EXHIBIT 13.1
ANNUAL REPORT TO STOCKHOLDERS
38
March 25, 2003
To Our Stockholders
On behalf of all of us at Sturgis Bank & Trust Company ("Bank") and Sturgis
Bancorp, Inc. ("Bancorp"), it is a pleasure to present Bancorp's 2002 Annual
Report. It was a good year.
The U.S. banking industry, including our Bank, was significantly affected by the
stable, low interest rates during 2002, after significant decreases in interest
rates during 2001. The low residential mortgage rates prompted significant
refinancing, as many qualified borrowers locked in new loans at the historically
low rates. The residential mortgage refinancing and subsequent sales outpaced
loan growth, especially in commercial mortgages. Net loans decreased to $212.0
million from $219.1 million at December 31, 2002 and 2001, respectively.
However, loans serviced for others increased to $178.5 million from $134.8
million. This demonstrates that the Bank is growing its relationship base, even
though net loans decreased. Growth in securities and interest-bearing deposits
at banks was primarily funded through growth in interest-bearing deposits.
The net income of the Bancorp was a record high of $2,790,387 in 2002, compared
to $2,787,937 in 2001. The decrease in net interest income, primarily caused by
assets repricing quicker than liabilities, was offset by an increase in
noninterest income.
The primary components of the increase in noninterest income were commission
income, mortgage banking activities and bank owned life insurance. The
commission income increased to $970,737 in 2002 from $796,688 in 2001, due to
new and expanded relationships of Oakleaf Financial Services, Inc., the
wholly-owned investment subsidiary of the Bank. Mortgage banking activities
generated $2,028,497 in 2002, compared to $1,508,451 in 2001, due to an increase
in the loans sold to $108.1 million in 2002, compared to $73.5 million in 2001.
The value of bank owned life insurance purchased December 28, 2001 increased
$332,470 in 2002, compared to $2,959 in 2001.
Noninterest expense increased $113,223, or 1.28%, to $9.0 million in 2002. The
primary components of the change in noninterest expense were salaries, employee
benefits and amortization of goodwill. Salaries and employee benefits increased
due to staffing adjustments, benefit costs and cost of living increases, which
became effective January 2002. Bancorp did not record amortization expense in
2002, as a result of adopting FAS 142. Amortization of goodwill was $574,864 in
2001.
The Bank increased its provision for loan losses to $1,494,916 in 2002 from
$1,056,194 in 2001. The allowance for loan losses was $1,920,037, or 0.88% of
gross loans at December 31, 2002, compared to $1,300,000, or 0.58% of gross
loans at December 31, 2001. This increase is due to depressed economic
conditions and the change of the Bank's mix of loans to include a greater
percentage of commercial loans.
The Bancorp's capital decreased to $27.5 million from $28.5 million at December
31, 2002 and 2001, respectively. This decrease is primarily the result of $3.0
million of stock redemptions during 2002. This decrease in capital contributed
to the increase in earnings per share to $0.95 in 2002 from $0.90 in 2001.
Total assets serviced by Bancorp at December 31, 2002 were $718.0 million
($296.7 million consolidated assets, $178.5 million loans service for others,
$120.9 million serviced by Oakleaf Financial Services, Inc., $94.6 million
serviced by the Trust Department and $27.3 million swept to an external mutual
fund).
The directors, officers and staff of the Bank and Bancorp wish to thank you for
your continuing interest and support. As always, your comments are welcome.
Sincerely,
/s/
Leonard L. Eishen
CONTENTS
--------
Page
----
Selected Financial Data 2
Corporate Year in Review 3
Management's Discussion and Analysis of Financial
Condition and Results of Operations 4
Directors and Officers of the Bancorp 21
Directors and Officers of the Bank 22
Bank Corporate Information 23
Market Information 24
Independent Accountants 25
Form 10-K Report 26
Report of Independent Accountants and
Consolidated Financial Statements 27
1
SELECTED FINANCIAL DATA
-----------------------
At December 31,
---------------
2002 2001 2000 1999 1998
---- ---- ---- ---- ----
Total assets $296,684,457 $279,789,272 $271,116,489 $251,596,319 $237,496,303
Cash and investment securities 39,767,645 28,801,672 25,533,283 23,493,106 33,539,244
Loans and loans held for sale 219,480,856 223,528,846 224,191,073 206,295,022 182,110,622
Mortgage-backed securities 8,912,723 1,034,119 1,261,585 1,519,508 1,997,645
Allowance for loan losses 1,920,037 1,300,000 803,744 730,000 686,896
Deposits 202,563,796 179,129,827 173,855,324 163,679,849 172,439,561
Short-term borrowings 6,671,907 6,000,000 9,560,855 23,506,029 -
Long-term borrowings 57,709,489 64,076,863 57,849,521 35,607,361 38,661,629
Stockholders' equity 27,452,528 28,496,934 26,515,396 25,347,607 23,950,820
Book Value per share 9.81 9.19 8.55 8.19 7.74
Shares outstanding (actual number) 2,799,535 3,101,534 3,101,534 3,094,886 3,094,779
Year Ended December 31,
-----------------------
2002 2001 2000 1999 1998
---- ---- ---- ---- ----
Interest income $17,410,692 $19,938,467 $19,138,924 $16,963,609 $15,890,135
Interest expense 8,414,100 10,401,412 10,526,202 8,673,279 8,769,897
Provision for loan losses 1,494,916 1,056,194 309,000 104,000 173,913
Noninterest income 5,392,666 4,482,780 3,361,115 3,021,639 2,770,928
Noninterest expense 8,986,026 8,872,803 9,082,503 8,516,520 7,367,354
Federal income tax 1,117,929 1,302,901 765,468 688,000 635,000
Net income 2,790,387 2,787,937 1,816,866 2,003,449 1,714,899
Earnings per share (basic) 0.95 0.90 0.59 0.65 0.67
Earnings per share (diluted) 0.95 0.90 0.59 0.65 0.65
Cash dividends per share 0.28 0.26 0.22 0.19 0.18
Dividend payout ratio 29.47% 28.89% 37.29% 29.23% 26.87%
Equity/Assets ratio 9.25% 10.19% 9.78% 10.07% 10.08%
Return on assets 0.95% 1.00% 0.69% 0.83% 0.75%
Return on equity 9.96% 10.14% 6.99% 8.16% 9.24%
Weighted average shares
outstanding (actual number):
Basic 2,949,874 3,101,534 3,099,630 3,094,854 2,565,069
Diluted 2,952,239 3,101,534 3,099,630 3,099,503 2,643,970
2
CORPORATE YEAR IN REVIEW
------------------------
On December 11, 2001, the shareholders of Sturgis Bank & Trust Company (the
"Bank") approved the reorganization of the Bank to become a wholly owned
subsidiary of Sturgis Bancorp, Inc. (the "Company"), a financial holding
company. The Company is a financial holding company under the Bank Holding
Company Act of 1956, as amended. This reorganization was effective January 1,
2002. As a result, historical information in this Annual Report for periods
before the January 1, 2002 effective date relate tot he Bank. Throughout this
Annual Report Sturgis Bancorp, Inc. will be referred to as the Company and
Sturgis Bank & Trust Company will be referred to as the Bank.
The Bank, a Michigan savings bank, was founded in 1905 as a state chartered
mutual savings and loan.
The original mission of the Bank was to promote personal savings and provide
financing for the purchase of homes. Today we remain committed to the same
objectives by offering consumer, educational, and property improvement loans,
along with a large selection of investment opportunities to our community. In
order to meet a growing demand for business loans, the Bank is conservatively
offering commercial loans to qualified customers.
The Bank has its main office in Sturgis and branch offices in Bronson,
Centreville, Climax, Coldwater, Colon, South Haven, Sturgis, Three Rivers and
White Pigeon, Michigan. The Bank's market area covers all of St. Joseph County
and parts of Cass, Branch, Calhoun, Van Buren, Allegan, Hillsdale and Kalamazoo
counties.
While the Bank's primary business has historically been and will continue to be
the origination of first mortgage loans on 1-4 family unit homes, it has
implemented strategies in the last few years that will put more emphasis on
originating commercial real estate and small business loans within its primary
market area. The Bank also intends to increase multi-family and consumer lending
products. The marketing of these loans will focus on the existing customer base
and new relationships within the Bank's primary market area.
The Bank's Trust Department has approximately $94.6 million of assets under
administration (excluding the Bank's investment portfolio) as of December 31,
2002, a decrease of $3.4 million, or 3.5%, during 2002. The decrease was
primarily due to market conditions.
In 2003 the Bank will:
* Offer trust services to its customers.
* Offer interest rates on deposit accounts that are competitive in its
market.
* Emphasize originations of home and family-related customer loans.
* Match asset/liability maturities to manage interest rate and liquidity
risks.
* Offer noninsured investment securities through Oakleaf Financial
Services, Inc., a wholly owned subsidiary of the Bank.
* Continue a caring attitude toward our customers with responsiveness to
their needs and concerns.
3
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
FORWARD LOOKING STATEMENTS
This report contains statements that constitute forward-looking statements.
