.
DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
The Statement of Financial Accounting Standards, No. 133, "Accounting for
Derivative Instruments and Certain Hedging Activities" as amended by the
Statement of Financial Accounting Standards, No. 138, establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities. All
derivatives, whether designated in hedging relationships or not, are required to
be recorded on the balance sheet at fair value. Changes in
11
the fair value of those derivatives are accounted for depending on the intended
use of the derivative and the resulting designation under specified criteria. If
the derivative is designated as a fair value hedge, the changes in the fair
value of the derivative and of the hedged item attributable to the hedged risk
are recognized in earnings. If the derivative is designated as a cash flow
hedge, designed to minimize interest rate risk, the effective portions of the
change in the fair value of the derivative are recorded in other comprehensive
income net of related income taxes. Ineffective portions of changes in the fair
value of cash flow hedges are recognized in earnings.
The Company utilizes derivative financial instruments such as interest rate
caps, floors, swaps and collars. These instruments are purchased and/or sold to
reduce the Company's exposure to changing interest rates. The Company marks to
market the value of its derivative financial instruments and reflects gain or
loss in earnings in the period of change or in other comprehensive income. The
company was not utilizing any derivative instruments as of June 30, 2005.
2. RECENT ACCOUNTING DEVELOPMENTS
On September 30, 2004, the Financial Accounting Standards Board ("FASB") issued
FASB Staff Position ("FSP") Emerging Issues Task Force ("EITF") Issue No. 03-1-1
delaying the effective date of paragraphs 10-20 of EITF 03-1, "The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments,"
which provides guidance for determining the meaning of the phrase
"other-than-temporarily impaired" and its application to certain debt and equity
securities within the scope of FASB Statement No. 115, "Accounting for Certain
Investments in Debt and Equity Securities," and investments accounted for under
the cost method. The guidance required that an investment which has declined in
value due to credit concerns or solely due to changes in interest rates must be
recorded as other-than-temporarily impaired unless the Company can assert and
demonstrate its intention to hold the security for a period of time sufficient
to allow for a recovery of fair value up to or beyond the cost of the
investment, which might mean maturity. In September 2004, the FASB issued the
proposed FSP Issue 03-1-a which was intended to provide implementation guidance
with respect to all securities analyzed for impairment under paragraphs 10-20 of
EITF 03-1. On June 29, 2005, the Financial Accounting Standards Board gave
direction that the proposed FSP Issue 03-1-a be issued as final thus nullifying
the paragraphs 10-18 of EITF 03-1. The measurement, disclosure, and subsequent
accounting for debt securities guidance, as well as the evaluation of whether a
cost method investment (as defined in Issue 03-1) is impaired, would remain in
effect. Management continues to monitor and evaluate how the provisions of EITF
03-1 and proposed FSP Issue 03-1-a will affect the Company.
3. INTERIM-PERIOD DISCLOSURE OF EMPLOYEE BENEFIT PLANS
COMPONENTS OF NET PERIODIC PENSION COST: Three months ended June 30, Six months ended June 30,
----------------------------------------------------------------------
(in thousands) 2005 2004 2005 2004
----------------------------------------------------------------------
Service cost $ 13 $ 12 $ 26 $ 24
Interest cost 65 64 130 128
Expected return on assets (29) (57) (58) (114)
Amortization of loss 237 126 474 252
Amortization of prior service cost 0 0 0 0
Amortization of transition obligation 0 0 0 0
----------------------------------------------------------------------
Net periodic pension cost $ 286 $ 145 $ 572 $ 290
======================================================================
12
See Note 12 to the Consolidated Financial Statements in the Company's 2004
Annual Report to Shareholders for a discussion regarding the Company's intent to
terminate the Defined Benefit Pension Plan during 2005.
EMPLOYER CONTRIBUTIONS
The Company previously disclosed in its financial statements for the year ended
December 31, 2004 that it expected to contribute $1.6 million to its Pension
Plan in 2005. As of June 30, 2005, $0 has been contributed to the Plan. The
Company still expects to contribute at least $1.6 million to the Plan in 2005.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FORWARD-LOOKING STATEMENTS
This quarterly report contains various forward-looking statements, usually
containing the words "estimate," "project," "expect," "objective," "goal," or
similar expressions and includes assumptions concerning the Company's
operations, future results, and prospects. These forward-looking statements are
based upon current expectations and are subject to risk and uncertainties. In
connection with the "safe-harbor" provisions of the Private Securities
Litigation Reform Act of 1995, the Company provides the following cautionary
statement identifying important factors which could cause the actual results of
events to differ materially from those set forth in or implied by the
forward-looking statements and related assumptions.
Such factors include the following: (i) the effect of changing regional and
national economic conditions; (ii) significant changes in interest rates and
prepayment speeds; (iii) credit risks of commercial, agricultural, real estate,
consumer, and other lending activities; (iv) changes in federal and state
banking laws or regulations; (v) competitive pressure in the banking industry;
(vi) changes in governmental fiscal or monetary policies; (vii) uncertainty
regarding the economic outlook resulting from the continuing war on terrorism,
as well as actions taken or to be taken by the U.S. or other governments as a
result of further acts or threats of terrorism; (viii) dividend restrictions;
(ix) asset/liability pricing risks and liquidity risks; (x) changes in the
securities markets; (xi) certain operational risks involving data processing
systems or fraud; (xii) the State of California's fiscal difficulties; and
(xiii) other external developments which could materially impact the Company's
operational and financial performance.
Readers are cautioned not to place undue reliance on these forward-looking
statements which speak only as of the date hereof. The Company undertakes no
obligation to update any forward-looking statements to reflect events or
circumstances arising after the date on which they are made.
INTRODUCTION
Farmers & Merchants Bancorp is a bank holding company formed March 10, 1999.
Its subsidiary, Farmers & Merchants Bank of Central California was formed in
1916. The Bank services the northern Central Valley of California with 19
banking offices. The service area includes Sacramento, San Joaquin, Stanislaus
and Merced Counties with branches in Sacramento, Elk Grove, Galt, Lodi,
Stockton, Linden, Modesto, Turlock and Hilmar. Substantially all of the
Company's business activities are conducted within its market area.
As a bank holding company, the Company is subject to regulation and examination
by the Board of Governors of the Federal Reserve System ("FRB"). The Bank is a
California state-chartered bank subject to the regulation and examination of the
California Department of Financial Institutions. Since August 1, 1940, the Bank
has also been a member of the Federal Reserve System and the FRB has served as
its
13
primary Federal regulator. However, at a meeting of the Board of Directors of
the Bank on April 5, 2005, the Board decided to withdraw from membership in the
Federal Reserve System. The Bank received the FRB's approval for this action on
April 18, 2005. As a result, the Bank's primary federal regulator will now be
the Federal Deposit Insurance Corporation. The FRB will continue to regulate and
examine the Company but not the Bank. Management and the Board believe that this
change will not have any operating or financial impact on the Company or the
Bank.
This section should be read in conjunction with the consolidated financial
statements and the notes thereto, along with other financial information
included in this report.
OVERVIEW
The Company's primary service area encompasses the northern Central Valley of
California, a region that is impacted by the seasonal needs of the agricultural
industry. Accordingly, discussion of the Company's Financial Condition and
Results of Operations is influenced by the seasonal banking needs of its
agricultural customers (e.g., during the spring and summer customers draw down
their deposit balances and increase loan borrowing to fund the purchase of
equipment and planting of crops. Correspondingly, deposit balances are
replenished and loans repaid in fall and winter as crops are harvested and
sold).
