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, 2003 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: 1.000-26099 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 763,977 as of August 1, 2003. 1 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, 2003, December 31, 2002 and June 30, 2002. 3 Consolidated Statements of Income for the Three Months and Six Months Ended June 30, 2003 and 2002. 4 Consolidated Statements of Comprehensive Income for the Three Months and Six Months Ended June 30, 2003 and 2002. 5 Statement of Changes in Shareholders' Equity for the Six Months Ended June 30, 2003 and 2002. 6 Consolidated Statement of Cash Flows for the Six Months Ended June 30, 2003 and 2002. 7 Notes to Consolidated Financial Statements 8 Item 2 - Management's Discussion and Analysis 12 Item 3 - Quantitative and Qualitative Disclosures About Market Risk 19 Item 4 - Controls and Procedures 23 PART II. - OTHER INFORMATION 27 ----------------- Signatures 29 Index to Exhibits 30 2 PART I. - FINANCIAL INFORMATION Item 1 - Financial Statements FARMERS & MERCHANTS BANCORP Consolidated Balance Sheets - ----------------------------------------------------------------------------------------------------------------------------------- (in thousands) June 30, December 31, June 30, 2003 2002 2002 Assets (Unaudited) (Unaudited) - ----------------------------------------------------------------------------------------------------------------------------------- Cash and Cash Equivalents: Cash and Due From $48,316 $45,389 $31,201 Federal Funds Sold - 8,185 5,985 - ----------------------------------------------------------------------------------------------------------------------------------- Total Cash and Cash Equivalents 48,316 53,574 37,186 Investment Securities: Available-for-Sale 218,010 206,063 166,128 Held-to-Maturity 42,907 27,870 29,846 - ----------------------------------------------------------------------------------------------------------------------------------- Total Investment Securities 260,917 233,933 195,974 - ----------------------------------------------------------------------------------------------------------------------------------- Loans 750,137 698,693 659,923 Less: Unearned Income (2,168) (2,018) (1,546) Less: Allowance for Loan Losses (17,091) (16,684) (13,093) - ----------------------------------------------------------------------------------------------------------------------------------- Loans, Net 730,878 679,991 645,284 - ----------------------------------------------------------------------------------------------------------------------------------- Land, Buildings & Equipment 11,099 11,342 11,511 Interest Receivable and Other Assets 44,406 43,067 40,328 - ----------------------------------------------------------------------------------------------------------------------------------- Total Assets $1,095,616 $1,021,907 $930,283 =================================================================================================================================== Liabilities & Shareholders' Equity Deposits: Demand $196,845 $205,997 $172,540 Interest Bearing Transaction 88,889 93,646 84,259 Savings 243,699 231,964 219,608 Time Deposits 328,299 318,618 303,679 - ----------------------------------------------------------------------------------------------------------------------------------- Total Deposits 857,732 850,225 780,086 - ----------------------------------------------------------------------------------------------------------------------------------- Federal Funds Purchased - 16,997 - FHLB Borrowings 121,965 40,965 40,983 Other Liabilities 7,472 10,155 8,061 - ----------------------------------------------------------------------------------------------------------------------------------- Total Liabilities 987,169 918,342 829,130 - ----------------------------------------------------------------------------------------------------------------------------------- Shareholders' Equity Common Stock 8 7 7 Additional Paid In Capital 72,717 64,979 65,661 Retained Earnings 33,052 36,749 32,644 Accumulated Other Comprehensive Income 2,670 1,830 2,841 - ----------------------------------------------------------------------------------------------------------------------------------- Total Shareholders' Equity 108,447 103,565 101,153 - ----------------------------------------------------------------------------------------------------------------------------------- Total Liabilities & Shareholders' Equity $1,095,616 $1,021,907 $930,283 =================================================================================================================================== The accompanying notes are an integral part of these consolidated financial statements 3 FARMERS & MERCHANTS BANCORP Consolidated Statements of Income (Unaudited) (in thousands) Three Months Six Months Ended June 30, Ended June 30, 2003 2002 2003 2002 - --------------------------------------------------------------------------------------------------------------------------- Interest Income: Interest & Fees on Loans $11,084 $10,226 $21,676 $20,128 Federal Funds Sold 18 187 97 330 Securities: Investments Available-for-Sale: Taxable 2,041 2,541 3,946 5,573 Non-taxable 285 240 569 477 Investments Held-to-Maturity: Taxable 5 8 9 18 Non-taxable 437 352 772 713 - --------------------------------------------------------------------------------------------------------------------------- Total Interest Income 13,870 13,554 27,069 27,239 - --------------------------------------------------------------------------------------------------------------------------- Interest Expense: Interest Bearing Transaction 30 75 79 164 Savings 352 528 697 1,140 Time Deposits 1,737 2,264 3,644 4,897 Interest on Borrowed Funds 828 556 1,405 1,106 - --------------------------------------------------------------------------------------------------------------------------- Total Interest Expense 2,947 3,423 5,825 7,307 - --------------------------------------------------------------------------------------------------------------------------- Net Interest Income 10,923 10,131 21,244 19,932 Provision for Loan Losses 125 300 325 500 - --------------------------------------------------------------------------------------------------------------------------- Net Interest Income After Provision for Loan Losses 10,798 9,831 20,919 19,432 - --------------------------------------------------------------------------------------------------------------------------- Non-Interest Income Service Charges on Deposit Accounts 1,228 1,155 2,404 2,244 Net Gain (Loss) on Sale of Investment Securities 242 232 374 276 Other 1,717 1,564 3,360 2,635 - --------------------------------------------------------------------------------------------------------------------------- Total Non-Interest Income 3,187 2,951 6,138 5,155 - --------------------------------------------------------------------------------------------------------------------------- Non-Interest Expense Salaries & Employee Benefits 5,311 4,568 10,250 8,748 Occupancy 368 422 773 835 Equipment 497 559 1,098 1,192 Other Operating 2,144 2,010 3,948 3,730 - --------------------------------------------------------------------------------------------------------------------------- Total Non-Interest Expense 8,320 7,559 16,069 14,505 - --------------------------------------------------------------------------------------------------------------------------- Net Income Before Taxes 5,665 5,223 10,988 10,082 Provision for Taxes 2,021 1,903 3,943 3,700 - --------------------------------------------------------------------------------------------------------------------------- Net Income $3,644 $3,320 $7,045 $6,382 =========================================================================================================================== Earnings Per Share $4.76 $4.30 $9.19 $8.21 =========================================================================================================================== The accompanying notes are an integral part of these consolidated financial statements 4 FARMERS & MERCHANTS BANCORP Consolidated Statements of Comprehensive Income (Unaudited) - ---------------------------------------------------------------------------------------------------------------------------------- (in thousands) Three Months Ended Six Months Ended June 30, June 30, June 30, June 30, 2003 2002 2003 2002 - ---------------------------------------------------------------------------------------------------------------------------------- Net Income $ 3,644 $ 3,320 $ 7,045 $ 6,382 Other Comprehensive Income (Loss) - Unrealized Gains on Derivative Instruments: Unrealized holding gains arising during the period, net of income tax effects of $30and $0 for the quarters ended June 30, 2003 and 2002, respectively, and $85 and $0 for the six months ended June 30, 2003 and 2002, respectively. $ 41 $ 0 $ 117 $ 0 Unrealized Gains (Losses) on Securities: Unrealized holding gains (losses) arising during the period, net of income tax effects of $870 and $(269) for the quarters ended June 30, 2003 and 2002, respectively, and of $682 and ($57) for the six months ended June 30, 2003 and 2002, respectively. 