These statements appear in several places in this report and include statements
regarding intent, belief, outlook, objectives, efforts, estimates or
expectations of the Company, primarily with respect to future events and the
future financial performance of the Company. Any such forward-looking statements
are not guarantees of future events or performance and involve risks and
uncertainties, and actual results may differ materially from those in the
forward-looking statement. Factors that could cause a difference between an
ultimate actual outcome and a preceding forward-looking statement include, but
are not limited to, changes in interest rates and interest rate relationships;
demand for products and services; the degree of competition by traditional and
non-traditional competitors; changes in banking laws and regulations; changes in
tax laws; changes in prices, levies, and assessments; the impact of
technological advances; government and regulatory policy changes; the outcome of
any pending and future litigation and contingencies; trends in consumer behavior
and ability to repay loans; and changes of the world, national and local
economies. The Company undertakes no obligation to update, amend or clarify
forward-looking statements as a result of new information, future events, or
otherwise.
CRITICAL ACCOUNTING POLICIES
The banking industry is highly regulated. Furthermore, the nature of the
banking industry is such that, other than described below, the use of estimates
and management judgment are not likely to present a material risk to the
financial statements. In cases where estimates or management judgment are
required, internal controls and processes are established to provide assurance
that such estimates and management judgments are materially correct to the best
of management's knowledge.
ALLOWANCE FOR LOAN LOSSES - Accounting for loan classifications, accrual status,
and determination of the allowance for loan losses is based on regulatory
guidance. This guidance includes, but is not limited to, generally accepted
accounting principles, the uniform retail credit classification and account
management policy issued by the Federal Financial Institutions Examination
Council ("FFIEC"), and the joint policy statement on the allowance for loan
losses methodologies issued by the FFIEC. Accordingly, the allowance for loan
losses includes a reserve calculation based on an evaluation of loans determined
to be impaired, risk ratings, historical losses, loans past due, and other
subjective factors.
COMMERCIAL LOAN RATING SYSTEM AND IDENTIFICATION OF IMPAIRED LOANS - The Company
has a defined risk rating system that is designed to assess the risk of
individual loans and overall risk of the commercial loan portfolio. The system
assigns a risk weighting to factors such as cash flow, collateral, financial
condition, operating performance, repayment history, management, and strength of
the industry. An assessment of risk is performed as a part of the loan approval
process as well as periodic updates based on the circumstances of the individual
loan. The Company employs both internal and external loan review services to
assess risk ratings.
4
RESULTS OF OPERATIONS
The Company reported net income of $2.8 million, $2.8 million and $1.8
million for the years ended December 31, 2002, 2001 and 2000, respectively.
Basic earnings per share was $0.95, $0.90 and $0.59 for the years ended December
31, 2002, 2001 and 2000, respectively. The decrease in net interest income from
2001 to 2002 was primarily offset by increases in mortgage banking income, so
that net income remained relatively stable. The stock redemption of nearly 10%
of outstanding shares of Sturgis Bancorp, Inc. common stock contributed to the
increase in earnings per share from 2001 to 2002. The increase in net income
from 2000 to 2001 was primarily due to the substantial increase in mortgage
banking activities.
INTEREST INCOME
2002 COMPARED TO 2001. Interest income decreased $2.5 million to $17.4
million from $19.9 million. This decrease is primarily due to the decreases in
interest rates and average loans outstanding to $217.6 million in 2002 from
$224.6 million in 2001. The average yield on interest-earning assets decreased
to 6.71% in 2002 from 7.87% in 2001. This is primarily due to changes in the
composition of interest-earning assets and lower yields as interest-earning
assets repriced through 2002. The decrease in interest income is likely to
reverse when interest rates increase. The Bank increased investment securities
and interest-bearing deposits as loans refinanced and were subsequently sold.
2001 COMPARED TO 2000. Interest income increased $0.8 million to $19.9
million from $19.1 million. This increase is primarily due to the increases in
average loans outstanding to $224.6 million in 2001 from $217.3 million in 2000.
The average yield on interest-earning assets decreased to 7.87% in 2001 from
8.20% in 2000. This is primarily due to changes in the composition of
interest-earning assets. The Bank reduced investment securities and reinvested
proceeds from their maturity into interest-bearing deposits, which contributed
to net interest income without significant market risk.
INTEREST EXPENSE
2002 COMPARED TO 2001. Interest expense decreased $2.0 million to $8.4
million in 2002 from $10.4 million in 2001. This was primarily due to the
decrease in rates paid on average interest-bearing deposits and FHLB advances.
The rate paid on average interest-bearing liabilities decreased to 3.39% in 2002
from 4.24% in 2001.
2001 COMPARED TO 2000. Interest expense decreased $0.1 million to $10.4
million in 2001 from $10.5 million in 2000. This was primarily due to the
decrease in rates paid on average interest-bearing deposits and FHLB advances,
which outpaced increased due to volume. The rate paid on average
interest-bearing liabilities decreased to 4.24% in 2001 from 4.55% in 2000.
5
NET INTEREST INCOME
2002 COMPARED TO 2001. Net interest income for the year ended December 31,
2002 was $9.0 million compared to $9.5 million for the year ended December 31,
2001, a decrease of $0.5 million or 5.7%. This decrease was caused primarily by
decreases in the Bank's net interest margin to 3.47% in 2002 from 3.77% in 2001.
Although market rates remained relatively stable during 2002, loans and
investments continued to reprice lower in accordance with their adjustment
cycle. Rates paid on interest-bearing liabilities decreased to 3.39% for 2002
from 4.24% for 2001. The Bank is positioned to increase net interest income with
rising interest rates.
2001 COMPARED TO 2000. Net interest income for the year ended December 31,
2001 was $9.5 million compared to $8.6 million for the year ended December 31,
2000, an increase of $0.9 million or 10.5%. The increase was caused primarily by
increases in average interest-earning assets from $233.4 million in 2000 to
$253.2 million in 2001, and interest-bearing liabilities from $231.1 million in
2000 to $245.4 million in 2001. The Bank's net interest margin increased from
3.69% for the year ended December 31, 2000 to 3.77% for the year ended December
31, 2001, primarily due to a decrease in average rate paid on interest-bearing
liabilities.
AVERAGE BALANCES, INTEREST RATES AND YIELDS. Net interest income is
affected by the difference ("interest rate spread") between rates of interest
earned on interest-earning assets and rates of interest paid on interest-bearing
liabilities and the relative amounts of interest-bearing liabilities and
interest-earning assets. When the total of interest-earning assets approximates
or exceeds the total of interest-bearing liabilities, any positive interest rate
spread will generate net interest income. Financial institutions have
traditionally used interest rate spreads as a measure of net interest income.
Another indication of an institution's net interest income is its "net yield on
interest-earning assets" or "net interest margin," which is net interest income
divided by average interest-earning assets.
6
AVERAGE BALANCES AND INTEREST RATES
YEAR ENDED DECEMBER 31,
---------------------------------------------------------------------------
2002 2001
------------------------------------ ------------------------------------
AVERAGE INTEREST AVERAGE INTEREST
OUTSTANDING EARNED/ YIELD/ OUTSTANDING EARNED/ YIELD/
BALANCE PAID RATE BALANCE PAID RATE
------------------------------------ ------------------------------------
Interest-Earning Assets:
Loans (1) $217,597,254 $15,729,020 7.23% $224,638,896 $18,276,561 8.14%
Mortgage-backed securities 6,083,847 238,145 3.91% 1,143,720 74,935 6.55%
Investment securities (2) 10,069,556 429,210 4.26% 7,768,763 537,388 6.92%
Interest-bearing deposits 25,879,158 1,014,317 3.92% 19,691,832 1,049,583 5.33%
------------------------------------ ------------------------------------
Total interest-earning assets $259,629,815 $17,410,692 6.71% $253,243,211 $19,938,467 7.87%
==================================== ====================================
Interest-Bearing Liabilities:
Deposits $184,120,609 $5,042,699 2.74% $177,212,048 $ 6,369,577 3.59%
FHLB advances 64,034,041 3,317,401 5.27% 68,153,648 4,031,835 5.92%
------------------------------------ ------------------------------------
Total interest-bearing
liabilities $248,154,649 $8,414,100 3.39% $245,365,696 $10,401,412 4.24%
==================================== ====================================
Net interest income $8,996,592 $9,537,055
============= =============
Interest rate spread 3.32% 3.63%
===== =====
Net interest-earning assets $11,475,165 $7,877,515
============ ============
Net interest margin 3.47% 3.77%
===== =====
(1) Interest on loans includes fees. Nonaccrual loans and loans held for
sale have been included in the average balances of loans. (2) Yield on
investment securities is reported on an actual and not a tax equivalent
basis
2000
------------------------------------
AVERAGE INTEREST
OUTSTANDING EARNED/ YIELD/
BALANCE PAID RATE
------------------------------------
Interest-Earning Assets:
Loans (1) $217,267,415 $18,097,475 8.33%
Mortgage-backed securities 1,388,320 87,076 6.27%
Investment securities (2) 13,443,781 880,876 6.55%
Interest-bearing deposits 1,280,132 73,497 5.74%
------------------------------------
Total interest-earning assets $233,379,648 $19,138,924 8.20%
====================================
Interest-Bearing Liabilities:
Deposits $173,688,056 $6,886,005 3.96%
FHLB advances 57,435,331 3,640,197 6.34%
------------------------------------
Total interest-bearing
liabilities $231,123,387 $10,526,202 4.55%
====================================
Net interest income $8,612,722
=============
Interest rate spread 3.64%
=====
Net interest-earning assets
(liabilities) $2,256,261
============
Net interest margin 3.69%
=====
(1) Interest on loans includes fees. Nonaccrual loans and loans held for
sale have been included in the average balances of loans.