For the three and six months ended June 30, 2005, Farmers & Merchants Bancorp
reported net income of $4,589,000 and $9,020,000, earnings per share of $5.52
and $10.85 and return on average assets of 1.47% and 1.46%. Return on average
shareholders' equity was 15.17% and 15.11% for the three and six months ended
June 30, 2005. For the three and six months ended June 30, 2004, net income
totaled $4,104,000 and $8,006,000, earnings per share was $4.90 and $9.55 and
return on average assets was 1.41% and 1.39%. Return on average shareholders'
equity for the three and six months ended June 30, 2004 was 14.61% and 14.33%,
respectively.
The Company's improved earnings performance in the first half of 2005 when
compared to the same period last year was due to a combination of (1) growth in
earning assets; (2) improvement in the net interest margin due to rising
interest rates; and (3) a reduction in the provision for loan losses.
The following is a summary of the financial results for the six-month period
ended June 30, 2005 compared to June 30, 2004.
- - Net income increased 12.7% to $9.0 million from $8.0 million.
- - Earnings per share increased 13.6% to $10.85 from $9.55.
- - Net interest income increased 17.2% to $27.9 million from $23.8 million.
- - Net interest margin increased 42 basis points from 4.57% to 5.05%
- - Total assets increased 6.6% to $1.3 billion.
- - Gross loans increased 7.4% to $905.4 million.
- - Total deposits increased 3.9% to $1.0 billion.
14
RESULTS OF OPERATIONS
NET INTEREST INCOME
The tables on the following pages reflect the Company's average balance sheets
and volume and rate analysis for the three and six month periods ending June 30,
2005 and 2004.
The average yields on earning assets and average rates paid on interest-bearing
liabilities have been computed on an annualized basis for purposes of
comparability with full year data. Average balance amounts for assets and
liabilities are the computed average of daily balances.
The volume and rate analysis of net interest revenue summarizes the changes in
interest income and interest expense based on changes in average asset and
liability balances (volume) and changes in average rates (rate). For each
category of interest-earning assets and interest-bearing liabilities,
information is provided with respect to changes attributable to (1) changes in
volume (change in volume multiplied by initial rate), (2) changes in rate
(change in rate multiplied by initial volume) and (3) changes in rate/volume
(allocated in proportion to the respective volume and rate components).
Net interest income is the amount by which the interest and fees on loans and
other interest earning assets exceed the interest paid on interest bearing
sources of funds. For the purpose of analysis, the interest earned on
tax-exempt investments and municipal loans is adjusted to an amount comparable
to interest subject to normal income taxes. This adjustment is referred to as
"taxable equivalent" and is noted wherever applicable. Interest income and
expense are affected by changes in the volume and mix of average interest
earning assets and average interest bearing liabilities, as well as fluctuations
in interest rates. Therefore, increases or decreases in net interest income are
analyzed as changes in volume, changes in rate and changes in the mix of assets
and liabilities.
The Company's earning assets and rate sensitive liabilities are subject to
repricing at different times, which exposes the Company to income fluctuations
when interest rates change. In order to minimize income fluctuations, the
Company attempts to match asset and liability maturities. However, some
maturity mismatch is inherent in the asset and liability mix.
Net interest income increased 17.2% to $27.9 million during the first six months
of 2005, compared to $23.8 million at June 30, 2004. On a fully taxable
equivalent basis, net interest income increased 17.7% and totaled $28.8 million
at June 30, 2005, compared to $24.4 million for the first six months of 2004.
As reported in previous quarters, a significant reason for the increase in net
interest income during the first six months of 2005 when compared to the same
period last year was an improvement in the volume and mix (as reflected by an
increase in loans as a percentage of average earning assets) of earning assets.
Additionally, as a result of the Federal Reserve Bank having increased
short-term market interest rates by 200 basis points since June 2004, the
Company's net interest income has benefited from an increase in the rate on
earning assets.
Net interest income on a taxable equivalent basis, expressed as a percentage of
average total earning assets, is referred to as the net interest margin. For
the three months ended June 30, 2005, the Company's net interest margin was
5.16% compared to 4.58% in 2004. The Company's yield on earning assets has
improved over the last twelve months as a result of increases in short-term
market interest rates. For further discussion see Market Risk - Interest Rate
Risk under Item 3. Quantitative and Qualitative Disclosures About Market Risk.
15
Loans, generally the Company's highest earning asset, increased $62.7 million as
of June 30, 2005 compared to June 30, 2004. On an average balance basis, loans
increased by $68.9 million for the six months ended June 30, 2005 compared to
the six months ended June 30, 2004. The yield on the loan portfolio increased
70 basis points to 6.59% for the six months ended June 30, 2005 compared to
5.89% for the six months ended June 30, 2004. This increase in yield and volume
resulted in interest revenue from loans increasing 20.8% to $28.6 million for
the first six months of 2005.
The investment portfolio is the other main component of the Company's earning
assets. Management believes the Company's investment policy is conservative.
The Company invests primarily in mortgage-backed securities, U.S. Government
Agencies, and high-grade municipals. Since the risk factor for these types of
investments is significantly lower than that of loans, the yield earned on
investments is generally less than that of loans.
Average investment securities increased $14.0 million at June 30, 2005. The
average yield, on a taxable equivalent basis, in the investment portfolio was
4.65% in 2005 compared to 4.40% in 2004, partially due to an increase in the mix
of longer term, higher yielding municipal securities in conjunction with pay
downs of lower yielding mortgage backed securities. The increase in the volume
and yield on investment securities resulted in an increase in interest income of
$636,000, or 11.5%, for the six months ended June 30, 2005. Net interest income
on the Schedule of Year-to-Date Average Balances and Interest Rates is shown on
a taxable equivalent basis, which is higher than net interest income on the
Consolidated Statements of Income because of adjustments that relate to income
on certain securities that are exempt from federal income taxes.
Since the second quarter of 2004, the Company has grown average interest-bearing
sources of funds by $34.7 million or 4.3%. Growth has occurred across all
deposit categories due to the improvement in the interest rate environment.
Interest bearing deposits grew $81.4 million while all other interest bearing
sources of funds (including FHLB Advances) decreased by $46.6 million (see
Deposits and Federal Home Loan Bank Advances and Other Borrowings). Overall,
the average interest rate on interest-bearing sources of funds was 1.45% for the
six months ended June 30, 2005 and 1.20% for the six months ended June 30, 2004.
The increase in the volume and rate on interest-bearing sources of funds
resulted in an increase in interest expense of $1.2 million, or 25.3%, for the
six months ended June 30, 2005.