1,200 371 940 (25) Less: Reclassification adjustment for realized (gains) losses included in net income, net of related income tax effects of ($101) and $0 for the quarters ended June 30, 2003 and 2002, respectively, and of $(157) and $(2) for the six months ended June 30, 2003 and 2002, respectively. (141) (8) (217) (4) - ---------------------------------------------------------------------------------------------------------------------------------- Total Other Comprehensive Income 1,100 363 840 (29) - ---------------------------------------------------------------------------------------------------------------------------------- Comprehensive Income $ 4,744 $ 3,683 $ 7,885 $ 6,353 ================================================================================================================================== The accompanying notes are an integral part of these consolidated financial statements 5 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 Equity - -------------------------------------------------------------------------------------------------------------------------------- Balance, December 31, 2001 719,269 $ 7 $ 61,360 $ 36,499 $ 2,870 $ 100,736 - -------------------------------------------------------------------------------------------------------------------------------- Net Income - - 6,382 - 6,382 Cash Dividends Declared on - Common Stock - - (1,472) - (1,472) 5% Stock Dividend 34,501 - 8,625 (8,625) - - Cash Paid in Lieu of Fractional Shares Related to Stock Dividend - - (140) - (140) Redemption of Stock (18,021) - (4,324) - - (4,324) Changes in Net Unrealized Gain (Loss) on Securities Available for Sale - - - (29) (29) - -------------------------------------------------------------------------------------------------------------------------------- Balance, June 30, 2002 735,749 $ 7 $ 65,661 $ 32,644 $ 2,841 $101,153 ================================================================================================================================ - -------------------------------------------------------------------------------------------------------------------------------- Balance, December 31, 2002 733,021 $ 7 $ 64,979 $ 36,749 $ 1,830 $ 103,565 - -------------------------------------------------------------------------------------------------------------------------------- Net Income - - 7,045 - 7,045 Cash Dividends Declared on Common Stock - - (1,604) - (1,604) 5% Stock Dividend 35,985 1 8,996 (8,996) - 1 Cash Paid in Lieu of Fractional Shares Related to Stock Dividend - - (142) - (142) Redemption of Stock (5,029) - (1,258) - - (1,258) Unrealized Gains on Derivative Instruments 117 117 Changes in Net Unrealized Gain (Loss) on Securities Available for Sale - - - 723 723 - -------------------------------------------------------------------------------------------------------------------------------- Balance, June 30, 2003 763,977 $ 8 $ 72,717 $ 33,052 $ 2,670 $ 108,447 ================================================================================================================================ The accompanying notes are an integral part of these consolidated financial statements 6 FARMERS & MERCHANTS BANCORP Consolidated Statement of Cash Flows (Unaudited) Six Months Ended (in thousands) June 30, June 30, 2003 2002 - ------------------------------------------------------------------------------------------------------------- Operating Activities: Net Income $7,045 $6,382 Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities: Provision for Loan Losses 325 500 Depreciation and Amortization 788 822 Provision for Deferred Income Taxes (50) (20) Net Accretion of Investment Securities 810 (75) Net Gain on Sale of Investment Securities (374) (315) Net Change in Operating Assets & Liabilities: (Increase) Decrease in Interest Receivable and Other Assets (1,796) (9,428) Increase (Decrease) in Interest Payable and Other Liabilities (2,584) (1,375) - ------------------------------------------------------------------------------------------------------------- Net Cash Provided (Used) by Operating Activities 4,164 (3,509) Investing Activities: Securities Available-for-Sale: Purchased (139,443) (10,694) Sold or Matured 128,276 87,808 Securities Held-to-Maturity: Purchased (22,096) (249) Matured 7,091 3,127 Net Loans Originated or Acquired (51,584) (56,478) Principal Collected on Loans Charged Off 372 154 Net Additions to Premises and Equipment (545) (901) - ------------------------------------------------------------------------------------------------------------- Net Cash Provided (Used) by Investing Activities (77,929) 22,767 Financing Activities: Net Decrease in Demand, Interest-Bearing Transaction, and Savings Accounts (2,174) (21,134) Increase (Decrease) in Time Deposits 9,681 (18,491) Federal Funds Purchased (16,997) 0 Federal Home Loan Bank Borrowings: Advances 81,018 0 Paydowns (18) (17) Cash Dividends (1,746) (1,612) Stock Redemption (1,257) (4,324) - ------------------------------------------------------------------------------------------------------------- Net Cash Provided (Used) by Financing Activities 68,507 (45,578) Increase (Decrease) in Cash and Cash Equivalents (5,258) (26,320) Cash and Cash Equivalents at Beginning of Year 53,574 63,506 - ------------------------------------------------------------------------------------------------------------- Cash and Cash Equivalents as of June 30, 2003 and June 30, 2002 $48,316 $37,186 ============================================================================================================= The accompanying notes are an integral part of these consolidated financial statements 7 FARMERS & MERCHANTS BANCORP NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (unaudited) For the six months ended June 30, 2003 and June 30, 2002 Significant Accounting Policies Farmers & Merchants Bancorp (the Company) was organized March 10, 1999. Its primary operations are related to traditional banking activities through its subsidiary Farmers & Merchants Bank of Central California (the Bank). The consolidated financial statements of the Company and its subsidiaries are prepared in conformity with generally accepted accounting principles and prevailing practices within the banking industry. In preparing the financial statements, management is required to make estimates and assumptions that affect reported amounts as of the date of the balance sheet and revenues and expenses for the period. These estimates are based on information available as of the date of the financial statements. Therefore, actual results could differ from those estimates. The following is a summary of the significant accounting and reporting policies used in preparing the consolidated financial statements. Basis of Presentation 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. 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. 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 net 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 and 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 Bank 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 methodology which approximates a level yield of interest over the estimated remaining period until maturity. Losses, reflecting a decline in value judged by the Bank to be other than temporary, are recognized in the period in which they become known. 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. Securities classified as available-for-sale include securities which may be sold to effectively manage interest rate risk exposure, prepayment risk, satisfy liquidity demands 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. 