(2) Yield on investment securities is reported on an actual and not a tax
equivalent basis
7
The following table presents information regarding the average yields received
on loans and other assets and the rates paid on deposits and borrowings at the
dates indicated. Non-accruing loans have been included in the table as loans
carrying a zero yield.
AT DECEMBER 31,
2002 2001 2000
WEIGHTED AVERAGE RATE:
Loans 6.89% 7.58% 8.42%
Mortgage-backed securities 5.29% 6.61% 7.30%
Investments(1) 5.12% 5.90% 6.12%
Interest-bearing deposits 3.60% 4.26% 6.71%
All interest-earning assets 6.45% 7.33% 8.27%
WEIGHTED AVERAGE COST:
Deposits (interest-bearing) 2.51% 2.77% 4.16%
FHLB advances 4.83% 5.68% 6.45%
All interest-bearing liabilities 3.10% 3.59% 4.80%
INTEREST RATE SPREAD 3.35% 3.74% 3.47%
(1) Yield on investment securities is reported on an actual and not a tax
equivalent basis.
RATE/VOLUME ANALYSIS. The following table sets forth certain information
regarding changes in interest income and interest expense of the Company for the
periods indicated. For each category of interest-earning asset and
interest-bearing liability, information is provided on changes attributable to:
(i) changes in volume (change in volume multiplied by the prior year rate) and
(ii) changes in rate (change in rate multiplied by the prior year volume).
Rate/volume variances have been allocated proportionately to the change due to
rate and the change due to volume.
YEAR ENDED DECEMBER 31, YEAR ENDED DECEMBER 31,
----------------------- -----------------------
2002 VS 2001 2001 VS 2000
------------ ------------
INCREASE (DECREASE) DUE TO: INCREASE (DECREASE) DUE TO:
--------------------------- ---------------------------
Interest Income: VOLUME RATE TOTAL VOLUME RATE TOTAL
------ ---- ----- ------ ---- -----
Loans ($488,311) ($2,059,230) ($2,547,541) $568,692 ($389,606) $179,086
Mortgage-backed securities 178,767 (15,558) 163,209 (16,259) 4,118 (12,141)
Investment securities 600,949 (709,127) (108,178) (395,707) 52,219 (343,488)
Interest-bearing deposits 3,545,106 (3,580,370) (35,265) 980,972 (4,886) 976,086
-------------------------------------- -------------------------------------
Total interest-earning assets 3,836,511 (6,364,285) (2,527,775) 1,137,698 (338,155) 799,543
-------------------------------------- -------------------------------------
Interest Expense:
Deposits 191,455 (1,518,323) (1,326,878) 143,333 (659,761) (516,428)
FHLB advances (173,773) (486,661) (660,435) 608,968 (217,330) 391,638
-------------------------------------- -------------------------------------
Total interest-bearing
liabilities 17,672 (2,004,984) (1,987,313) 752,301 (877,091) (124,790)
-------------------------------------- -------------------------------------
Net Interest Income $3,818,839 ($4,359,301) ($540,462) $385,397 $538,936 $924,333
====================================== =====================================
8
YEAR ENDED DECEMBER 31,
-----------------------
2000 VS 1999
------------
INCREASE (DECREASE) DUE TO:
---------------------------
Interest Income: VOLUME RATE TOTAL
------ ---- -----
Loans $2,329,358 $177,084 $2,506,442
Mortgage-backed securities (10,718) 470 (10,248)
Investment securities (49,011) (34,608) (83,619)
Interest-bearing deposits (170,618) (66,642) (237,260)
--------------------------------------
Total interest-earning assets 2,099,011 76,304 2,175,315
--------------------------------------
Interest Expense:
Deposits (89,190) 611,223 522,033
FHLB advances 1,032,174 298,716 1,330,890
--------------------------------------
Total interest-bearing
liabilities 942,984 909,939 1,852,923
--------------------------------------
Net Interest Income $1,156,027 ($833,635) $322,392
======================================
PROVISION FOR LOAN LOSSES
2002 COMPARED TO 2001. The provision for loan losses was $1,494,916 for the
year ended December 31, 2002 and $1,056,194 for the year ended December 31,
2001, an increase of $438,722. The increase is due to the depressed economy,
which has increased past due and classified loans, and the Bank's gradually
changing portfolio to include more commercial loans. The provision for loan
losses was based upon management's assessment of relevant factors, including
types and amounts of non-performing loans, historical and anticipated loss
experience on such types of loans, and economic conditions.
2001 COMPARED TO 2000. The provision for loan losses was $1,056,194 for the
year ended December 31, 2001 and $309,000 for the year ended December 31, 2000,
an increase of $747,194. The increase is due to management's assessment of
market conditions, the general recession in the economy, and the changing mix of
historically residential loan portfolio to higher risk commercial loan
portfolio.
The allowance for loan losses as a percentage of total loans has increased
from 2000 to 2002. This increase is due to the increasing exposure of the Bank
to commercial lending. Because of the Bank's continuing growth in commercial
loans, the Bank will continue to fund the allowance for loan losses due to
higher risks related to commercial lending, especially as the Bank establishes a
history of net charge-offs related to its commercial loans.
Nonperforming loans and net charge-offs have increased in 2002 and 2001
compared to prior years. This increase is primarily due to the Bank's quicker
classification of nonaccrual loans and general weakness in economic conditions.
The Bank has enhanced collection efforts to address this issue. The Bank has
added a Loss Mitigation Officer, which Management expects will both reduce
charge-offs and increase recoveries. The Loss Mitigation Officer will attempt to
maximize recoveries on loans previously charged off. The Bank has also added a
Credit Analyst, who will primarily be responsible for underwriting new loans.
The Credit Analyst will also be able to accelerate identification of weaknesses
in commercial relationships. Additional training and technology have been
provided to the collections staff. The Bank has also accelerated its collections
and foreclosure actions to reduce the level of nonperforming assets and net
charge-offs.
9
NONINTEREST INCOME
2002 COMPARED TO 2001. Noninterest income was $5.4 million in 2002 compared
to $4.5 million in 2001, an increase of $909,886. The primary components of the
increase were mortgage banking activities and increase in cash surrender value
of life insurance. The increase in mortgage banking activities was due to the
increase in loan sales during 2002 compared to 2001. Proceeds from sale of loans
increased to $108.7 million in 2002 from $74.3 million in 2001. Mortgage banking
activities are expected to continue strong through the beginning of 2003,
although an increase in interest rates should decrease activity. During 2002,
the Bank recognized an increase in cash surrender value of life insurance
totaling $332,470, compared to $2,959 for 2001 related to insurance policies on
key personnel. The life insurance was purchased with a single premium payment in
December 2001. Commission income from Oakleaf Financial Services, Inc.
("Oakleaf"), the Bank's investment subsidiary, increased to $970,737 in 2002
from $796,688 in 2001. This increase is due to growth in the relationships
managed by Oakleaf. Management anticipates continued growth in fee income from
Oakleaf, as the relationship base increases.
2001 COMPARED TO 2000. Noninterest income was $4.5 million in 2002 compared
to $3.4 million in 2001, an increase of $1.1 million. The primary component of
the increase was mortgage banking activities. The increase in mortgage banking
activities was due to the increase in loan sales during 2001 compared to 2000.
Proceeds from sale of loans increased to $74.3 million in 2001 from $13.9
million in 2000. Commission income from Oakleaf Financial Services, Inc.
("Oakleaf"), the Bank's investment subsidiary, increased to $796,688 in 2001
from $691,766 in 2000, due to growth of relationships and the acquisition of
McKillen Financial, Inc. in January 2000.
NONINTEREST EXPENSE
2002 COMPARED TO 2001. Noninterest expense was $9.0 million in 2002,
compared to $8.9 million in 2001, an increase of $113,223 or 1.3%. The largest
component of the increase was salaries and employee benefits, which increased
$640,158 to $4.7 million in 2002 from $4.0 million in 2001. These increases are
due to increases in the cost of employer-provided medical insurance and salary
adjustments. Employer-provided medical insurance was $615,320 in 2002 and
$421,971 in 2001. Salary adjustments were the result of staffing changes and
cost of living increases which took effect January 2002. Offsetting this
increase were decreases in occupancy and equipment expense and amortization of
goodwill. Occupancy and equipment expense decreased $104,074 to $1.3 million in
2002 from $1.4 million in 2001. Depreciation expense was the primary component
of the decrease in occupancy and equipment expense. Depreciation expense
decreased to $605,318 in 2002 from $670,844 in 2001. Amortization expense was
not recognized in 2002, due to adoption of FAS 142. Amortization expense for
2001 was $574,864.