16
FARMERS & MERCHANTS BANCORP
QUARTERLY AVERAGE BALANCES AND INTEREST RATES
(Interest and Rates on a Taxable Equivalent Basis)
(in thousands)
Three Months Ended June 30, Three Months Ended June 30,
2005 2004
ASSETS Balance Interest Rate Balance Interest Rate
- ------------------------------------------------------------------------------------------------------------------------------
Federal Funds Sold $ 1,851 $ 14 3.03% $ 2,967 $ 8 1.08%
Investment Securities Available-for-Sale
U.S. Agencies 60,678 571 3.82% 69,348 607 3.55%
Municipals - Taxable 0 0 0.00% 1,045 16 6.21%
Municipals - Non-Taxable 16,297 259 6.44% 17,717 280 6.41%
Mortgage Backed Securities 79,965 780 3.96% 108,091 1,012 3.80%
Other 4,962 52 4.25% 8,334 101 4.91%
- ------------------------------------------------------------------------------------------------------------------------------
Total Investment Securities Available-for-Sale 161,902 1,662 4.16% 204,535 2,016 4.00%
- ------------------------------------------------------------------------------------------------------------------------------
Investment Securities Held-to-Maturity
U.S. Agencies 30,736 308 4.06% 13,526 175 0.00%
Municipals - Non-Taxable 68,416 1,061 6.29% 36,828 582 6.41%
Mortgage Backed Securities 12,568 120 3.87% 10,083 112 0.00%
Other 287 2 2.83% 354 4 4.58%
- ------------------------------------------------------------------------------------------------------------------------------
Total Investment Securities Held-to-Maturity 112,007 1,491 5.40% 60,791 873 5.82%
- ------------------------------------------------------------------------------------------------------------------------------
Loans
Real Estate 502,006 8,527 6.81% 481,220 7,428 6.19%
Home Equity 63,969 980 6.14% 55,899 648 4.65%
Agricultural 135,860 2,281 6.73% 132,447 1,670 5.06%
Commercial 168,707 2,959 7.03% 136,733 1,878 5.51%
Consumer 12,778 255 8.00% 10,856 242 8.94%
Credit Card 4,981 121 9.74% 4,498 106 9.45%
Municipal 980 11 4.50% 1,051 11 4.20%
- ------------------------------------------------------------------------------------------------------------------------------
Total Loans 889,281 15,134 6.83% 822,704 11,983 5.84%
- ------------------------------------------------------------------------------------------------------------------------------
Total Earning Assets 1,165,041 $ 18,301 6.30% 1,090,997 $ 14,880 5.47%
================== =================
Unrealized Gain/(Loss) on Securities Available-for-Sale (1,872) (82)
Allowance for Loan Losses (17,916) (17,725)
Cash and Due From Banks 33,632 33,098
All Other Assets 70,714 61,987
- --------------------------------------------------------------------------- -----------
TOTAL ASSETS $1,249,599 $1,168,275
=========================================================================== ===========
LIABILITIES & SHAREHOLDERS' EQUITY
Interest Bearing Deposits
Interest Bearing DDA $ 113,921 $ 19 0.07% $ 94,713 $ 15 0.06%
Savings 298,309 327 0.44% 279,282 251 0.36%
Time Deposits 350,921 1,956 2.24% 312,045 1,263 1.62%
- ------------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Deposits 763,151 2,302 1.21% 686,040 1,529 0.89%
Other Borrowed Funds 81,548 860 4.23% 123,775 782 2.53%
Subordinated Debentures 10,310 157 6.12% 10,310 103 4.01%
- ------------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities 855,009 $ 3,319 1.56% 820,125 $ 2,414 1.18%
================== =================
Interest Rate Spread 4.74% 4.29%
Demand Deposits (Non-Interest Bearing) 258,379 224,623
All Other Liabilities 15,226 11,157
- --------------------------------------------------------------------------- -----------
TOTAL LIABILITIES 1,128,614 1,055,905
Shareholders' Equity 120,985 112,370
- --------------------------------------------------------------------------- -----------
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY $1,249,599 $1,168,275
=========================================================================== ===========
Impact of Non-Interest Bearing Deposits and Other Liabilities 0.41% 0.29%
Net Interest Income and Margin on Total Earning Assets 14,982 5.16% 12,466 4.58%
Tax Equivalent Adjustment (484) (315)
- ------------------------------------------------------------------------------------------------------------------------------
Net Interest Income $ 14,498 4.99% $ 12,151 4.47%
==============================================================================================================================
<FN>
Notes: Yields on municipal securities have been calculated on a fully taxable equivalent basis. Loan Fees are included in
interest income for loans. Unearned discount is included for rate calculation purposes. Nonaccrual loans and lease financing
receivables have been included in the average balances. Yields on securities available-for-sale are based on historical cost.
17
FARMERS & MERCHANTS BANCORP
YEAR-TO-DATE AVERAGE BALANCES AND INTEREST RATES
(Interest and Rates on a Taxable Equivalent Basis)
(in thousands)
Six Months Ended June 30, Six Months Ended June 30,
2005 2004
ASSETS Balance Interest Rate Balance Interest Rate
- -------------------------------------------------------------------------------------------------------------------------------
Federal Funds Sold $ 4,320 $ 56 2.61% $ 11,773 $ 60 1.02%
Investment Securities Available-for-Sale
U.S. Agencies 64,805 1,191 3.73% 66,179 1,184 3.63%
Municipals - Taxable 162 5 6.26% 1,067 33 6.27%
Municipals - Non-Taxable 16,415 518 6.40% 20,869 623 6.05%
Mortgage Backed Securities 82,082 1,612 3.98% 110,740 2,028 3.71%
Other 4,982 116 4.72% 8,177 212 5.26%
- -------------------------------------------------------------------------------------------------------------------------------
Total Investment Securities Available-for-Sale 168,446 3,442 4.14% 207,032 4,080 4.00%
- -------------------------------------------------------------------------------------------------------------------------------
Investment Securities Held-to-Maturity
U.S. Agencies 25,787 551 4.33% 6,798 175 5.22%
Municipals - Non-Taxable 62,444 1,937 6.29% 36,569 1,172 6.50%
Mortgage Backed Securities 12,873 246 3.88% 5,068 112 4.48%
Other 290 8 5.59% 363 9 5.03%
- -------------------------------------------------------------------------------------------------------------------------------
Total Investment Securities Held-to-Maturity 101,394 2,742 5.48% 48,798 1,468 6.10%
- -------------------------------------------------------------------------------------------------------------------------------
Loans
Real Estate 498,188 16,240 6.57% 470,304 14,607 6.23%
Home Equity 63,642 1,861 5.90% 55,550 1,285 4.64%
Agricultural 132,373 4,252 6.48% 128,290 3,244 5.07%
Commercial 162,162 5,429 6.75% 135,008 3,762 5.59%
Consumer 12,515 521 8.40% 11,147 517 9.30%
Credit Card 4,939 245 10.00% 4,525 218 9.66%
Municipal 981 22 4.52% 1,074 23 4.29%
- -------------------------------------------------------------------------------------------------------------------------------
Total Loans 874,800 28,570 6.59% 805,898 23,656 5.89%
- -------------------------------------------------------------------------------------------------------------------------------
Total Earning Assets 1,148,960 $ 34,810 6.11% 1,073,501 $ 29,264 5.47%
================== =================
Unrealized Gain/(Loss) on Securities Available-for-Sale (1,214) 1,374
Allowance for Loan Losses (17,855) (17,553)
Cash and Due From Banks 33,439 32,283
All Other Assets 69,535 61,050
- --------------------------------------------------------------------------- -----------
TOTAL ASSETS $1,232,865 $1,150,655
=========================================================================== ===========
LIABILITIES & SHAREHOLDERS' EQUITY
Interest Bearing Deposits
Interest Bearing DDA $ 113,304 $ 38 0.07% $ 94,426 $ 29 0.06%
Savings 303,132 653 0.43% 278,333 507 0.37%
Time Deposits 350,335 3,611 2.08% 312,659 2,585 1.66%
- -------------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Deposits 766,771 4,302 1.13% 685,418 3,121 0.91%
Other Borrowed Funds 64,769 1,449 4.51% 111,357 1,498 2.70%
Subordinated Debentures 10,310 297 5.83% 10,310 208 4.06%
- -------------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities 841,850 $ 6,048 1.45% 807,085 $ 4,827 1.20%
================== =================
Interest Rate Spread 4.66% 4.27%
Demand Deposits (Non-Interest Bearing) 257,520 221,253
All Other Liabilities 14,079 10,614
- --------------------------------------------------------------------------- -----------
TOTAL LIABILITIES 1,113,449 1,038,952
Shareholders' Equity 119,416 111,703
- --------------------------------------------------------------------------- -----------
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY $1,232,865 $1,150,655
=========================================================================== ===========
Impact of Non-Interest Bearing Deposits and Other Liabilities 0.39% 0.30%
Net Interest Income and Margin on Total Earning Assets 28,762 5.05% 24,437 4.57%
Tax Equivalent Adjustment (900) (654)
- -------------------------------------------------------------------------------------------------------------------------------
Net Interest Income $ 27,862 4.89% $ 23,783 4.47%
===============================================================================================================================
<FN>
Notes: Yields on municipal securities have been calculated on a fully taxable equivalent basis. Loan Fees are included in
interest income for loans. Unearned discount is included for rate calculation purposes. Nonaccrual loans and lease financing
receivables have been included in the average balances. Yields on securities available-for-sale are based on historical cost.