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. 8 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, net of related loan origination costs, 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 on the observable or estimated market price of the loan or 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 remaining principal and interest can be reasonably assured. Allowance for Loan Losses As a financial institution which assumes lending and credit risks as a principal element in its business, 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 can be reasonably estimated. The allowance is increased by provisions charged to operating expense and reduced by net 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 in determining the adequacy of the allowance balance. The conditions evaluated in connection with the allowance may include existing general economic and business conditions affecting the key lending areas of the Company, 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. 9 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. Premises and Equipment Premises, equipment and leasehold improvements are stated at cost, less accumulated depreciation and amortization. Depreciation is computed principally by the straight-line method over the estimated useful lives of the assets. Estimated useful lives of buildings range from 30 to 40 years, and for furniture and equipment from 3 to 8 years. Leasehold improvements are amortized over the lesser of the terms of the respective leases, or their useful lives, which are generally 5 to 10 years. Remodeling and capital improvements are capitalized while maintenance and repairs are charged directly to occupancy expense. Other Real Estate Other real estate owned, which is included in other assets, is comprised of properties acquired through foreclosures in satisfaction of indebtedness. These properties are recorded upon acquisition at fair value less estimated selling costs. Revised estimates to the fair value less cost to sell are reported as adjustments to the carrying amount of the asset, provided that such adjusted value is not in excess of the carrying amount at acquisition. Initial losses on properties acquired through full or partial satisfaction of debt are treated as credit losses and charged to the Allowance for Loan Losses at the time of acquisition. Subsequent declines in value from the recorded amounts, routine holding costs, and gains or losses upon disposition, if any, are included in non-interest income or expense as incurred. Income Taxes As required, the Company uses the liability method of accounting for income taxes. This method results in the recognition of deferred tax assets and liabilities that are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. The deferred provision for income taxes is the result of the net change in the deferred tax asset and deferred tax liability balances during the year. This amount combined with the current taxes payable or refundable results in the income tax expense for the current year. Earnings Per Share The actual number of shares outstanding at June 30, 2003, was 763,977. Basic earnings per share is calculated on the basis of the weighted average number of shares outstanding during the period. Weighted average number of shares for the six months ending June 30, 2003 and 2002 were 766,971 and 777,402, respectively. Earnings per share for the six months ending June 30, 2003 and 2002 were $9.19 and $8.21, respectively. Weighted average number of shares for the three months ending June 30, 2003 and 2002 were 765,375 and 771,734, respectively. Earnings per share for the three months ending June 30, 2003 and 2002 were $4.76 and $4.30, respectively. Prior periods per share amounts have been restated for the 5% stock dividend declared during 2003 and 2002. 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. 10 On April 1, 2003, the Board of Directors declared a 5% stock dividend payable May 14, 2003, to shareholders of record at the close of business on April 15, 2003. Common stock shareholders of record as of April 15, 2003, 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 $12.50 per share was paid in lieu of the stock dividend. The Board of Directors of Farmers & Merchants Bancorp declared a cash dividend on June 3, 2003, in the amount of $2.10 per share, an increase from the $2.00 per share paid last year. The cash dividend was paid on July 1, 2003, to stockholders of record as of June 17, 2003. Segment Reporting The Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" requires that public companies report certain information about operating segments. It also requires that public companies report certain information about their products and services, the geographic areas in which they operate, and their major customers. The Company is a community bank which offers a wide array of products and services to its customers. Pursuant to its banking strategy, emphasis is placed on building relationships with its customers, as opposed to building specific lines of business. As a result, the Company is not organized around discernable lines of business and prefers to work as an integrated unit to customize solutions for its customers, with business line emphasis and product offerings changing over time as needs and demands change. 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 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. Ineffective portions of changes in the fair value of cash flow hedges are recognized in earnings. As required, SFAS No. 133 was adopted by the Company effective January 1, 2001. 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, as appropriate. Comprehensive Income The Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" establishes standards for the reporting and display of comprehensive income and its components in the financial statements. Other comprehensive income refers to revenues, expenses, gains and losses that generally accepted accounting principles recognize as changes in value to an enterprise but are excluded from net income. For the Company, comprehensive income includes net income (loss) and changes in fair value of its available-for-sale investment securities, pension plan liability adjustments and cash flow hedges. 11 Recent Accounting Pronouncements In May 2003, the Financial Accounting Standards Board (FASB or the "Board") issued FASB Statement No. 150 (FAS 150 or the "Standard"), Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity. The Standard specifies that instruments within its scope embody obligations of the issuer and that, therefore, the issuer must classify them as liabilities. FAS 150 represents phase 1 of the FASB's broader project on (1) distinguishing between liability and equity instruments and (2) accounting for instruments that have characteristics of both types of instruments (the "liabilities and equity project"). The Standard covers a limited number of instruments that are to be classified as liabilities. It is expected that phase 2 of the project, set to begin in July, will address (1) separating compound financial instruments (including convertible debt and conditionally redeemable stock) that have characteristics of liabilities and equity into their liability and equity components, (2) the definition of an ownership relationship, and (3) the definition of liabilities in FASB Concepts Statement No. 6 (CON 6), Elements of Financial Statements. For calendar-year-end companies, FAS 150 will become effective at the beginning of their third quarters. The Company does not anticipate that the adoption of Statement No. 150 will have a material impact on the financial condition or operating results of the Company. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS Management's discussion and analysis is written to provide greater insight into the results of operations and the financial condition of Farmers & Merchants Bancorp and its subsidiaries. For a more complete understanding of the Company and its operations, reference should be made to the financial statements included in this report and in the Company's 2002 Annual Report on Form 10-K. Certain statements in this Report on Form 10-Q constitute "forward-looking statements" and usually contain the words "estimate," "project," "expect," "objective," "goal," or similar expressions and include 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, real estate, consumer, and other lending activities; (iv) changes in federal and state banking regulations; (v) competitive pressure in the banking industry and changes in banking or other laws and regulations or governmental fiscal or monetary policies; (vi) 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; (vii) dividend restrictions; (viii) asset/liability pricing risks and liquidity risks; (ix) changes in the securities markets; (x) certain operational risks involving data processing systems or fraud; and (xi) 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. 