2001 COMPARED TO 2000. Noninterest expense was $8.9 million in 2001,
compared to $9.1 million in 2000, a decrease of $209,700 or 2.2%. The largest
components of this decrease were professional fees, contributions and deposit
account expenses. Deposit account expenses decreased due to a vendor change for
statement rendering and check processing services. In 2000, contributions
included the $110,000 donation of the Bank's Covert, Michigan building to the
Covert community for use as a walk-in medical clinic. In 2000, the professional
fees of $606,206 included expenses of approximately $370,000 for the proposed
merger with Southern Michigan Bancorp, Inc. The merger with Southern Michigan
Bancorp, Inc. was terminated on October 4, 2000.
10
The effective federal income tax rate was 28.6% in 2002, 31.8% in 2001 and
29.6% in 2000. The decrease is primarily due to the increase in value of
bank-owned life insurance, which is not subject to federal income taxes.
CASH FLOWS
OPERATING. Cash flows from operating activities are most significantly
affected by net income and mortgage banking activities. Net income was
$2,790,387, $2,787,937, and $1,816.866 for the years ended December 31, 2002,
2001 and 2000, respectively. Gain on sale of loans was $1.2 million, $783,640
and $114,610 for the years ended December 31, 2002, 2001, and 2000,
respectively. Loans originated for sale and proceeds from the sale of loans also
increased with the historically low mortgage loan rates. Loans originated for
sale were $111.1 million, $77.3 million, and $14.4 million for the years ended
December 31, 2002, 2001, and 2000, respectively. The increases in loans
originated for sale in 2002 and 2001 are primarily due to the low residential
mortgage rates. Proceeds from sales of loans were $109.3 million, $74.3 million,
and $13.9 million for the years ended December 31, 2002, 2001, and 2000,
respectively. Because the Bank generally has a policy of selling long-term fixed
rate mortgage loans, the volume of loan sales varies with customer demand for
these loans. Also affecting cash flows from operating activities are the
add-backs of non-cash expenses, which include the provision for loan losses,
depreciation and amortization of mortgage servicing rights.
INVESTING. Cash flows from investing activities are most significantly
affected by loans made to customers net of principal payments, changes in the
Bank's investment portfolio, increases in interest-bearing deposits in banks,
and the acquisition of bank owned life insurance. For the year ended December
31, 2002 and 2001 there were decreases in loans of $4.7 million and $3.4
million, respectively, primarily due to refinanced loans. Investment purchases
and maturities also affect cash flows from investing activities. The Bank's
management maintains investments at levels that provide the Bank with optimal
return, risk, and liquidity. The Bank increased its holdings of interest-bearing
deposits in banks by $8.0 million to $23.0 million at December 31, 2002 from
$15.0 million at December 31, 2001 and $7.7 million at December 31, 2000. The
Bank purchased $6.0 million of bank-owned life insurance in 2001. The increase
in holdings of interest-bearing deposits and the purchase of bank-owned life
insurance were primarily funded by deposits.
FINANCING. Cash flows from financing activities are mostly affected by
changes in deposits and FHLB advances. Deposits increased $23.4 million, $3.8
million and $10.2 million for the years ended December 31, 2002, 2001, and 2000,
respectively. The Bank also used FHLB advances for financing its operating and
investing activities. The FHLB advances decreased $5.7 million for the year
ended December 31, 2002 and increased $2.7 million and $8.3 million for the
years ended December 31, 2001 and 2000, respectively.
FINANCIAL CONDITION
ASSETS. The Bank's total assets at December 31, 2002 were $296.7 million
compared to $279.8 million at December 31, 2001, an increase of $16.9 million or
6.0%. The increase was primarily in interest-bearing deposits in banks and
11
investment securities. The low market interest rates prompted a heavy
refinancing year for residential mortgages. The funds from the refinanced
residential mortgages were redeployed into commercial loans, investments and
interest-bearing deposits in banks. Interest-bearing deposit liabilities
increased with the decreased confidence in the equity markets. An increase in
market interest rates or rebound in equity markets could change the unusually
high liquidity position of the Bank.
LOANS. The Bank's net loans decreased to $212.0 million at December 31,
2002 from $219.1 million at December 31, 2001. This decrease was primarily due
to residential loans refinanced with the decrease in market rates.
Adjustable-rate mortgage loans were refinanced into fixed rate mortgages to lock
in low rates. The Bank sells long-term, fixed rate, residential mortgages in the
secondary market, so the residential mortgages decreased to $127.8 million at
December 31, 2002 from $151.8 million at December 31, 2002. Commercial mortgage
loans increased to $50.4 million, or 23.2% of gross loans, at December 31, 2002
from $34.9 million, or 15.6% of gross loans at December 31, 2001. The demand for
fixed-rate mortgage loans in 2002 was higher due to lower average interest rates
during the period. The proceeds from sales of loans (all fixed-rate, residential
mortgages) were $108.7 million and $74.3 million for 2002 and 2001,
respectively. The mortgage loans originated for sale ($111.1 million during 2002
and $77.3 million during 2001) were primarily funded by the secondary mortgage
market sales. At December 31, 2002, outstanding loan commitments were $9.8
million and $17.9 million on fixed and variable-rate loans, respectively. These
loan commitments will be funded by interest-bearing deposits, maturing assets,
and additional FHLB borrowings, if needed. The decision to sell fixed-rate
mortgages with original maturities of 10 years or greater protects the Bank from
the interest rate risk inherent in holding these longer fixed-rate loans and
provides a source of liquidity to fund loan demand. Bank Management does not
view the decrease in loan balances as a continuing trend. An increase in market
interest rates will decelerate the pace of refinance in the residential loan
portfolio and the Bank is continuing its growth in commercial loans.
Loans serviced for others increased by $43.7 million to $178.5 million at
December 31, 2002 from $134.8 million at December 31, 2001. This servicing
portfolio consists of loans originated by the Bank and sold in the secondary
mortgage market with servicing retained by the Bank. Bancorp has no purchased
mortgage servicing portfolio. The originated mortgage servicing rights asset had
a valuation allowance at December 31, 2002 of $273,852. This allowance was
established to recognize the measured impairment of the asset. The Bank will
continue to monitor the valuation of the servicing rights asset. If subsequent
analysis shows reductions in the impairment, the valuation allowance will be
reduced.
INTEREST-BEARING DEPOSITS IN BANKS. Interest-bearing deposits in banks were
$23.0 million at December 31, 2002, compared to $15.0 million at December 31,
2001, an increase of $8.0 million. During 2002, growth in deposits and
refinanced loans provided funds for investments in $100,000 certificates of
deposit in domestic financial institutions.
SECURITIES - HELD-TO-MATURITY. Investment securities consisting of U.S
treasury and agency securities, municipal obligations, and mortgage-backed
securities were $12.6 million at December 31, 2002 compared to $3.9 million at
December 31, 2001, an increase of $8.7 million. The increase was primarily in
commercial mortgage-backed securities issued by the Small Business Association,
a U.S. Agency.
12
DEPOSITS AND BORROWED FUNDS. Deposits were $202.6 million at December 31,
2002 compared to $179.1 million at December 31, 2001, an increase of $23.5
million or 13.1%. The increase is primarily in certificates of deposit of
$100,000 or greater, which were $34.5 million and $15.1 million at December 31,
2002 and 2001, respectively. The increase in certificates of deposit includes
$10.0 million of brokered certificates. The Bank will continue to manage the
rates offered on its time deposits and use borrowed funds, when that strategy
enhances net interest income.
The Bank has an available line of credit with the Federal Home Loan Bank of
Indianapolis ("FHLB") which provides for advances up to $10.0 million and
matures in March 2003. All borrowings from FHLB are collateralized by FHLB stock
and substantially all mortgage loans.
Long-term advances were $57.7 million at December 31, 2002 compared to
$64.1 million at December 31, 2001 a decrease of $6.4 million. Short-term
advances were $6.7 million at December 31, 2002 compared to $6.0 million at
December 31, 2001 a decrease of $0.7 million.
CAPITAL
The stockholders' equity of the Bancorp was $27.5 million at December 31,
2002 compared to the Bank's stockholders' equity of $28.5 million at December
31, 2001, a decrease of $1.0 million or 3.74%. The primary component of this
decrease was redemption of common stock. During January 2002, the Board of
Bancorp approved a program to repurchase up to 10 percent of Bancorp's issued
and outstanding common stock in the open market and in privately negotiated
transactions. Through December 31, 2002, Bancorp redeemed 301,999 shares of its
common stock at a total redemption price of $3.0 million. Cash dividends during
2002 of $0.28 per share reduced retained earnings by $829,499. The stockholders'
equity was 9.25% of total assets at December 31, 2002.
ASSET/LIABILITY MANAGEMENT
The primary component of the Bank's earnings is net interest income. The
Bank's asset/liability management strategy is to maximize net interest income
over time by reducing the impact of fluctuating interest rates. This is
accomplished by matching the mix and maturities of its assets and liabilities.