18
FARMERS & MERCHANTS BANCORP
VOLUME AND RATE ANALYSIS OF NET INTEREST REVENUE
(Rates on a Taxable Equivalent Basis)
(in thousands) Three Months Ended Six Months Ended
June 30, 2005 compared June 30, 2005 compared
to June 30, 2004 to June 30, 2004
INTEREST EARNING ASSETS Volume Rate Net Chg. Volume Rate Net Chg.
- ----------------------------------------------------------------------------------------------------------------
Federal Funds Sold $ (19) $ 25 $ 6 $ (109) $ 105 $ (4)
Investment Securities Available for Sale
U.S. Agencies (254) 218 (36) (53) 60 7
Municipals - Taxable (8) (8) (16) (28) 0 (28)
Municipals - Non-Taxable (31) 10 (21) (196) 91 (105)
Mortgage Backed Securities (496) 264 (232) (791) 375 (416)
Other (37) (12) (49) (76) (20) (96)
- ----------------------------------------------------------------------------------------------------------------
Total Investment Securities Available for Sale (826) 472 (354) (1,144) 506 (638)
- ----------------------------------------------------------------------------------------------------------------
Investment Securities Held to Maturity
U.S. Agencies 0 133 133 468 (92) 376
Municipals - Non-Taxable 556 (77) 479 877 (112) 765
Mortgage Backed Securities 0 8 8 180 (46) 134
Other (1) (1) (2) (3) 2 (1)
- ----------------------------------------------------------------------------------------------------------------
Total Investment Securities Held to Maturity 555 63 618 1,522 (248) 1,274
- ----------------------------------------------------------------------------------------------------------------
Loans:
Real Estate 330 769 1,099 844 789 1,633
Home Equity 103 229 332 201 375 576
Agricultural 44 567 611 104 904 1,008
Commercial 494 587 1,081 819 848 1,667
Consumer 136 (123) 13 115 (111) 4
Credit Card 12 3 15 20 7 27
Other (3) 3 0 (3) 2 (1)
- ----------------------------------------------------------------------------------------------------------------
Total Loans 1,116 2,035 3,151 2,100 2,814 4,914
- ----------------------------------------------------------------------------------------------------------------
Total Earning Assets 826 2,595 3,421 2,369 3,177 5,546
- ----------------------------------------------------------------------------------------------------------------
INTEREST BEARING LIABILITIES
Interest Bearing Deposits:
Transaction 3 1 4 6 3 9
Savings 18 58 76 47 99 146
Time Deposits 173 520 693 330 696 1,026
- ----------------------------------------------------------------------------------------------------------------
Total Interest Bearing Deposits 194 579 773 383 798 1,181
Other Borrowed Funds (1,391) 1,469 78 (1,569) 1,520 (49)
Subordinated Debentures 0 54 54 0 89 89
- ----------------------------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities (1,197) 2,102 905 (1,186) 2,407 1,221
- ----------------------------------------------------------------------------------------------------------------
TOTAL CHANGE $ 2,023 $ 493 $ 2,516 $ 3,555 $ 770 $ 4,325
================================================================================================================
<FN>
Notes: Rate/volume variance is allocated based on the percentage relationship of changes in volume and changes
in rate to the total "net change". The above figures have been rounded to the nearest whole number.
19
ALLOWANCE AND PROVISION FOR LOAN LOSSES
As a financial institution that assumes lending and credit risks as a principal
element of its business, some level of credit losses will be experienced in the
normal course of business. The Company manages and controls credit risk through
credit management policies and procedures, underwriting and approval standards,
dollar limits on loans to one borrower and by restricting loans made primarily
to its principal market area where management believes it is better able to
assess the applicable risk. Additionally, management has established guidelines
to ensure the diversification of the Company's credit portfolio such that even
within key portfolio sectors such as real estate or agriculture, the portfolio
is diversified across factors such as location, building type, crop type, etc.
Management actively monitors the existing portfolio and reports regularly to the
Board of Directors regarding trends and conditions in the loan portfolio and
regularly conducts credit reviews of individual loans. Loans that are
performing but have shown some signs of weakness are subjected to more stringent
reporting and oversight.
The allowance for loan losses is established to absorb losses inherent in the
portfolio. The allowance for loan losses is maintained at a level considered by
management to be adequate to provide for losses that are inherent in the loan
portfolio. The allowance is increased by provisions charged to operating
expense and reduced by net charge-offs. In determining the adequacy of the
allowance for loan losses, management takes into consideration many factors
including: existing general economic and business conditions affecting the key
lending areas of the Company, current levels of problem loans and delinquencies,
credit quality trends, collateral values, loan volumes and concentration,
seasoning of the loan portfolio, specific industry conditions, recent loss
experience, duration of the current business cycle, bank regulatory examination
results and findings of the Company's internal credit examiners. The allowance
is based on estimates and ultimate losses may vary from the current estimates.
Management reviews these estimates periodically and, when adjustments are
necessary, they are reported in the period in which they become known.
After reviewing the above factors, management concluded that, due to the
improvement in non-performing assets (see Non-Performing Assets) from $2.5
million at June 30, 2004 to $64,000 at June 30, 2005, no provision for loan
losses was necessary during the first and second quarters of 2005 and the
allowance for loan losses as of June 30, 2005 was adequate. The provision for
loan losses for the second quarter of 2004 was $350,000.
As of June 30, 2005, the allowance for loan losses was $17.9 million, which
represents 2.0% of the total loan balances. As of June 30, 2004, the allowance
was $17.8 million or 2.1% of total loans. The table below illustrates the
change in the allowance for the first six months of 2005 and 2004.
Allowance for Loan Losses (in thousands)
- -------------------------
Balance, December 31, 2004 $ 17,727
Provision Charged to Expense 0
Recoveries of Loans Previously Charged Off 496
Loans Charged Off (280)
==================================================================================
Balance, June 30, 2005 $ 17,943
==================================================================================
Balance, December 31, 2003 $ 17,220
Provision Charged to Expense 725
Recoveries of Loans Previously Charged Off 74
Loans Charged Off (243)
==================================================================================
Balance, June 30, 2004 $ 17,776
==================================================================================
20
NON-INTEREST INCOME
Overall, non-interest income decreased $1.1 million or 15.1% for the six months
ended June 30, 2005 compared to the same period of 2004. Most of the decline
occurred in gain on sale of investment securities, which was $747,000 through
the first six months of 2004 as compared to $144,000 for the first six months of
2005. During the first six months of 2004 the Company took advantage of a
decline in interest rates by selling approximately $37 million in investment
securities for a gain.