12 Analysis of the Results of Operations Overview For the three and six months ended June 30, 2003, Farmers & Merchants Bancorp reported net income of $3,644,000 and $7,045,000, earnings per share of $4.76 and $9.19 and return on average assets of 1.34% for both periods. Return on average shareholders' equity (net of accumulated other comprehensive income) was 13.84% and 13.54% for the three and six months ended June 30, 2003. For the three and six months ended June 30, 2002, net income totaled $3,320,000 and $6,382,000, earnings per share was $4.30 and $8.21 and return on average assets was 1.42% and 1.37%, respectively. Return on average shareholders' equity (net of accumulated other comprehensive income) for the three and six months ended June 30, 2002 was 13.63% and 13.08%, respectively. The Company's improved earnings performance in 2003 was due to a combination of (1) growth in earning assets, (2) improvement in the mix of earning assets as reflected by an increase in loans as a percentage of average earning assets, (3) improvement in non-interest income and (4) a reduction of the Company's effective tax rate from 36.6% at June 30, 2002 to 35.9% at June 30, 2003. These factors combined to offset a decline in the Bank's net interest margin as a result of the declining interest rate environment. The following is a summary of the financial results for the six-month period ended June 30, 2003 compared to June 30, 2002. o Net income increased 10.4% to $7.0 million from $6.4 million. o Net interest income increased 6.6% to $21.2 million from $19.9 million. o The provision for loan losses decreased 35.0% to $325 thousand from $500 thousand. o Non-interest income increased 19.1% to $6.1 million from $5.2 million. o Non-interest expense increased 10.8% to $16.1 million from $14.5 million. o Total assets increased 17.8% to $1.1 billion. o Investment securities increased 33.1% to $260.9 million. o Gross loans increased 13.7% to $750.1 million. o Total deposits increased 10.0% to $857.7 million. o Total shareholders' equity increased 7.2% to $108.4 million. Net Interest Income 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. 13 Net interest income increased 6.6% to $21.2 million during the first six months of 2003, compared to $19.9 million at June 30, 2002. On a fully taxable equivalent basis, net interest income increased 7.0% and totaled $22.0 million at June 30, 2003, compared to $20.6 million for the first six months of 2002. 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, which represents the average net effective yield on earning assets. For the six months ended June 30, 2003, the net interest margin on a taxable equivalent basis was 4.54% compared to 4.78% in 2002. This decrease in net interest margin was primarily a result of the declining interest rate environment between the first six months of 2002 and the first six months of 2003. Loans, generally the Company's highest earning asset, increased $90.2 million as of June 30, 2003 compared to June 30, 2002. On an average balance basis, loans increased by $100.6 million for the six months ended June 30, 2003. Due to the decline in interest rates during 2002 and the first six months of 2003, the yield on the loan portfolio decreased 52 basis points to 6.23% for the six months ended June 30, 2003 compared to 6.75% for the six months ended June 30, 2002. This decrease in yield was offset by the growth in loan balances, which resulted in interest revenue from loans increasing 7.7% to $21.7 million for the first six months of 2003. The investment portfolio is the other main component of the Company's earning assets. 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. 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 $30.2 million compared to the average balance at June 30, 2002. Even with the increase in the average balance of investment securities there was a decrease in interest income of $1.3 million for the six months ended June 30, 2003, due to the declining interest rate environment. The average yield, on a taxable equivalent basis, in the investment portfolio was 4.66% in 2003 compared to 6.44% in 2002. 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. Average interest-bearing sources of funds increased $87.5 million or 13.4%. Of that increase, average other borrowed funds increased $45.8 million and interest-bearing deposits increased $41.7 million. Even as deposits increased, interest expense decreased 20.3% as a result of declining interest rates paid for those sources of funds. Overall, the average interest cost on deposits was 1.36% at June 30, 2003 and 2.04% at June 30, 2002. 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. During March and April, 2003, the Bank implemented an asset/liability strategy designed to both increase its net interest margin and reduce the overall maturity mismatch in its asset and liability mix. This strategy involved borrowing $80 million of short-term advances from the Federal Home Loan Bank (FHLB) and investing primarily in mortgage-backed securities and high-grade municipals. Prepayments and maturities on these securities will either be reinvested or used to fund loan growth. 14 Allowance and Provision for Loan Losses As a financial institution that assumes lending and credit risks as a principal element of its business, credit losses will be experienced in the normal course of business. 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 risks 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 examinations by the Company's supervisory authorities, results of internal credit reviews, financial condition of borrowers, loan concentrations, prior loan loss experience, and general economic conditions. 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. The Company's written lending policies, along with applicable laws and regulations governing the extension of credit, require risk analysis as well as ongoing portfolio and credit management through loan product diversification, lending limits, ongoing credit reviews and approval policies prior to funding of any loan. The Company manages and controls credit risk through diversification, dollar limits on loans to one borrower and by primarily restricting loans made to its principal market area. Loans that are performing but have shown some signs of weakness are subjected to more stringent reporting. Fixed-rate real estate loans are comprised primarily of loans with maturities of less than five years. Generally, long-term residential loans are originated by the Company and sold on the secondary market. The appropriate allowance amount is based upon growth in the loan portfolio, management's evaluation of the credit quality of the loan portfolio, the prevailing economic climate, and its effect on borrowers' ability to repay loans in accordance with the terms of the notes and current loan losses. After reviewing all factors, management concluded that the current allowance for loan losses was adequate. As of June 30, 2003, the allowance for loan losses was $17.1 million, which represents 2.3% of the total loan balances. As of June 30, 2002, the allowance was $13.1 million or 2.0% of total loans. The table below illustrates the change in the allowance for the first six months of 2003 and 2002. Allowance for Loan Losses (in thousands) Balance, December 31, 2002 $ 16,684 Provision Charged to Expense 325 Recoveries of Loans Previously Charged Off 372 Loans Charged Off (290) ============================================================== Balance, June 30, 2003 $ 17,091 ============================================================== Balance, December 31, 2001 $ 12,709 Provision Charged to Expense 500 Recoveries of Loans Previously Charged Off 154 Loans Charged Off (270) ============================================================== Balance, June 30, 2002 $ 13,093 ============================================================== 15 Non-Interest Income Overall, non-interest income increased $983 thousand or 19.1% for the six months ended June 30, 2003 compared to the same period of 2002. Most of the growth occurred in other non-interest income, which increased $725 thousand through the first six months of 2003. The increase was mainly the result of: (1) an increase of $140,000 in the cash surrender value of life insurance contracts, which is recognized as other non-interest income, (2) an increase of $188,000 in fees generated from ATM Non-Customer Use and (3) an increase of $135,000 in Gain on Loan Sales. Non-Interest Expense Overall, non-interest expense increased $1.6 million or 10.8% over the first six months of 2002, primarily as a result of a $1.5 million increase in Salaries and Employee Benefits. This increase was due to: (1) 18 month cycle salary merit increases which occurred in October, 2002, (2) increased contributions to the Bank's Profit Sharing Plan and (3) increased expense recognition associated with the Bank's Defined Benefit Pension Plan. Income Taxes The provision for income taxes increased 6.6% to $3.9 million for the first six months of 2003. The Company's effective tax rate decreased for the first six months of 2003 and was 35.9% compared to 36.7% for the same period in 2002. Balance Sheet Analysis 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. The investment portfolio provides the Company with an income alternative to loans. As of June 30, 2003 the investment portfolio represented 23.8% of the Company's total assets. Total investment securities increased $64.9 million from a year ago and now total $260.9 million. As previously discussed (see "Net Interest Income"), the Bank has implemented an asset/liability strategy involving FHLB borrowings invested in investment securities. Not included in the investment portfolio are overnight investments in Federal Funds Sold. For the six months ended June 30, 2003, average Federal Funds Sold was $11.6 million compared to $32.9 million in 2002. Loans The Company's loan portfolio at June 30, 2003 increased $90.2 million from June 30, 2002. The increase was due to strong loan demand in the Company's market area, along with an aggressive calling program on high quality loan prospects. Additionally, on an average balance basis loans have increased $100.6 million or 16.7%. The table following sets forth the distribution of the loan portfolio by type as of the dates indicated. 16 Loan Portfolio As Of: (in thousands) June 30, 2003 Dec. 31, 2002 June 30, 2002 - ------------------------------------------------------------------------------- Real Estate $375,413 $322,074 $306,797 Real Estate Construction 61,993 66,467 51,963 Home Equity 48,377 45,150 34,643 Agricultural 115,722 109,130 102,642 Commercial 128,950 135,877 143,743 Consumer 19,682 19,995 20,135 - ------------------------------------------------------------------------------- Gross Loans 750,137 698,693 659,923 Less: Unearned Income 2,168 2,018 1,546 Allowance for Loan Losses 17,091 16,684 13,093 - ------------------------------------------------------------------------------- Net Loans $730,878 $ 679,991 $ 645,284 =============================================================================== 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, 2003, the Company had entered into commitments with certain customers amounting to $262.5 million compared to $275.5 million at June 30, 2002. Letters of credit at June 30, 2003, and June 30, 2002, were $18.1 million and $17.2 million, respectively. Non-Performing Assets Non-performing assets are comprised of non-performing loans and other real estate owned. As set forth in the table below, non-performing loans as of June 30, 2003 were $2.9 million compared to $10.3 million at June 30, 2002. Accrued interest reversed from income on loans placed on a non-accrual status totaled $386 thousand at June 30, 2003 compared to $264 thousand at June 30, 2002. The Company reported no other real estate owned for both June 30, 2003 and June 31, 2002. Non-Performing Assets (dollar amounts in thousands) June 30, 2003 Dec. 31, 2002 June 30, 2002 - ----------------------------------------------------------------------------------- Non-performing Loans $2,928 $2,907 $10,330 Other Real Estate Owned 0 0 0 =================================================================================== Total $2,928 $2,907 $10,330 =================================================================================== Non-Performing Assets as a % of Total Loans 0.4% 0.4% 1.57% Allowance for Loan Losses as a % of Non-Performing Loans 583.7% 573.9% 126.7% Except for non-performing loans shown in the table above, the Bank's management is not aware of any loans as of June 30, 2003 for which known credit problems of the borrower would cause serious doubts as to the ability of such 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 Bank's management cannot, however, predict the extent to which any deterioration in general economic conditions, real estate values, increase in general rates of interest, change in the financial conditions or business of a borrower may adversely affect a borrower's ability to pay. 17 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, 2003, deposits totaled $857.7 million. This represents an increase of 10.0% or $77.6 million from June 30, 2002. The increase was focused in demand and savings accounts, which increased $24.3 million and $24.1 million, respectively. The Bank's calling efforts for prospective customers includes acquiring both loan and deposit relationships which results in new demand, interest bearing transaction and savings accounts. Federal Home Loan Bank Advances Advances from the Federal Home Loan Bank are another key source of funds to support earning assets. These advances are also used to manage the Bank'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 as of June 30, 2003 were $121.9 million compared to $40.9 million as of June 30, 2002. As previously discussed (see "Net Interest Income"), the Bank has implemented an asset/liability strategy involving FHLB borrowings invested in investment securities. Capital 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 (as defined in the regulations) to risk-weighted assets (as defined in the regulations), and of Tier I capital (as defined in the regulations) to average assets (as defined in the regulations). Management believes, as of June 30, 2003, that the Company and the Bank meet all capital adequacy requirements to which it is subject. As of June 30, 2002, 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, 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. 18 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, 2003 Total Capital to Risk Weighted Assets $117,929 12.19% $77,383 8.0% N/A N/A Tier I Capital to Risk Weighted Assets 105,776 10.94% 38,692 4.0% N/A N/A Tier I Capital to Average Assets 105,776 9.73% 43,464 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, 2003 Total Capital to Risk Weighted Assets $116,150 12.03% $77,236 8.0% $96,545 10.0% Tier I Capital to Risk Weighted Assets 104,020 10.77% 38,618 4.0% 57,927 6.0% Tier I Capital to Average Assets 104,020 9.61% 43,286 4.0% 54,108 5.0% ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Risk Management The Company has adopted a Risk Management Plan to ensure the proper control and management of all risk factors inherent in the operation of the Company and the Bank. Specifically, credit risk, interest rate risk, liquidity risk, compliance risk, strategic risk, reputation risk and price 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 and Bank 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 and correspondent bank accounts is addressed through defined limits in the Bank's policy statements. In addition, certain securities carry insurance to enhance credit quality of the bond. Credit risk in the loan portfolio is controlled by limits on industry concentration, aggregate customer borrowings and geographic boundaries. Standards on loan quality also are designed to reduce loan credit risk. Senior Management, Directors' Committees, and the Board of Directors are provided with information to appropriately identify, measure, control and monitor the credit risk of the Bank. The Company's methodology for assessing the appropriateness of the allowance is conducted on a regular basis and considers all loans. The systemic methodology consists of two major elements. The first major element includes a detailed analysis of the loan portfolio in two phases. The first phase is conducted in accordance with SFAS No. 114, "Accounting by Creditors for the Impairment of a Loan" as amended by SFAS No. 118, "Accounting by Creditors for Impairment of a Loan -- Income Recognition and Disclosures." Individual loans are reviewed to identify loans for impairment. A loan is impaired when principal and interest are deemed uncollectable in accordance with the original contractual terms of the loan. Impairment is measured as either the expected future cash flows discounted at each loan's effective interest rate, the fair value of the loan's collateral if the loan is collateral dependent, or an observable market price of the loan (if one exists). Upon measuring the impairment, the Company will insure an appropriate level of allowance is present or established. 