At the same time the Bank's asset/liability strategies for managing interest
rate risk must also accommodate customer demands for particular types of deposit
and loan products. The Bank uses various asset/liability management techniques
in an attempt to maintain a profitable mix of financial assets and liabilities,
provide deposit and loan products that meet the needs of its market area, and
maintain control over interest rate risk resulting from changes in interest
rates.
Net interest income, the primary component of the Bank's net income, is
derived from the difference or "spread" between the yield on interest-earning
assets and the cost of interest-bearing liabilities. The Bank has sought to
reduce its exposure to changes in interest rates by matching more closely the
effective maturities and repricings of its interest-sensitive assets and
liabilities. At the same time, the Bank's asset/liability management strategies
must also accommodate customer demands for particular types of deposit and loan
products.
13
While much of the Bank's asset/liability management efforts involve
strategies that increase the rate sensitivity of its loans and investments, such
as the sale of long-term fixed rate loans, originations of adjustable rate loans
and purchases of adjustable rate mortgage-backed securities or relatively short
average life fixed-rate investments, it also uses certain techniques to reduce
the rate sensitivity of its deposits and borrowed money. Those techniques
include attracting longer-term certificates of deposit when the market will
permit, emphasizing core deposits, which are less sensitive to changes in
interest rates, and borrowing through long-term FHLB advances. The Bank's
asset/liability management strategy will appropriately change when market rates
change.
The Bank measures its exposure to interest rate fluctuations primarily by
using a computer modeling system designed for savings institutions such as the
Bank. The model uses assumptions which management believes are reasonable for
the analysis. These assumptions include (but are not limited to) prepayment and
decay rates based on nine interest rate scenarios. It allows the Bank to adjust
its asset-liability mix based on the interest rate risk identified. The analysis
estimates the changes in the market value of the Bank's equity using interest
rate change scenarios ranging from +4% to -4%, in 1% increments from current
market rates. At December 31, 2002, the following table illustrates the interest
rate sensitivity of the Bank's equity to changes in market interest rates.
(in Thousands of Dollars)
-----------------------
Book value of stockholders' equity $27,453
4% increase in market rates 43,152
3% increase in market rates 43,422
2% increase in market rates 45,191
1% increase in market rates 44,376
No change (current market value of equity) 42,905
1% decrease in market rates 40,075
2% decrease in market rates 37,143
3% decrease in market rates 33,661
4% decrease in market rates 29,268
As the table shows, the Bank's book value of equity is less than estimated
market value in all of the scenarios. That indicates that the Bank is able to
withstand fluctuations in market interest rates without posting a significant
threat to either the Bank's stockholders' equity or the federal deposit
insurance system, and therefore, the Bank can be deliberate in its actions to
adjust the asset-liability mix. The Bank would meet the regulatory minimum
capital requirements in all of the interest-rate scenarios.
The Bank has an Asset-Liability Management Committee (ALCO) that meets as
needed. The purpose of this Committee is to communicate, coordinate, and monitor
asset-liability management procedures. The Committee establishes and monitors
the volume and mix of both assets and funding sources. The objective is to
manage assets and funding sources to produce results consistent with the Bank's
liquidity requirements, capital adequacy, growth, and profitability goals. To
accomplish this objective, the ALCO uses internal budget variance reports,
forecasts for changes in interest rates and consumer deposit activity, as well
as forecasts of loan demand in each of the Bank's loan types, investment
maturities and new investment alternatives, and various other internal and
external reports.
14
Static Gap Analysis: The management of interest rate sensitivity
includes monitoring the maturities and repricing opportunities of
interest-earning assets and interest-bearing liabilities. The following table
summarizes the interest rate repricing gaps for selected maturity periods as of
December 31, 2002:
(In Thousands)
1 Mo. 2-3 Mos. 4-6 Mos. 7-9 Mos. 10-12 Mos. >1-5 Yrs. >5 Yrs. Total
-----------------------------------------------------------------------------------------
Non-loan interest-earning assets $12,401 $10,770 $1,568 $7,611 $3,779 $1,539 $2,063 $39,731
Loans 74,069 13,821 17,881 16,128 13,648 75,911 8,023 219,481
-----------------------------------------------------------------------------------------
Total interest-earning assets 86,470 24,591 19,449 23,739 17,427 77,450 10,086 259,212
-----------------------------------------------------------------------------------------
Savings accounts 1,168 2,335 3,817 3,817 3,817 20,483 5,454 40,891
Checking accounts 1,600 3,157 4,838 4,838 4,838 24,815 6,638 50,724
Certificates & Term IRA's 8,568 12,864 10,843 7,512 10,909 38,625 8,881 98,202
Other IB liabilities (FHLB advances) 6,672 3,565 112 0 3,700 9,332 41,000 64,381
-----------------------------------------------------------------------------------------
Total interest-bearing liabilities 18,008 21,921 19,610 16,167 23,264 93,255 61,973 254,198
-----------------------------------------------------------------------------------------
Asset (liability) gap 66,462 2,670 -161 7,572 -5,837 -15,805 -51,887 5,014
Cumulative asset gap 66,462 71,132 70,971 78,543 72,706 56,901 5,014
Cumulative gap as a percentage
of cumulative earning assets 26.4% 27.4% 27.4% 30.3% 28.0% 22.0% 1.9%
Total interest-earning assets exceeded interest-bearing liabilities by $5.0
million at December 31, 2002. This difference was funded mainly through
non-interest-bearing liabilities. The above table shows that total assets
maturing or repricing within one year exceed liabilities maturing or repricing
within one year by $72.7 million. This indicates the Bank's net interest income
would increase with rising interest rates, because more of its assets than
liabilities would reprice at the higher rates in the next year. However, the
repricing and cash flows of certain categories of assets and liabilities are
subject to competitive and other influences that are beyond the control of the
Bank. As a result, certain assets and liabilities indicated as maturing or
repricing within a stated period may, in fact, mature or reprice in other
periods or at different volumes.
Simulation: The Bank recognizes the limitations of static gap analysis as a
tool for managing its interest rate risk. The Bank also uses a computer-based
earnings simulation model to estimate the effects of various interest rate
environments on the balance sheet structure and net interest income. These
simulation techniques involve changes in interest rate relationships, asset and
liability mixes, and prepayment options inherent in financial instruments, as
well as interest rate levels in order to quantify risk. The Bank's sensitivity
is estimated by first forecasting the next twelve months of net interest income
under an assumed environment of constant market interest rates. Next, immediate
parallel interest rate shocks are constructed in the model. The rate shocks
15
reflect changes of equal magnitude to all market interest forecast under each of
the rate shock scenarios. The resulting change in net interest income is an
indication of the sensitivity change in net earnings to directional changes in
market interest rates. This model is based solely on parallel changes in market
rates and does not reflect the levels of interest rate risk that may arise from
other factors such as changes in the spreads between key market rates or in the
shape of the Treasury yield curve. The net interest income simulation model
includes on-balance sheet loan, investment, deposit, and debt instruments as
well as off-balance sheet interest rate swaps.
The Bank's Board of Directors compares net interest income sensitivity and
has established tolerance limits for fluctuation. Throughout 2002, the
forecasted exposure was within the Bank's established policy limits, except in
falling rate change scenarios. The Bank's Board of Directors and Management
consider further significant rate decreases from December 31, 2002 as unlikely.
Net Interest Income Sensitivity: Change in Projected Results vs. Constant Rates
Year-End 2002 12 Month Projection
Rate Shock Amount
(2.00%) (1.00%) 0.00% 1.00% 2.00%
----------------------------------------------------
Percent Change in net interest
income vs constant rates (13.12%) (6.67%) 0.00% 4.92% 11.83%
ALCO Policy (6.00%) (3.00%) 0.00% (4.00%) (8.00%)
EFFECT OF INTEREST RATE FLUCTUATIONS
Bancorp's consolidated results of operations depend to a large extent on
the Bank's level of net interest income, which is the difference between
interest income earned on its loan and investment portfolios versus the interest
paid on deposits and borrowed funds. If the cost of funds increases faster than
the yield on its interest-earning assets, net interest income will be reduced.
The Bank measures its interest rate risk primarily using simulation
analysis. This analysis is prepared by the Chief Financial Officer and reviewed
by the Asset/Liability Management Committee ("ALCO"). The ALCO is comprised of
the Chief Executive Officer, Chief Financial Officer and other representatives
from operations, branch administration, lending, trust, private banking, and
marketing. The Bank's Board of Directors reviews quarterly reports that estimate
the Bank's sensitivity to changes in interest rates. Sensitivity is estimated
for net interest income and market value of portfolio equity.
While the Bank uses various tools to monitor interest rate risk, it is
unable to predict future fluctuations in interest rates or the specific impact
thereof. The market value of most of the Bank's financial assets is sensitive to
fluctuations in market interest rates. Fixed-rate investments including mortgage
loans and mortgage-backed securities decline in value as interest rates rise.
Adjustable-rate loans and securities generally have less market value volatility
than do fixed-rate products.