The remaining decrease in non-interest income occurred in service charges on
deposit accounts due to: (1) the conversion of certain deposit customers to a
newly offered high performance checking product that does not have a monthly
service charge; (2) increasing interest rates which reduced service charges for
those commercial customers on business account analysis; and (3) a decrease in
fees generated from money service business relationships as a result of the
Company's strategic decision to exit this product line.
Other non-interest income also decreased because of derivative contract gains in
the amount of $118,000 and a gain on sale of fixed assets in the amount of
$125,000 that were recorded during the first six months of 2004 but not during
the first six months of 2005.
NON-INTEREST EXPENSE
Overall, non-interest expense increased $2.2 million or 12.8% over the first six
months of 2005, primarily as a result of a $1.6 million increase in Salaries and
Employee Benefits. This increase was due to officer salary merit increases
which occurred in May 2004 and a $1.2 million increase in Pension Plan expense
related to the Company's decision to terminate its Defined Benefit Pension Plan
during 2005. This increased level of Pension Plan expense will continue until
the plan is terminated during the fourth quarter of 2005. Refer to Note 12 of
the Consolidated Financial Statements in the Company's 2004 Annual Report to
Shareholders for more information.
The other factor impacting non-interest expense was the introduction of a new
high performance checking product and the associated direct mail and other
ancillary expenses incurred to promote this product.
PROVISION FOR INCOME TAXES
The provision for income taxes increased 11.0% to $5.1 million for the first six
months of 2005. The Company's effective tax rate decreased for the first six
months of 2005 and was 36.2% compared to 36.5% for the same period in 2004.
FINANCIAL CONDITION
INVESTMENT SECURITIES
The Financial Accounting Standards Board Statement, "Accounting for Certain
Investments in Debt and Equity Securities", requires the Company to classify its
investments as held-to-maturity, trading or available-for-sale. Securities are
classified as held-to-maturity and are carried at amortized cost when the
Company has the positive intent and ability to hold the securities to maturity.
Trading securities are securities acquired for short-term appreciation and are
carried at fair value, with unrealized gains and losses recorded in non-interest
income. Securities classified as available-for-sale include securities, which
may be sold to effectively manage interest rate risk exposure, prepayment risk,
satisfy liquidity demand and other factors. These securities are reported at
fair value with aggregate, unrealized gains or losses excluded from income and
included as a separate component of shareholders' equity, net of related income
taxes.
21
The investment portfolio provides the Company with an income alternative to
loans. As of June 30, 2005 the investment portfolio represented 21.3% of the
Company's total assets. Total investment securities increased $9.0 million from
a year ago and now total $269.2 million. Beginning in the fourth quarter of
2004, the Company's asset and liability management strategy called for
increasing the size of the Company's longer-term municipal security portfolio.
These balances have increased $31.0 million since June 30, 2004. This strategy
is intended to provide the Company, which is asset-sensitive, with some
protection in the event of a drop in interest rates. For further discussion see
Market Risk - Interest Rate Risk under Item 3. Quantitative and Qualitative
Disclosures About Market Risk.
Not included in the investment portfolio are overnight investments in Federal
Funds Sold. For the six months ended June 30, 2005, average Federal Funds Sold
was $4.3 million compared to $11.8 million in 2004.
LOANS
The Company's loan portfolio at June 30, 2005 increased $62.7 million from June
30, 2004. The increase was due to strong loan demand in the Company's market
area, along with an aggressive calling program on selected loan prospects.
Additionally, on an average balance basis loans have increased $68.9 million or
8.6%. The table following sets forth the distribution of the loan portfolio by
type as of the dates indicated.
Loan Portfolio As Of:
- ---------------------
(in thousands) June 30, 2005 Dec. 31, 2004 June 30, 2004
- ----------------------------------------------------------------------------
Real Estate $ 450,491 $ 431,746 $ 420,835
Real Estate Construction 59,903 62,446 65,742
Home Equity 64,571 63,782 56,628
Agricultural 147,243 151,002 139,425
Commercial 164,368 142,133 143,695
Consumer 18,836 17,973 16,411
- ----------------------------------------------------------------------------
Gross Loans 905,412 869,082 842,736
Less:
Unearned Income 2,343 2,174 2,014
Allowance for Loan Losses 17,943 17,727 17,776
- ----------------------------------------------------------------------------
Net Loans $ 885,126 $ 849,181 $ 822,946
============================================================================
In the ordinary course of business, the Company enters into commitments to
extend credit to its customers. These commitments are not reflected in the
accompanying consolidated financial statements. As of June 30, 2005, the Company
had entered into commitments with certain customers amounting to $421.2 million
compared to $323.1 million at June 30, 2004. Letters of credit at June 30, 2005
and June 30, 2004, were $15.4 million and $13.1 million, respectively.
NON-PERFORMING ASSETS
Non-performing assets are comprised of non-performing loans (defined as
non-accrual loans plus accruing loans past due 90 days or more) and other real
estate owned. As set forth in the table below, non-performing loans as of June
30, 2005 were $64,000 compared to $2.5 million at June 30, 2004. Accrued
interest reversed from income on loans placed on a non-accrual status totaled
$3,000 at June 30, 2005 compared to $338,000 at June 30, 2004. The Company
reported no other real estate owned for both June 30, 2005 and June 31, 2004.
22
Non-Performing Assets
- ---------------------
(in thousands) June 30, 2005 Dec. 31, 2004 June 30, 2004
- ----------------------------------------------------------------------------------
Non-performing Loans $ 64 $ 225 $ 2,483
Other Real Estate Owned - - -
==================================================================================
Total $ 64 $ 225 $ 2,483
==================================================================================
- ----------------------------------------------------------------------------------
Non-Performing Assets
as a % of Total Loans 0.01% 0.03% 0.3%
- ----------------------------------------------------------------------------------
Allowance for Loan Losses as a
% of Non-Performing Loans 28,035.9% 7,878.7% 715.9%
- ----------------------------------------------------------------------------------
Except for non-performing loans shown in the table above, the Bank's management
is not aware of any loans as of June 30, 2005 for which known credit problems of
the borrower would cause serious doubts as to the ability of these borrowers to
comply with their present loan repayment terms, or any known events that would
result in the loan being designated as non-performing at some future date. The
Company's management cannot, however, predict the extent to which the following
or other factors may affect a borrower's ability to pay: 1) deterioration in
general economic conditions, real estate values or agricultural commodity
prices; 2) increases in interest rates; or 3) changes in the overall financial
condition or business of a borrower.
DEPOSITS
One of the key sources of funds to support earning assets (loans and
investments) is the generation of deposits from the Company's customer base.
The ability to grow the customer base and subsequently deposits is a significant
element in the performance of the Company.
At June 30, 2005, deposits totaled $1.0 billion. This represents an increase of
3.9% or $37.8 million from June 30, 2004. The increase was focused in demand
and interest bearing transaction deposit accounts, which increased $26.4 million
and $17.1 million, respectively. The Company's calling efforts for prospective
customers includes acquiring both loan and deposit relationships which results
in new demand, interest bearing transaction and savings accounts. Due to strong
growth in demand, interest bearing transaction and savings balances, the Company
has reduced its focus on growing higher cost time deposits; therefore,
non-public time deposits have decreased $7.9 million since June 30, 2004. This
reduced reliance on higher cost time deposits has had, and is expected to
continue to have, a positive impact on the Company's net interest margin (see
Net Interest Income).