19 Central to the first phase and the Company's credit risk management 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 second phase is conducted by segmenting the loan portfolio by risk rating and into groups of loans with similar characteristics in accordance with SFAS No. 5, "Accounting for Contingencies". In this second phase, groups of loans are reviewed and applied the appropriate allowance percentage to determine a portfolio formula allowance. The second major element in the Company's methodology for assessing the appropriateness of the allowance consists of management's considerations of all known relevant internal and external factors that may affect a loan's collectibility. This includes management's estimates of the amounts necessary for concentrations, economic uncertainties, the volatility of the market value of collateral and other relevant factors. The relationship of the two major elements of the allowance to the total allowance may fluctuate from period to period. In the second major element of the analysis which considers all known relevant internal and external factors that may affect a loan's collectibility is based upon management's evaluation of various conditions, the effects of which are not directly measured in the determination of the formula and specific allowances. The evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty because they are not identified with specific problem credits or portfolio segments. The conditions evaluated in connection with the second element of the analysis of the allowance include, but are not limited to the following conditions that existed as of the balance sheet date: |X| then-existing general economic and business conditions affecting the key lending areas of the Company; |X| credit quality trends (including trends in non-performing loans expected to result from existing conditions); |X| collateral values; |X| loan volumes and concentrations; 20 |X| seasoning of the loan portfolio; |X| specific industry conditions within portfolio segments; |X| recent loss experience in particular segments of the portfolio; |X| duration of the current business cycle; |X| bank regulatory examination results; and |X| findings of the Company's internal credit examiners. Management reviews these conditions in discussion with the Company's senior credit officers. To the extent that any of these conditions is evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management's estimate of the effect of such condition may be reflected as a specific allowance applicable to such credit or portfolio segment. Where any of these conditions is not evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management's evaluation of the inherent loss related to such condition is reflected in the second major element allowance. Implicit in lending activities is the risk that losses will and do occur and that the amount of such losses will vary over time. Consequently, the Company maintains an allowance for loan losses by charging a provision for loan losses to earnings. Loans determined to be losses are charged against the allowance for loan losses. The Company's allowance for loan losses is maintained at a level considered by management to be adequate to provide for estimated losses inherent in the existing portfolio along with unused commitments to provide financing including commitments under commercial and standby letters of credit. Management believes that the allowance for loan losses at June 30, 2003 was adequate to provide for both recognized losses and estimated inherent losses in the portfolio. No assurances can be given that future events may not result in increases in delinquencies, non-performing loans or net loan chargeoffs that would increase the provision for loan losses and thereby adversely affect the results of operations. Asset / Liability Management 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. Farmers & Merchants Bancorp'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 potential impact on both its economic value and earnings. The methods for governing the amount of interest rate risk include: (a) analysis of asset and liability mismatches (GAP analysis); (b) the utilization of a simulation model; and (c) limits on maturities of investment, loan and deposit products to relatively short periods which reduces the market volatility of those instruments. The 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 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. 21 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 also utilizes the results of a dynamic simulation model to quantify the estimated exposure of net interest income to 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, 2003, 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 1.37% if rates increase by 200 basis points and a decrease in net interest income of 0.19% if rates decline 100 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 conditions including how customer preferences or competitor influences might change. See Note 13 of the Notes to the Consolidated Financial Statements located in the 2002 Annual Report to Shareholders. Liquidity Risk Liquidity risk is the risk to earnings or capital resulting from the Bank's inability to meet its obligations when they come due without incurring unacceptable losses. It includes the ability to manage unplanned decreases or changes in funding sources and to recognize or address changes in market conditions that affect the Bank'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 to 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 Fed Funds and the use of funds provided by the cash flow from the investment portfolio. The Company maintains overnight investments in Fed Funds as a cushion for temporary liquidity needs. During the second quarter of 2003, Federal Funds averaged $4.3 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 $46 million from the Federal Home Loan Bank. 22 At June 30, 2003, the Company had available liquid assets, which included cash and cash equivalents and unpledged investment securities of approximately $172.3 million, which represents 15.7% of total assets. ITEM 4. CONTROLS AND PROCEDURES The Company maintains 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-14(c). 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 controls and disclosure procedures under the supervision and with the participation of the Chief Executive Officer, the Chief Financial Officer and other senior management of the Company. 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 subsequent to the date the Company completed its evaluation. Average Balance Sheets 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, 2003 and 2002. 