16
LIQUIDITY
The Bank maintains certain levels of liquid assets (the most liquid of
which are cash and cash equivalents and investment securities) in order to meet
demands from loan commitments, savings withdrawals and other obligations. The
Bank manages liquidity by maintaining a portion of its liquid assets in
overnight accounts and by keeping various maturities in its portfolio of
investment securities. The primary sources of liquidity are loan repayments and
sales, maturing investments, deposit accounts, and FHLB borrowings.
Two factors contributed to the increased liquidity at December 31, 2002:
low interest rates for residential mortgages and decreased confidence in equity
markets. The residential mortgages that have refinanced into low fixed-rate
terms have been sold to the secondary mortgage market, providing funds for the
Bank to redeploy. The Bank originated commercial mortgage and commercial
nonmortgage loans, so the percentage of commercial loans to total loans
increased. Decreased investor confidence in equity markets has increased bank
deposits nationally, including deposits at the Bank. This increase in deposits
provided additional funds the Bank invested in securities and interest-bearing
deposits in other banks. Either an increase in loan rates or investor confidence
in equity markets could significantly reduce the Bank's liquidity position.
CONTRACTUAL OBLIGATIONS
Payments Due by Period
--------------------------------------------------------------------------------------
Less than 1 - 3 4 - 5 After 5
Total 1 year years years years
----- ------ ----- ----- -----
Certificates of deposit $98,201,884 $50,476,860 $22,426,772 $16,416,948 $8,881,304
FHLB advances 57,709,489 7,377,466 5,985,951 3,346,072 41,000,000
---------- --------- --------- --------- ----------
Total contractual cash
obligations $155,911,373 $57,854,359 $28,412,723 $19,763,020 $49,881,304
The long-term debt obligations consist of certificates of deposit and
advances from the Federal Home Loan Bank. The above schedule represents
principal payments only and does not include interest.
RECENT ACCOUNTING DEVELOPMENTS
In June 2001, Statement of Financial Accounting Standards No. 142 (FAS
142), GOODWILL AND OTHER INTANGIBLE ASSETS was issued and is effective for
fiscal years beginning after December 15, 2001. Under FAS 142, identifiable
intangible assets that meet certain criteria will continue to be amortized over
their estimated useful lives. However, goodwill and non-identifiable intangible
assets will no longer be amortized. Instead, these assets will be evaluated for
impairment on an annual basis. If an asset is deemed to be impaired, the asset
will be written down through an adjustment to current earnings. As a result of
adopting FAS 142, the Bank will no longer be amortizing goodwill. Goodwill
amortization was $574,864 in 2001 and $587,979 in 2000. No impairment loss was
recorded upon adoption of FAS 142. For comparison purposes, had FAS 142 been
adopted in 2001 and 2000, net income would have been approximately $3,167,347 in
2001 and $2,204,932 in 2000.
17
RECENT LEGISLATION
THE SARBANES-OXLEY ACT OF 2002 On July 30, 2002, President Bush signed into
law the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley Act"). The stated goals of
the Sarbanes-Oxley Act are to increase corporate responsibility, to provide for
enhanced penalties for accounting and auditing improprieties at publicly traded
companies and to protect investors by improving the accuracy and reliability of
corporate disclosures pursuant to the securities laws.
The Sarbanes-Oxley Act is the most far-reaching U.S. securities legislation
enacted in some time. The Sarbanes-Oxley Act generally applies to all companies,
both U.S. and non-U.S., that file or are required to file periodic reports with
the Securities and Exchange Commission (the "SEC") under the Securities Exchange
Act of 1934, or the Exchange Act. Given the extensive SEC role in implementing
rules relating to many of the Sarbanes-Oxley Act's new requirements, the final
scope of these requirements remains to be determined.
The Sarbanes-Oxley Act includes very specific additional disclosure
requirements and new corporate governance rules, requires the SEC and securities
exchanges to adopt extensive additional disclosure, corporate governance and
other related rules and mandates further studies of certain issues by the SEC
and the Comptroller General. The Sarbanes-Oxley Act represents significant
federal involvement in matters traditionally left to state regulatory systems,
such as the regulation of the accounting profession, and to state corporate law,
such as the relationship between a board of directors and management and between
a board of directors and its committees.
The Sarbanes-Oxley Act addresses, among other matters:
- audit committees for all reporting companies;
- certification of financial statements by the chief executive officer
and the chief financial officer;
- the forfeiture of bonuses or other incentive-based compensation and
profits from the sale of an issuer's securities by directors and
senior officers in the twelve month period following initial
publication of any financial statements that later require
restatement;
- a prohibition on insider trading during pension plan black out
periods;
- disclosure of off-balance sheet transactions;
- a prohibition on personal loans to directors and officers;
- expedited filing requirements for Forms 4's;
- disclosure of a code of ethics and filing a Form 8-K for a change or
waiver of such code;
- "real time" filing of periodic reports;
- the formation of a public accounting oversight board;
- auditor independence; and
- various increased criminal penalties for violations of securities
laws.
18
The Sarbanes-Oxley Act contains provisions which became effective upon
enactment on July 30, 2002 and provisions which will become effective from
within 30 days to one year from enactment. The SEC has been delegated the task
of enacting rules to implement various provisions with respect to, among other
matters, disclosure in periodic filings pursuant to the Exchange Act.
USA PATRIOT ACT - Under the USA PATRIOT Act of 2001, adopted by the U.S.
Congress on October 26, 2001 to combat terrorism, FDIC insured banks and
commercial banks will be required to increase their due diligence efforts for
correspondent accounts and private banking customers. The USA PATRIOT Act
requires banks to engage in additional record keeping or reporting, requiring
identification of owners of accounts, or of the customers of foreign banks with
accounts, and restricting or prohibiting certain correspondent accounts.
During 2002, the Federal Crimes Enforcement Network, a bureau of the
Department of Treasury, issued regulations to implement the provisions of the
USA PATRIOT Act. To date, it has not been possible to predict the impact and USA
PATRIOT Act and its implementing regulations may have on the Company and the
Bank.
19
DIRECTORS OF THE BANCORP
------------------------
Raymond H. Dresser, Jr. Chairman, Dresser, Dresser, Haas & Caywood, P.C.
Retained Counsel
Eric L. Eishen President and Chief Executive Officer,
Sturgis Bank & Trust Company
Leonard L, Eishen Retired President and Chief Executive Officer,
Sturgis Bank & Trust Company
Lawrence A. Franks Chairman of the Board
President, Burr Oak Tool and Gauge Company, Inc.
Donald A. Frost President, LTI Printing, Inc.
James A. Goethals Vice Chairman of the Board
Retired President, Sturgis Foundry Corporation
Philip G. Ward President Emeritus, Glen Oaks Community College
OFFICERS OF THE BANCORP
-----------------------
Leonard L. Eishen President, Chief Executive Officer
Eric L. Eishen Vice President
Brian P. Hoggatt Chief Financial Officer, Secretary/Treasurer
20
DIRECTORS OF THE BANK
---------------------
Raymond H. Dresser, Jr. Chairman, Dresser, Dresser, Haas & Caywood, P.C.
Retained Counsel
Eric L. Eishen President and Chief Executive Officer
Leonard L. Eishen Retired President and Chief Executive Officer
Lawrence A. Franks Vice Chairman of the Board
President, Burr Oak Tool and Gauge Company, Inc.
Donald L. Frost President, LTI Printing, Inc.
James A. Goethals Chairman of the Board
President, Sturgis Foundry Corporation - Retired
Philip G. Ward President Emeritus, Glen Oaks Community College
OFFICERS OF THE BANK
--------------------
Eric L. Eishen President, Chief Executive Officer
Steven G. Gage Senior Vice President, Commercial Lending
Brian P. Hoggatt Senior Vice President, Chief Financial Officer,
Treasurer, Corporate Secretary
Tracey L. Parker Senior Vice President, Retail Lending
Ronald W. Scheske Executive Vice President
David E. Watters Vice President, Senior Trust Officer
Jose D. Albarran Vice President
Donald G. Baldwin Vice President, Operations, Compliance Officer
Debora L. Capman Vice President, Trust Officer
Emily D. Haller Vice President, Human Resources
Steven A. Haller Vice President, Loss Mitigation
Jason J. Hyska Vice President
Gary E. Metz Vice President
Larry W. Miller Vice President
Christine M. Moline Vice President, Private Banking
Jason A. Wagner Vice President
Sandra J. Cagle Assistant Vice President
Trudy R. Gloy Assistant Vice President
Stacie L. Ogg Assistant Vice President
Regina Switalski Assistant Vice President
21
BANK CORPORATE INFORMATION
Location Address City, St Zip Telephone Fax
-------- ------- ------------ --------- ---
Sturgis (Main Office) 113-125 East Chicago Road Sturgis, MI 49091 (269) 651-9345 (269) 651-5512
(269) 651-8263
Branch Offices
--------------
Bronson 863 West Chicago Road Bronson, MI 49028 (517) 369-7322 (517) 369-2347
Centreville 158 West Main Centreville, MI 49032 (269) 467-8525 (269) 467-4180
Climax 125 North Main Climax, MI 49034 (269) 746-4256 (269) 746-4108
Coldwater 290 East Chicago Road Coldwater, MI 49036 (517) 278-5634 (517) 278-5613
Colon 110 South Blackstone Street Colon, MI 49040 (269) 432-3229 (269) 432-2971
South Haven 1121 LaGrange Street South Haven, MI 49090 (269) 637-8444 (269) 637-5560
Sturgis 1001 South Centerville Road Sturgis, MI 49091 (269) 651-9379 (269) 651-1514
Sturgis 1501 East Chicago Road Sturgis, MI 49091 (269) 651-9345 (269) 651-5609
Three Rivers 115 North Main Street Three Rivers, MI 49093 (269) 273-8481 (269) 273-1732
White Pigeon 122 West Chicago Road White Pigeon, MI 49099 (269) 483-9668 (269) 483-2725
22
MARKET INFORMATION
------------------
Shares of common stock of Bancorp were held by 422 shareholders of record as of
December 31, 2002 according to Bancorp's transfer agent. Bancorp's shares are
traded on the NASDAQ exchange under the symbol of "STBI". Trading activity has
been infrequent, and previous price information had not been regularly
published.