As previously discussed (see Overview) the Company's deposit balances are
seasonally affected by its agricultural customers. From December 31, 2004 to
June 30, 2005 demand, interest bearing transaction and savings deposits declined
$29.2 million or 4.3%. Management believes that much of this decline is
attributable to normal seasonal patterns, as well as the Company's decision to
not aggressively compete for deposits solely on a rate basis. Management
believes that the deposit outflows experienced during the first half of 2005 are
easily compensated for through other funding sources available to the Company
such as Federal Funds and Federal Home Loan Bank advances (see Liquidity Risk
and Federal Home Loan Bank Advances and Other Borrowings) and that the Company's
net interest margin benefits from its strategy of not aggressively competing for
deposits solely on a rate basis.
23
FEDERAL HOME LOAN BANK ADVANCES AND OTHER BORROWINGS
Advances from the Federal Home Loan Bank and Federal Funds Purchased are other
key sources of funds to support earning assets (see Liquidity Risk). These
borrowings are also used to manage the Company's interest rate risk exposure,
and as opportunities exist, to borrow and invest the proceeds at a positive
spread through the investment portfolio. FHLB Advances and Federal Funds
Purchased as of June 30, 2005 were $113.3 million compared to $85.9 million as
of June 30, 2004. This increase of $27.4 million occurred as a result of
seasonal deposit outflows during the first six months of 2005 (see Deposits).
LONG-TERM SUBORDINATED DEBENTURES
On December 17, 2003 the Company raised $10 million through an offering of trust
preferred securities. Although this amount is reflected as subordinated debt on
the Company's balance sheet, under applicable regulatory guidelines, trust
preferred securities qualify as regulatory capital (see Capital). These
securities accrue interest at a variable rate based upon 3-month Libor plus
2.85%. Interest rates reset quarterly and were 6.27% as of June 30, 2005
compared to 4.41% at June 30, 2004.
CAPITAL
The Company relies primarily on capital generated through the retention of
earnings to satisfy its capital requirements. The Company engages in an ongoing
assessment of its capital needs in order to support business growth and to
insure depositor protection. Shareholders' Equity totaled $120.7 million at
June 30, 2005 and $110.9 million at June 30, 2004.
The Company and the Bank are subject to various regulatory capital requirements
administered by the federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory, and possibly discretionary, actions
by regulators that, if undertaken, could have a direct material effect on the
Company and the Bank's financial statements. Under capital adequacy guidelines
and the regulatory framework for prompt corrective action, the Company and the
Bank must meet specific capital guidelines that involve quantitative measures of
the Company and the Bank's assets, liabilities, and certain off-balance-sheet
items as calculated under regulatory accounting practices. The Company and the
Bank's capital amounts and classification are also subject to qualitative
judgments by the regulators about components, risk weightings, and other
factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Company and the Bank to maintain minimum amounts and ratios set
forth in the table below of Total and Tier I capital to risk-weighted assets and
of Tier I capital to average assets (all terms as defined in the regulations).
Management believes, as of June 30, 2005, that the Company and the Bank meet all
capital adequacy requirements to which it is subject.
As of June 30, 2004, the most recent notification from the Federal Reserve Bank
categorized the Company and the Bank as well capitalized under the regulatory
framework for prompt corrective action. To be categorized as well capitalized,
the Company and the Bank must maintain minimum Total risk-based, Tier I
risk-based, and Tier I leverage ratios as set forth in the table. There are no
conditions or events since that notification that management believes have
changed the institutions' categories.
24
TO BE WELL
CAPITALIZED UNDER
REGULATORY CAPITAL PROMPT CORRECTIVE
(IN THOUSANDS) ACTUAL REQUIREMENTS ACTION PROVISIONS
- -----------------------------------------------------------------------------------------------------
THE COMPANY: AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
- -----------------------------------------------------------------------------------------------------
As of June 30, 2005
Total Capital to Risk Weighted Assets $146,678 13.05% $ 89,922 8.0% N/A N/A
Tier I Capital to Risk Weighted Assets $132,585 11.80% $ 44,961 4.0% N/A N/A
Tier I Capital to Average Assets $132,585 10.68% $ 49,656 4.0% N/A N/A
TO BE WELL
CAPITALIZED UNDER
REGULATORY CAPITAL PROMPT CORRECTIVE
(IN THOUSANDS) ACTUAL REQUIREMENTS ACTION PROVISIONS
- -----------------------------------------------------------------------------------------------------
THE BANK: AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
- -----------------------------------------------------------------------------------------------------
As of June 30, 2005
Total Capital to Risk Weighted Assets $144,135 12.85% $ 89,721 8.0% $ 112,151 10.0%
Tier I Capital to Risk Weighted Assets $130,066 11.60% $ 44,860 4.0% $ 67,291 6.0%
Tier I Capital to Average Assets $130,066 10.50% $ 49,529 4.0% $ 61,911 5.0%
As previously discussed (see Long-term Subordinated Debentures), in order to
supplement its regulatory capital base, during December, 2003 the Company raised
$10 million of trust preferred securities. Under applicable regulatory
guidelines, trust preferred securities qualify as Tier 1 capital up to a maximum
of 25% of Tier 1 capital. Any additional portion of trust preferred securities
would qualify as Tier 2 capital. The Company has received notification from the
Federal Reserve Bank of San Francisco that all of the Company's trust preferred
securities currently qualify as Tier 1 capital.
In accordance with the provisions of Financial Accounting Standard Board
Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"),
the Company does not consolidate the subsidiary trust which has issued the trust
preferred securities.
In a March 1, 2005 press release, the FRB issued its final rule concerning the
regulatory capital treatment of trust preferred securities by bank holding
companies. The final rule closely follows the proposed rule that was released on
May 6, 2004 and states that bank holding companies may include trust preferred
securities in Tier 1 capital in an amount equal to 25% of the sum of core
capital elements net of goodwill, less any associated deferred tax liability.
The Company currently has no goodwill or associated deferred tax liability so
this requirement does not impact the Company. The effective date of this final
rule is April 11, 2005.
In 1998, the Board approved the Company's first stock repurchase program which
expired on May 1, 2001. During the second quarter of 2004, the Board of
Directors of Farmers & Merchants Bancorp approved a second stock repurchase
program because it has concluded that the Company continues to have more capital
than it needs to meet present and anticipated regulatory guidelines to be
classified as "well capitalized".
Repurchases under the second program will be made on the open market or through
private transactions. The aggregate price to be paid by the Company for all
repurchased stock will not exceed $10,000,000 and the program will expire on or
before May 31, 2007. The repurchase program also requires that no purchases may
be made if the Company would not remain "well-capitalized" after the repurchase.
All shares repurchased under the repurchase program will be retired (see Part
II, Item 2. Unregistered Sales of Securities and Use of Proceeds).
25
Since 1999, the Company has repurchased over 46,000 shares for total
consideration of $12.8 million, including 2,130 shares during the first six
months of 2005 at an average price of $499 per share.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
This "Management's Discussion and Analysis of Financial Condition and Results of
Operations," is based upon the Company's consolidated financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States. In preparing the Company's financial statements
management makes estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses. These judgments govern areas such
as the allowance for loan losses, the fair value of financial instruments,
accounting for income taxes and pension accounting.
For a full discussion of the Company's critical accounting policies and
estimates see "Management's Discussion and Analysis" in the Company's Annual
Report to Shareholders for the year ended December 31, 2004.