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 average asset and liability balances and interest earned and paid resulting from changes in average asset and liability balances (volume) and changes in average interest rates and the total net change in interest income and expenses. The changes in interest due to both rate and volume have been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amount of the change in each. 23 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, 2003 2002 Assets Balance Interest Rate Balance Interest Rate - ---------------------------------------------------------------------------------------------------------------------------------- Federal Funds Sold $ 4,348 $ 18 1.66% $ 27,586 $ 187 2.72% Investment Securities Available-for-Sale U.S. Treasuries 0 0 0.00% 0 0 0.00% U.S. Agencies 43,400 372 3.48% 4,314 56 5.26% Municipals - Taxable 1,295 20 6.26% 1,597 23 5.84% Municipals - Non-Taxable 31,973 447 5.67% 21,908 367 6.79% Mortgage Backed Securities 156,574 1,450 3.76% 155,312 2,311 6.03% Other 17,803 199 4.53% 9,462 152 6.51% - ---------------------------------------------------------------------------------------------------------------------------------- Total Investment Securities Available-for-Sale 251,045 2,488 4.02% 192,593 2,909 6.13% - ---------------------------------------------------------------------------------------------------------------------------------- Investment Securities Held-to-Maturity U.S. Treasuries 0 0 0.00% 0 0 0.00% U.S. Agencies 0 0 0.00% 0 0 0.00% Municipals - Taxable 0 0 0.00% 0 0 0.00% Municipals - Non-Taxable 43,280 686 6.43% 29,436 537 7.40% Mortgage Backed Securities 0 0 0.00% 0 0 0.00% Other 469 6 5.19% 540 7 5.26% - ---------------------------------------------------------------------------------------------------------------------------------- Total Investment Securities Held-to-Maturity 43,749 692 6.41% 29,976 544 7.36% - ---------------------------------------------------------------------------------------------------------------------------------- Loans Real Estate 411,976 6,660 6.48% 342,186 6,269 7.35% Home Equity 47,905 627 5.25% 29,055 385 5.31% Agricultural 107,073 1,389 5.20% 95,224 1,267 5.34% Commercial 130,563 1,889 5.80% 128,138 1,849 5.79% Installment 14,178 402 11.37% 15,862 361 9.13% Credit Card 4,371 101 9.27% 3,268 74 9.08% Municipal 1,223 16 5.25% 968 21 8.70% - ---------------------------------------------------------------------------------------------------------------------------------- Total Loans 717,289 11,084 6.20% 614,701 10,226 6.67% - ---------------------------------------------------------------------------------------------------------------------------------- Total Earning Assets 1,016,431 $14,282 5.64% 864,856 $13,866 6.43% ===================== ====================== Unrealized Gain/(Loss) on Securities Available-for-Sale 4,517 4,898 Allowance for Loan Losses (17,111) (13,106) Cash and Due From Banks 29,182 28,656 All Other Assets 55,786 49,136 - ------------------------------------------------------------------------ --------------- Total Assets $1,088,805 $934,440 ======================================================================== =============== Liabilities & Shareholders' Equity Interest Bearing Deposits Interest Bearing DDA $89,099 $ 30 0.14% $87,554 $ 75 0.34% Savings 244,690 352 0.58% 214,843 527 0.98% Time Deposits 322,479 1,737 2.16% 308,999 2,266 2.94% - ---------------------------------------------------------------------------------------------------------------------------------- Total Interest Bearing Deposits 656,268 2,119 1.30% 611,396 2,868 1.88% Other Borrowed Funds 123,614 828 2.69% 40,990 556 5.44% - ---------------------------------------------------------------------------------------------------------------------------------- Total Interest Bearing Liabilities 779,882 $2,947 1.52% 652,386 $3,424 2.11% ===================== ====================== Demand Deposits (Non-Interest Bearing) 191,186 173,225 All Other Liabilities 10,360 8,499 - ------------------------------------------------------------------------ --------------- Total Liabilities 981,428 834,110 Shareholders' Equity 107,377 100,330 - ------------------------------------------------------------------------ --------------- Total Liabilities & Shareholders' Equity $1,088,805 $934,440 ======================================================================== =============== Net Interest Margin 4.42% 4.79% ================================================================================================================================== Notes: Yields on municipal securities have been calculated on a fully taxable equivalent basis using the combined Federal and State income tax rate of 42.06%. 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. 24 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, 2003 2002 Assets Balance Interest Rate Balance Interest Rate - ---------------------------------------------------------------------------------------------------------------------------------- Federal Funds Sold $ 11,643 $ 97 1.68% $ 32,948 $ 330 2.02% Investment Securities Available-for-Sale U.S. Treasuries 0 0 0.00% 0 0 0.00% U.S. Agencies 37,890 638 3.41% 5,072 133 5.32% Municipals - Taxable 1,319 41 6.30% 1,618 51 6.39% Municipals - Non-Taxable 31,963 893 5.66% 21,853 729 6.76% Mortgage Backed Securities 136,569 2,819 4.19% 165,141 5,080 6.24% Other 19,139 448 4.75% 9,404 310 6.68% - ---------------------------------------------------------------------------------------------------------------------------------- Total Investment Securities Available-for-Sale 226,880 4,839 4.32% 203,088 6,303 6.29% - ---------------------------------------------------------------------------------------------------------------------------------- Investment Securities Held-to-Maturity U.S. Treasuries 0 0 0.00% 0 0 0.00% U.S. Agencies 0 0 0.00% 0 0 0.00% Municipals - Taxable 0 0 0.00% 0 0 0.00% Municipals - Non-Taxable 36,085 1,207 6.79% 29,632 1,089 7.45% Mortgage Backed Securities 0 0 0.00% 0 0 0.00% Other 474 13 5.56% 542 17 6.36% - ---------------------------------------------------------------------------------------------------------------------------------- Total Investment Securities Held-to-Maturity 36,559 1,220 6.77% 30,174 1,106 7.43% - ---------------------------------------------------------------------------------------------------------------------------------- Loans Real Estate 398,413 13,102 6.63% 337,888 12,277 7.33% Home Equity 47,226 1,214 5.18% 26,665 697 5.27% Agricultural 103,650 2,678 5.21% 93,954 2,600 5.58% Commercial 133,189 3,742 5.67% 122,805 3,649 5.99% Consumer 13,934 705 10.20% 15,923 714 9.04% Credit Card 4,361 203 9.39% 3,303 158 9.65% Municipal 1,237 32 5.22% 876 33 7.60% - ---------------------------------------------------------------------------------------------------------------------------------- Total Loans 702,010 21,676 6.23% 601,414 20,128 6.75% - ---------------------------------------------------------------------------------------------------------------------------------- Total Earning Assets 977,092 $27,832 5.74% 867,624 $27,867 6.48% ====================== ==================== Unrealized Gain/(Loss) on Securities Available-for-Sale 4,503 5,002 Allowance for Loan Losses (16,975) (13,041) Cash and Due From Banks 29,212 28,471 All Other Assets 55,047 46,718 - ------------------------------------------------------------------------- --------------- Total Assets $1,048,879 $934,774 ========================================================================= =============== Liabilities & Shareholders' Equity Interest Bearing Deposits Interest Bearing DDA $89,208 $ 79 0.18% $88,359 $ 164 0.37% Savings 243,955 697 0.58% 212,769 1,140 1.08% Time Deposits 321,664 3,644 2.28% 312,026 4,897 3.16% - ---------------------------------------------------------------------------------------------------------------------------------- Total Interest Bearing Deposits 654,827 4,420 1.36% 613,154 6,201 2.04% Other Borrowed Funds 86,788 1,405 3.26% 40,993 1,106 5.44% - ---------------------------------------------------------------------------------------------------------------------------------- Total Interest Bearing Liabilities 741,615 $5,825 1.58% 654,147 $7,307 2.25% ====================== ==================== Demand Deposits (Non-Interest Bearing) 191,973 171,769 All Other Liabilities 9,165 8,360 - ------------------------------------------------------------------------- --------------- Total Liabilities 942,753 834,276 Shareholders' Equity 106,126 100,498 - ------------------------------------------------------------------------- --------------- Total Liabilities & Shareholders' Equity $1,048,879 $934,774 ========================================================================= =============== Net Interest Margin 4.54% 4.78% ================================================================================================================================== Notes: Yields on municipal securities have been calculated on a fully taxable equivalent basis using the combined Federal and State income tax rate of 42.06%. 