The range of high and low trade prices for each quarterly period during the past
two years is presented below:
Year Ended December 31,
-----------------------
2002 2001
--------------------- ---------------------
High Low High Low
---- --- ---- ---
First quarter $10.00 $ 7.57 $ 6.50 $ 4.88
Second quarter 11.00 9.07 7.00 5.84
Third quarter 11.00 10.16 8.99 6.27
Fourth quarter 11.00 10.19 9.49 7.25
The trade prices listed above are based on actual transactions obtained from
public Internet sources obtained by Bancorp.
The following table summarizes cash dividends paid per share of common stock for
each quarterly period during 2001 and 2000.
2002 2001
-------------------------
First quarter $.07 $.06
Second quarter .07 .06
Third quarter .07 .07
Fourth quarter .07 .07
-------------------------
$.28 $.26
On December 11, 2001, the shareholders of the Bank approved the reorganization
of the Bank to become a wholly owned subsidiary of Sturgis Bancorp, Inc., a
financial holding company. Sturgis Bancorp, Inc. is a financial holding company
under the Bank Holding Company Act of 1956, as amended (the "Bancorp"). This
reorganization was approved at a special meeting of the shareholders of the Bank
on December 11, 2001. The necessary affirmative vote of the holders of at least
two-thirds (2/3) of the Bank common stock (of which 3,101,534 shares were
outstanding on October 30th, 2001 the record date for the meeting) was obtained.
Prior to the special meeting of the shareholders of the Bank, Bancorp received
the necessary approvals from the Board of Governors of the Federal Reserve and
the Federal Deposit Insurance Corporation. On December 21, 2001, the Michigan
Department of Consumer and Industry Services, Office of Financial and Insurance
Services, Division of Financial Institutions approved the consolidation to
complete the consummation of Bancorp acquiring one hundred percent of the issued
and outstanding common stock of the Bank.
23
This reorganization became effective as of the opening of business on January 1,
2002. Bancorp is a legal entity separate and distinct from its subsidiaries.
Substantially all of Bancorp's revenues result from dividends paid to it by the
Bank and from earnings on investments. There are statutory and regulatory
requirements applicable to the payment of dividends by the Bank to Bancorp, as
well as by Bancorp to its shareholders.
Under the Michigan Savings Bank Act, Bancorp may not declare a cash dividend or
a dividend of any kind except out of net income then on hand after deducting all
losses and bad debts, and then only if it will have a surplus amounting to not
less than 20% of its capital after the payment of the dividend. Moreover, the
Bank may not declare or pay any cash dividend or dividend in kind until the
cumulative dividends on its preferred stock, if any, have been paid in full.
Further, if the surplus of the Bank is at any time less than the amount of its
capital, before the declaration of a cash dividend or dividend in kind, it must
transfer to surplus not less than 10% of its net income for the preceding 6
months (in the case of quarterly or semi-annual dividends) or the preceding two
consecutive 6 month periods (in the case of annual dividends).
Pursuant to the Michigan Business Corporation Act, Bancorp may not make
distributions to its shareholders if, after giving effect to the distribution,
the corporation would not be able to pay its debts as they become due in the
usual course of business, or the corporation's total assets would be less than
the sum of it total liabilities plus, unless the corporation's articles of
incorporation permit otherwise, the amount that would be needed, if the
corporation were to be dissolved at the time of the distribution, to satisfy the
preferential rights upon dissolution of shareholders whose preferential rights
are superior to those receiving the distribution.
The payment of dividends by Bancorp and its subsidiaries may also be affected or
limited by other factors, such as the requirements to maintain adequate capital
above regulatory guidelines. In addition, if, in the opinion of the applicable
regulatory authority, a bank under its jurisdiction is engaged in or is about to
engage in an unsafe or unsound practice (which, depending on the financial
condition of the Bank, could include the payment of dividends), such authority
may require, after notice and hearing, that such bank cease and desist from such
practice or prohibit the payment of future dividends. The Federal Reserve has
indicated that paying dividends that deplete a bank's capital base to an
inadequate level would be an unsafe and unsound banking practice. The Federal
Reserve, the FDIC and the Division of Financial Institutions of the Michigan
Department of Consumer & Industry Services Office of Financial and Insurance
Services ("DFI") have issued policy statements which provide that bank holding
companies and insured banks should generally only pay dividends out of current
operating earnings.
INDEPENDENT ACCOUNTANTS
-----------------------
Bancorp has employed the accounting firm of Plante & Moran, PLLC as Independent
Accountants for the years ended December 31, 2002, 2001 and 2000. There have
been no disagreements on accounting or financial disclosure matters within this
time period.
24
FORM 10-K REPORT
----------------
A copy of Bancorp's Annual Report on Form 10-K, as filed with the Securities
Exchange Commission, for the year ended December 31, 2002, as well as other
filings of Bancorp may be obtained by contacting Eric L. Eishen at Sturgis Bank
& Trust Company, 113-125 East Chicago Road, Sturgis, Michigan 49091, telephone
number (269) 651-9345 or through the Securities and Exchange Commission Edgar
System at WWW.SEC.GOV. Copies of the Bank's filings with the FDIC under the
Securities Exchange Act of 1934 can be obtained from Sturgis Bank & Trust
Company by contacting Eric L. Eishen at Sturgis Bank & Trust Company, 113-125 E
Chicago Road, Sturgis, Michigan 49091, telephone number (616) 651-9345 or, for a
nominal fee from the FDIC at telephone number (202) 898-8913 or fax number (202)
898-3909.
25
STURGIS BANCORP, INC. AND SUBSIDIARIES
=======================================================
CONSOLIDATED FINANCIAL REPORT
DECEMBER 31, 2002
================================================================================
CONTENTS
REPORT LETTER 1
CONSOLIDATED FINANCIAL STATEMENTS
Balance Sheet 2
Statement of Income 3
Statement of Changes in Stockholders' Equity 4
Statement of Cash Flows 5
Notes to Consolidated Financial Statements 6-33
Independent Auditor's Report
To the Board of Directors and Stockholders
Sturgis Bancorp, Inc. and Subsidiaries
Sturgis, Michigan
We have audited the accompanying consolidated balance sheet of Sturgis Bancorp,
Inc. and Subsidiaries as of December 31, 2002 and 2001 and the related
consolidated statements of income, changes in stockholders' equity and cash
flows for each year in the three-year period ended December 31, 2002. These
consolidated financial statements are the responsibility of the Corporation's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audits to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the consolidated
financial statements. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Sturgis
Bancorp, Inc. and Subsidiaries as of December 31, 2002 and 2001 and the
consolidated results of their operations and their cash flows for each year in
the three-year period ended December 31, 2002 in conformity with accounting
principles generally accepted in the United States of America.
As discussed in Note 1 to the financial statements, the Corporation changed its
method of accounting for goodwill in 2002.