OFF BALANCE SHEET ARRANGEMENTS
Off-balance sheet arrangements are any contractual arrangement to which an
unconsolidated entity is a party, under which the Company has: (1) any
obligation under a guarantee contract; (2) a retained or contingent interest in
assets transferred to an unconsolidated entity or similar arrangement that
serves as credit, liquidity or market risk support to that entity for such
assets; (3) any obligation under certain derivative instruments; or (4) any
obligation under a material variable interest held by the Company in an
unconsolidated entity that provides financing, liquidity, market risk or credit
risk support to the Company, or engages in leasing, hedging or research and
development services with the Company.
For a full discussion of the Company's off balance sheet arrangements, see the
Notes to the Consolidated Financial Statements in the Company's 2004 Annual
Report to Shareholders.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
RISK MANAGEMENT
The Company has adopted a Risk Management Plan to provide for the proper control
and management of risk factors inherent in the operation of the Company.
Specifically, credit risk, interest rate risk, liquidity risk, compliance risk,
strategic risk, and reputation risk can all affect the market risk of the
Company. These specific risk factors are not mutually exclusive. It is
recognized that any product or service offered by the Company may expose the
Company to one or more of these risk factors.
CREDIT RISK
Credit risk is the risk to earnings or capital arising from an obligor's failure
to meet the terms of any contract or otherwise fail to perform as agreed.
Credit risk is found in all activities where success depends on counterparty,
issuer or borrower performance.
Credit risk in the investment portfolio is addressed through defined limits in
the Company's policy statements. The Company's investment policy is
conservative. The Company invests primarily in mortgage-backed securities, U.S.
Treasuries, U.S. Government Agencies, and high-grade municipals. Additionally,
most municipal securities carry insurance to enhance the credit quality of the
bond.
The Company manages and controls credit risk in the loan portfolio through
credit management policies and procedures, underwriting and approval standards,
dollar limits on loans to one borrower and by restricting loans made primarily
to its principal market area where management believes it is better able to
assess the applicable risk. Additionally, management has established guidelines
to ensure the diversification of the Company's credit portfolio such that even
within key portfolio sectors such as real estate or agriculture, the portfolio
is diversified across factors such as location, building type, crop type,
26
etc. Management actively monitors the existing portfolio and reports regularly
to the Board of Directors regarding trends and conditions in the loan portfolio
and regularly conducts credit reviews of individual loans. Loans that are
performing but have shown some signs of weakness are subjected to more stringent
reporting and oversight.
As a financial institution which assumes lending and credit risks as a principal
element in its business, the Company anticipates that credit losses will be
experienced in the normal course of business. Accordingly, an allowance for loan
losses is maintained at a level considered adequate by management to provide for
losses that are inherent in the portfolio. The allowance is increased by
provisions charged to operating expense and by recoveries on loans previously
charged-off and reduced by charge-offs. Management employs a systematic
methodology for determining the allowance for loan losses. On a quarterly basis,
management reviews the credit quality of the loan portfolio and considers many
factors in determining the adequacy of the allowance balance.
Central to the Company's evaluation of the adequacy of the allowance for loan
losses is its loan risk rating system. The originating credit officer assigns
borrowers an initial risk rating, which is based primarily on a thorough
analysis of each borrower's financial position in conjunction with industry and
economic trends. Approvals are made based upon the amount of inherent credit
risk specific to the transaction and are reviewed for appropriateness by senior
credit administration personnel. Credits are monitored by credit administration
personnel for deterioration in a borrower's financial condition, which would
impact the ability of the borrower to perform under the contract. Risk ratings
are adjusted as necessary.
Based on the risk rating system specific allowances are established in cases
where management has identified significant conditions or circumstances related
to a credit that management believes indicates the possibility of loss.
Management performs a detailed analysis of these loans, including, but not
limited to, cash flows, appraisals of the collateral, conditions of the
marketplace for liquidating the collateral and assessment of the guarantors.
Management then determines the inherent loss potential and allocates a portion
of the allowance for losses as a specific allowance for each of these credits.
The Company also segments the loan portfolio by risk rating and into groups of
loans with similar characteristics in accordance with SFAS No. 5, "Accounting
for Contingencies". During this process groups of loans are reviewed and
applied the appropriate allowance percentage to determine a portfolio formula
allowance.
Finally, the Company's methodology for assessing the appropriateness of the
allowance involves management's consideration of all known relevant internal and
external factors that may affect a loan's collectibility. The factors evaluated
in connection with the allowance may include existing general economic and
business conditions affecting the key lending areas of the Company, current
levels of problem loans and delinquencies, credit quality trends, collateral
values, loan volumes and concentration, seasoning of the loan portfolio,
specific industry conditions, recent loss experience, duration of the current
business cycle, bank regulatory examination results and findings of the
Company's internal credit examiners.
While the Company utilizes a systematic methodology in determining its
allowance, the allowance is based on estimates, and ultimate losses may vary
from current estimates. The estimates are reviewed periodically and, as
adjustments become necessary, are reported in earnings in the periods in which
they become known.
27
Management believes that the allowance for loan losses at June 30, 2005 was
adequate to provide for losses inherent in the portfolio. No assurances can be
given that future events may not result in increases in delinquencies,
non-performing loans or net loan charge-offs that would increase the provision
for loan losses and thereby adversely affect the results of operations.
INTEREST RATE RISK
The mismatch between maturities of interest sensitive assets and liabilities
results in uncertainty in the Company's earnings and economic value and is
referred to as interest rate risk. The Company's primary objective in managing
interest rate risk is to minimize the potential for significant loss as a result
of changes in interest rates.
The Company measures interest rate risk in terms of the potential impact on both
its economic value and earnings. Methods for analyzing interest rate risk
include: (1) asset/liability mismatch ("GAP") analysis; (2) earnings simulation
model; and (3) economic value of equity ("EVE") analysis.
The Company's GAP analysis measures, at specific time intervals, the divergence
between earning assets and interest bearing liabilities for which repricing
opportunities will occur. A positive difference, or positive gap, indicates
that earning assets will reprice faster than interest-bearing liabilities. This
will generally produce a greater net interest margin during periods of rising
interest rates and a lower net interest margin during periods of declining
interest rates. Conversely, a negative gap will generally produce a lower net
interest margin during periods of rising interest rates and a greater net
interest margin during periods of decreasing interest rates.
The interest rates paid on deposit accounts do not always move in unison with
the rates charged on loans. In addition, the magnitude of changes in the rates
charged on loans is not always proportionate to the magnitude of changes in the
rate paid for deposits. Consequently, changes in interest rates do not
necessarily result in an increase or decrease in the net interest margin solely
as a result of the differences between repricing opportunities of earning assets
or interest bearing liabilities.
The Company's earnings simulation model quantifies the estimated exposure to net
interest income of sustained interest rate changes. The sensitivity of the
Company's net interest income is measured over a rolling one-year horizon.
The simulation model estimates the impact of changing interest rates on interest
income from all interest earning assets and the interest expense paid on all
interest bearing liabilities reflected on the Company's balance sheet. This
sensitivity analysis is compared to policy limits, which specify a maximum
tolerance level for net interest income exposure over a one-year horizon
assuming no balance sheet growth, given a 200 basis point upward and a 100 basis
point downward shift in interest rates. A shift in rates over a 12-month period
is assumed. Results that exceed policy limits, if any, are analyzed for risk
tolerance and reported to the Board with appropriate recommendations. At June
30, 2005, the Company's estimated net interest income sensitivity to changes in
interest rates, as a percent of net interest income was an increase in net
interest income of 1.29% if rates increase by 200 basis points and a decrease in
net interest income of 2.95% if rates decline 200 basis points.