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. 25 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, 2003 compared to June 30, 2002 June 30, 2003 compared to June 30, 2002 Interest Earning Assets Volume Rate Net Chg. Volume Rate Net Chg. - ------------------------------------------------------------------------------------------------------------------------- Federal Funds Sold $ (116) $ (53) $ (169) $ (185) $ (48) $ (233) Investment Securities Available for Sale U.S. Treasuries 0 0 0 0 0 0 U.S. Agencies 454 (138) 316 661 (157) 504 Municipals - Taxable 0 (3) (3) (9) 0 (9) Municipals - Non-Taxable 419 (339) 80 477 (313) 164 Mortgage Backed Securities 131 (992) (861) (779) (1,482) (2,261) Other 314 (267) 47 392 (254) 138 - ----------------------------------------------------------------------------------------------------------------------------- Total Investment Securities Available for Sale 1,318 (1,739) (421) 742 (2,206) (1,464) - ----------------------------------------------------------------------------------------------------------------------------- Investment Securities Held to Maturity U.S. Treasuries 0 0 0 0 0 0 U.S. Agencies 0 0 0 0 0 0 Municipals - Taxable 0 0 0 0 0 0 Municipals - Non-Taxable 565 (416) 149 364 (246) 118 Mortgage Backed Securities 0 0 0 0 0 0 Other 0 (1) (1) (2) (2) (4) - ----------------------------------------------------------------------------------------------------------------------------- Total Investment Securities Held to Maturity 565 (417) 148 362 (248) 114 - ----------------------------------------------------------------------------------------------------------------------------- Loans: Real Estate 3,999 (3,608) 391 3,612 (2,787) 825 Home Equity 275 (33) 242 552 (35) 517 Agricultural 313 (191) 122 471 (393) 78 Commercial 35 5 40 544 (451) 93 Installment (31) 72 41 (187) 178 (9) Credit Card 25 2 27 57 (12) 45 Other 26 (31) (5) 23 (24) (1) - ----------------------------------------------------------------------------------------------------------------------------- Total Loans 4,642 (3,784) 858 5,072 (3,524) 1,548 - ----------------------------------------------------------------------------------------------------------------------------- Total Earning Assets 6,409 (5,993) 416 5,991 (6,026) (35) - ----------------------------------------------------------------------------------------------------------------------------- Interest Bearing Liabilities Interest Bearing Deposits: Transaction 10 (55) (45) 5 (90) (85) Savings 396 (571) (175) 407 (850) (443) Time Deposits 606 (1,135) (529) 424 (1,677) (1,253) - ----------------------------------------------------------------------------------------------------------------------------- Total Interest Bearing Deposits 1,012 (1,761) (749) 836 (2,617) (1,781) Other Borrowed Funds 2,022 (1,750) 272 1,534 (1,235) 299 - ----------------------------------------------------------------------------------------------------------------------------- Total Interest Bearing Liabilities 3,034 (3,511) (477) 2,370 (3,852) (1,482) - ----------------------------------------------------------------------------------------------------------------------------- Total Change $3,375 $ (2,482) $ 893 $3,621 $ (2,174) $ 1,447 ============================================================================================================================= 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. 26 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. ITEM 2. Changes in Securities None ITEM 3. Defaults Upon Senior Securities Not applicable ITEM 4. Submission of Matters to a Vote of Security Holders Annual Meeting of Shareholders of Farmers & Merchants Bancorp held on April 21, 2003. The business conducted at the meeting included election of directors and ratification of PricewaterhouseCoopers LLP as the Company's independent auditors. Following is the voting results from the 2003 annual meeting of shareholders. As of April 21, 2003, 563,327 shares represented in person and by proxy participated in this election and shares were voted on the two measures before the shareholders as follows: 1. ELECTION OF DIRECTORS Directors % For % Withheld --------- - --- - -------- Stewart C. Adams, Jr. 98.67 555,842 1.33 7,485 -------------- ------------------- ----------- ---------------- Ralph Burlington 98.77 556,417 1.23 6,910 -------------- ------------------- ----------- ---------------- Edward Corum, Jr. 98.77 556,388 1.23 6,939 -------------- ------------------- ----------- ---------------- Robert F. Hunnell 98.77 556,417 1.23 6,910 -------------- ------------------- ----------- ---------------- Ole R. Mettler 98.74 556,227 1.26 7,100 -------------- ------------------- ----------- ---------------- James E. Podesta 98.77 556,417 1.23 6,910 -------------- ------------------- ----------- ---------------- Kevin Sanguinetti 98.77 556,417 1.23 6,910 -------------- ------------------- ----------- ---------------- H. C. Schumacher 98.74 556,227 1.26 7,100 -------------- ------------------- ----------- ---------------- Kent A. Steinwert 98.74 556,227 1.26 7,100 -------------- ------------------- ----------- ---------------- Calvin (Kelly) Suess 98.77 556,417 1.23 6,910 -------------- ------------------- ----------- ---------------- Carl A. Wishek, Jr. 98.59 555,392 1.41 7,935 -------------- ------------------- ----------- ---------------- 27 2. PROPOSAL TO RATIFY THE APPOINTMENT OF PRICEWATERHOUSECOOPERS, LLP No. of Shares % For: 549,280 74.93 ------------------------ --------------------- Against: 4,859 0.66 ------------------------ --------------------- Abstain 9,187 1.25 ------------------------ --------------------- ITEM 5. Other Information None ITEM 6(a). Exhibits See Exhibit Index on Page 30 ITEM 6(b). Reports on Form 8-K None 28 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 ___, 2003 /s/ Kent A. Steinwer ------------------------------ Kent A. Steinwert President and Chief Executive Officer (Principal Executive Officer) Date: August ___, 2003 /s/ Stephen W. Haley ------------------------------ Stephen W. Haley Executive Vice President and Chief Financial Officer (Principal Accounting Officer) 29 Index to Exhibits Exhibit No. Description 2 Plan of Reorganization as filed on Form 8-K dated April 30, 1999, are incorporated herein by reference. 3(i) Amended and Restated Certificate of Incorporation of Farmers & Merchants Bancorp, filed as Exhibit 3(i) to Registrant's 8-K dated April 30, 1999, is incorporated herein by reference. 3(ii)By-Laws of Farmers & Merchants Bancorp, filed as Exhibit 3(i) to Registrant's 8-K dated April 30, 1999, is incorporated herein by reference. 10.1 Employment Agreement dated July 8, 1997, between Farmers & Merchants Bank of Central California and Kent A. Steinwert, filed as Exhibit 10.1 to Registrant's 8-K dated April 30, 1999, is incorporated herein by reference. 10.2 Employment Agreement dated July 8, 1997, between Farmers & Merchants Bank of Central California and Richard S. Erichson, filed as Exhibit 10.2 to Registrant's 8-K dated April 30, 1999, is incorporated herein by reference. 10.3 Deferred Bonus Plan of Farmers & Merchants Bank of Central California adopted as of June 2, 1999, filed as Exhibit 10.3 to Registrant's 8-K dated April 30, 1999, is incorporated herein by reference. 10.4 Amended and Restated Deferred Bonus Plan of Farmers & Merchants Bank of Central California, executed May 11, 1999, filed as Exhibit 10.4 to Registrant's 8-K dated April 30, 1999, is incorporated herein by reference. 10.5 Employment Agreement dated December 29, 2000, between Farmers & Merchants Bank of Central California and Deborah E. Hodkin, filed as Exhibit 10.5 to Registrant's 10-K for the year ended December 31, 2002, is incorporated herein by reference. 10.6 Employment Agreement dated December 10, 2001, between Farmers & Merchants Bank of Central California and Chris C. Nelson, filed as Exhibit 10.6 to Registrant's 10-K for the year ended December 31, 2002, is incorporated herein by reference. 10.7 Employment Agreement dated June 25, 2003, between Farmers & Merchants Bank of Central California and Stephen W. Haley, filed as Exhibit 10.7 to Registrant's 10-K for the year ended December 31, 2002, is incorporated herein by reference. 31 Rule 13(a)-14(a)/15d-14(a) Certifications. 32 Chief Executive Officer and Chief Financial Officer Certification pursuant to 10 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 30