The estimated sensitivity does not necessarily represent a Company forecast and
the results may not be indicative of actual changes to the Company's net
interest income. These estimates are based upon a number of assumptions
including: the nature and timing of interest rate levels including yield curve
shape, prepayments on loans and securities, pricing strategies on loans and
deposits, replacement of asset and liability cashflows, and other assumptions.
While the assumptions used are based on current economic and local market
conditions, there is no assurance as to the predictive nature of these
28
conditions including how customer preferences or competitor influences might
change. See Note 13 of the Notes to the Consolidated Financial Statements
located in the 2004 Annual Report to Shareholders.
The Company's EVE analysis measures the present value of the Company's assets,
less the present value of its liabilities, the net present value of any
off-balance sheet items. This analysis is compared to policy limits, which
specify a maximum tolerance level the Company has established based on the
Summary Guidelines found in Thrift Bulletin 13a.
LIQUIDITY RISK
Liquidity risk is the risk to earnings or capital resulting from the Company's
inability to meet its obligations when they come due without incurring
unacceptable losses. It includes the ability to manage unplanned changes in
funding sources and to recognize or address changes in market conditions that
affect the Company's ability to liquidate assets or acquire funds quickly and
with minimum loss of value. The Company endeavors to maintain a cash flow
adequate to fund operations, handle fluctuations in deposit levels, respond to
the credit needs of borrowers and take advantage of investment opportunities as
they arise. The principal sources of liquidity include credit facilities from
correspondent banks, brokerage firms and the Federal Home Loan Bank, as well as,
interest and principal payments on loans and investments, proceeds from the
maturity or sale of investments, and growth in deposits.
In general, liquidity risk is managed daily by controlling the level of Federal
Funds (either purchased or sold) to supplement the cash flows received from
operating, investing and other financing activities (see Consolidated Statement
of Cash Flows). During the first half of 2005, Federal Funds sold averaged $4.3
million and Federal Funds purchased averaged $6.9 million. The Company
maintains Federal Fund credit lines of $50 million with major banks subject to
the customary terms and conditions for such arrangements and $175 million in
repurchase lines with major brokers. In addition the Company has additional
borrowing capacity of $152.4 million from the Federal Home Loan Bank.
At June 30, 2005, the Company had available liquid assets, which included cash
and cash equivalents and unpledged investment securities of approximately $134.5
million, which represents 10.6% of total assets.
ITEM 4. CONTROLS AND PROCEDURES
The Company maintains disclosure controls and procedures designed to ensure that
information is recorded and reported in all filings of financial reports. Such
information is reported to the Company's management, including its Chief
Executive Officer and its Chief Financial Officer to allow timely and accurate
disclosure based on the definition of "disclosure controls and procedures" in
Rule 13a-15(e). In designing these controls and procedures, management
recognizes that they can only provide reasonable assurance of achieving the
desired control objectives. Management also evaluated the cost-benefit
relationship of possible controls and procedures.
As of the end of the period covered by this report, the Company carried out an
evaluation of the effectiveness of Company's disclosure controls and procedures
under the supervision and with the participation of the Chief Executive Officer,
the Chief Financial Officer and other senior management of the Company. The
evaluation was based, in part, upon reports and affidavits provided by a number
of executives. Based on the foregoing, the Company's Chief Executive Officer and
the Chief Financial Officer concluded that the Company's disclosure controls and
procedures were effective.
There have been no significant changes in the Company's internal controls or in
other factors that could significantly affect the internal controls over
financial reporting subsequent to the date the Company completed its evaluation.
29
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
- -------------------------
Certain lawsuits and claims arising in the ordinary course of business have been
filed or are pending against the Company or its subsidiaries. Based upon
information available to the Company, its review of such lawsuits and claims and
consultation with its counsel, the Company believes the liability relating to
these actions, if any, would not have a material adverse effect on its
consolidated financial statements.
There are no material proceedings adverse to the Company to which any director,
officer or affiliate of the Company is a party.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
- -------------------------------------------------------------------
The following table indicates the number of shares repurchased by Farmers &
Merchants Bancorp during the second quarter of 2005.
NUMBER OF SHARES APPROXIMATE DOLLAR
PURCHASED AS PART VALUE OF SHARES THAT
AVERAGE OF A PUBLICLY MAY YET BE
NUMBER OF PRICE PER ANNOUNCED PLAN OR PURCHASED UNDER THE
SECOND QUARTER 2005 SHARES SHARE PROGRAM PLAN OR PROGRAM
- ----------------------------------------------------------------------------------------
04/01/2005 - 04/30/2005 0 $ 0 0 $ 7,895,000
05/01/2005 - 05/31/2005 439 499 439 7,676,100
06/01/2005 - 06/30/2005 1,678 500 1,678 6,837,100
- ----------------------------------------------------------------------------------------
Total 2,117 $ 500 2,117 $ 6,837,100
All of the above shares were repurchased in private transactions.
The common stock of Farmers & Merchants Bancorp is not widely held, is not
listed on any exchange, nor is it included on the NASDAQ National Market or the
NASDAQ Small Cap Market. However, trades may be reported on the OTC Bulletin
Board under the symbol "FMCB.OB". Additionally, management is aware that there
are private transactions in the Company's common stock.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
- ---------------------------------------
Not applicable
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
- -----------------------------------------------------------
The Annual Meeting of Shareholders of Farmers & Merchants Bancorp was held on
April 18, 2005. The business conducted at the meeting included election of
directors. Following is the voting results from the 2005 annual meeting of
shareholders. As of April 18, 2005 there were 555,557 shares represented in
person and by proxy that participated in this election and shares were voted on
the measure before the shareholders as follows:
30
1. ELECTION OF DIRECTORS
Directors % For % Withheld
--------- - --- - --------
Stewart C. Adams, Jr. 98.88 549,360 1.12 6,197
------ ------- ----- --------
Ralph Burlington 98.98 549,899 1.02 5,658
------ ------- ----- --------
Edward Corum, Jr. 98.98 549,899 1.02 5,658
------ ------- ----- --------
Robert F. Hunnell 98.98 549,899 1.02 5,658
------ ------- ----- --------
Ole R. Mettler 98.95 549,708 1.05 5,849
------ ------- ----- --------
James E. Podesta 98.97 549,849 1.03 5,708
------ ------- ----- --------
Kevin Sanguinetti 98.98 549,899 1.02 5,658
------ ------- ----- --------
H. C. Schumacher 98.98 549,899 1.02 5,658
------ ------- ----- --------
Kent A. Steinwert 98.95 549,708 1.05 5,849
------ ------- ----- --------
Calvin (Kelly) Suess 98.98 549,899 1.02 5,658
------ ------- ----- --------
Carl A. Wishek, Jr. 98.72 548,432 1.28 7,125
------ ------- ----- --------
ITEM 5. OTHER INFORMATION
- -------------------------
None
ITEM 6. EXHIBITS
- ----------------
See Exhibit Index on Page 32
31
SIGNATURES
Pursuant to the requirement 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.
FARMERS & MERCHANTS BANCORP
Date: August 4, 2005 /s/ Kent A. Steinwert
------------------------------
Kent A. Steinwert
President and
Chief Executive Officer
(Principal Executive Officer)
Date: August 4, 2005 /s/ Stephen W. Haley
------------------------------
Stephen W. Haley
Executive Vice President and
Chief Financial Officer
(Principal Accounting Officer)
INDEX TO EXHIBITS
- -----------------
Exhibit No. Description
- ----------- -----------
31(a) Certification of the Chief Executive Officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31(b) Certification of the Chief Financial Officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32 Certifications of the Chief Executive Officer and Chief Financial Officer
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
32