/s/ Plante & Moran PLLC
Kalamazoo, Michigan
January 22, 2003
STURGIS BANCORP, INC. AND SUBSIDIARIES
================================================================================
CONSOLIDATED BALANCE SHEET
December 31
-----------
2002 2001
---- ----
ASSETS
Cash and due from banks $ 13,064,101 $ 10,629,027
Interest-bearing deposits in banks 23,018,375 15,042,616
Other short-term investments 7,183 259,735
Securities - Held-to-maturity (Note 2) 12,590,709 3,904,413
Federal Home Loan Bank stock, at cost 4,115,400 4,115,400
Loans held for sale 7,437,506 4,414,906
Loans, net (Note 3) 212,043,350 219,113,940
Real estate owned 1,358,759 451,173
Bank owned life insurance (Note 9) 6,335,429 6,002,959
Accrued interest receivable 1,731,948 1,724,681
Investment in limited partnerships 161,080 224,080
Premises and equipment, net (Note 5) 6,641,980 6,370,160
Goodwill, net of accumulated amortization 5,109,419 5,109,419
Originated mortgage servicing rights (Note 4) 1,501,922 1,281,208
Other assets 1,567,296 1,145,555
------------ ------------
Total assets $296,684,457 $279,789,272
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Deposits
Noninterest-bearing $ 12,747,121 $ 10,862,894
Interest bearing (Note 6) 189,816,675 168,266,933
Federal Home Loan Bank advances (Note 7) 64,381,396 70,076,863
Deferred federal income taxes (Note 8) 306,667 248,333
Accrued interest payable 935,954 993,783
Other liabilities 1,044,116 843,532
------------ ------------
Total liabilities 269,231,929 251,292,338
============ ============
STOCKHOLDERS' EQUITY (Notes 1, 10, and 11)
Preferred stock - $1 par value:
Authorized - 1,000,000 shares and 0 shares
at December 31 2002 and 2001, respectively
Issued and outstanding - 0 shares at
December 31, 2002 and 2001 - -
Common stock - $1 par value:
Authorized - 9,000,000 shares and
4,000,000 shares at December 31, 2002 and
2001, respectively
Issued and outstanding - 2,799,535 shares
and 3,101,534 shares at December 31, 2002
and 2001, respectively 2,799,535 3,101,534
Additional paid-in capital 17,732,617 20,435,912
Retained earnings 6,920,376 4,959,488
------------ ------------
Total stockholders' equity 27,452,528 28,496,934
------------ ------------
Total liabilities and stockholders'
equity $296,684,457 $279,789,272
============ ============
See Notes to Consolidated Financial Statements.
2
STURGIS BANCORP, INC. AND SUBSIDIARIES
=====================================================================================================
CONSOLIDATED STATEMENT OF INCOME
Year Ended December 31
----------------------
2002 2001 2000
---- ---- ----
INTEREST INCOME
Loans $15,729,020 $18,276,561 $18,097,475
Mortgage-backed securities 238,145 74,935 87,076
Investments 429,210 537,388 880,876
Interest-bearing deposits 1,014,317 1,049,583 73,497
--------------- --------------- ---------------
Total interest income 17,410,692 19,938,467 19,138,924
INTEREST EXPENSE
Deposits 5,042,699 6,369,577 6,886,005
FHLB advances 3,371,401 4,031,835 3,640,197
--------------- --------------- ---------------
Total interest expense 8,414,100 10,401,412 10,526,202
--------------- --------------- ---------------
NET INTEREST INCOME 8,996,592 9,537,055 8,612,722
PROVISION FOR LOAN LOSSES (Note 3) 1,494,916 1,056,194 309,000
--------------- --------------- ---------------
NET INTEREST INCOME - After provision for loan losses 7,501,676 8,480,861 8,303,722
NONINTEREST INCOME
Service charges and other fees 1,536,181 1,634,957 1,640,704
Commission income 970,737 796,688 691,776
Mortgage banking activities 2,028,497 1,508,451 467,269
Trust fee income 478,653 492,803 465,737
Increase in value of bank owned life insurance 332,470 2,959 --
Other income 46,128 46,922 95,629
--------------- --------------- ---------------
Total noninterest income 5,392,666 4,482,780 3,361,115
NONINTEREST EXPENSES
Salaries and employee benefits (Note 9) 4,651,787 4,011,629 4,015,290
Occupancy and equipment 1,304,802 1,408,876 1,370,974
Deposit account expenses 210,206 227,384 328,544
Service bureau expense 651,991 592,805 569,490
Professional services 353,039 367,586 606,206
Amortization of goodwill -- 574,864 587,979
Other 1,814,201 1,689,659 1,604,020
--------------- --------------- ---------------
Total noninterest expenses 8,986,026 8,872,803 9,082,503
--------------- --------------- ---------------
INCOME - Before income tax expense 3,908,316 4,090,838 2,582,334
INCOME TAXES (Note 8) 1,117,929 1,302,901 765,468
--------------- --------------- ---------------
NET INCOME $ 2,790,387 $ 2,787,937 $ 1,816,866
=============== =============== ===============
BASIC EARNINGS PER SHARE $ 0.95 $ 0.90 $ 0.59
=============== =============== ===============
DILUTED EARNINGS PER SHARE $ 0.95 $ 0.90 $ 0.59
=============== =============== ===============
See Notes to Consolidated Financial Statements.
3
STURGIS BANCORP, INC. AND SUBSIDIARIES
====================================================================================================================================
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
Total
Common Additional Paid- Retained Stockholders'
Stock in Capital Earnings Equity
----- ---------- -------- ------
BALANCE - January 1, 2000 $ 3,094,886 $ 10,409,632 $ 11,843,089 $ 25,347,607
Exercise of stock options (Note 10) 6,648 26,280 -- 32,928
Net income for the year ended Decembr 31, 2000 -- -- 1,816,866 1,816,866
Cash dividends ($.22 per share) -- -- (682,005) (682,005)
------------ ------------ ------------ ------------
BALANCE - December 31, 2000 3,101,534 10,435,912 12,977,950 26,515,396
Transfer of retained earnings to additional paid-in capital -- 10,000,000 (10,000,000) --
Net income for the year ended December 31, 2001 -- -- 2,787,937 2,787,937
Cash dividends ($.26 per share) -- -- (806,399) (806,399)
------------ ------------ ------------ ------------
BALANCE - December 31, 2001 3,101,534 20,435,912 4,959,488 28,496,934
Stock Redemption (301,999) (2,703,295) -- (3,005,294)
Net income for the year ended December 31, 2002 -- -- 2,790,387 2,790,387
Cash dividends ($.28 per share) -- -- (829,499) (829,499)
------------ ------------ ------------ ------------
BALANCE - December 31, 2002 $ 2,799,535 $ 17,732,617 $ 6,920,376 $ 27,452,528
============ ============ ============ ============
See Notes to Consolidated Financial Statements.
4
STURGIS BANCORP, INC. AND SUBSIDIARIES
====================================================================================================================================
CONSOLIDATED STATEMENT OF CASH FLOWS
Year Ended December 31
----------------------
2002 2001 2000
---- ---- ----
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 2,790,387 $ 2,787,937 $ 1,816,866
Adjustments to reconcile net income to net cash from operating activities:
Depreciation 605,318 670,844 701,580
Amortization of intangibles 1,155,206 1,100,901 673,265
Provision for loan losses 1,494,916 1,056,194 309,000
Deferred income tax expense (benefit) 58,334 (1,667) --
Premiums and discounts on investment and
mortgage-backed securities 61,319 3,040 20,233
Gain on sale of loans (1,206,616) (783,640) (114,610)
Proceeds from the sale of loans held for sale 109,268,788 74,319,076 13,883,962
Loans originated for sale (111,084,772) (77,333,342) (14,356,352)
Loss on disposal of premises and equipment -- 74,110 109,764
Loss of equity in limited partnership 63,000 18,000 18,000
Increase in cash value of bank owned life insurance (332,470) (2,959) --
Changes in assets and liabilities:
(Increase) decrease in accrued interest and other assets (1,804,928) (1,510,283) 100,315
Increase (decrease) in accrued interest and other liabilities 142,755 230,202 (121,863)
-------------- -------------- --------------
Net cash provided by operating activities 1,211,237 628,413 3,040,160
CASH FLOWS FROM INVESTING ACTIVITIES
Net increase in interest-bearing deposits in banks (7,975,759) (8,162,616) (6,880,000)
Proceeds from maturities of securities held-to-maturity 1,105,000 4,630,000 7,230,000
Purchases of securities held-to-maturity (10,213,700) (1,425,000) (1,675,000)
Principal reductions of mortgage-backed securities 361,085 223,494 252,154
Purchase of Federal Home Loan Bank stock -- (617,900) (274,700)
Proceeds (purchase) of other securities 252,552 132,614 66,539
Net (increase) decrease in loans 4,668,088 3,403,939 (17,618,051)
Purchases of premises and equipment (877,138) (381,990) (720,115)
Proceeds from the sale of premises and equipment -- 355,190 25,026
Purchased goodwill from the acquisition of investment broker -- -- (475,000)
Purchase of bank owned life insurance -- (6,000,000) --
-------------- -------------- --------------
Net cash used in investing activities (12,679,872) (7,842,269) (20,069,147)
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase (decrease) in demand and savings account deposits 6,016,796 8,657,724 (58,772)
Net increase (decrease) in certificates of deposit 17,417,173 (4,861,501) 10,236,030
Repayment of FHLB advances (28,367,374) (36,433,513) (24,557,840)
Proceeds from FHLB advances 22,671,907 39,100,000 32,854,826
Dividends paid (829,499) (806,399) (682,005)
Exercise of stock options -- -- 32,928
Stock Redemption (3,005,294) -- --
-------------- -------------- --------------
Net cash provided by financing activities 13,903,709 5,656,311 17,825,167
-------------- -------------- --------------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 2,435,074 (1,557,545) 796,180
CASH AND CASH EQUIVALENTS - Beginning of year 10,629,027 12,186,572 11,390,392
-------------- -------------- --------------
CASH AND CASH EQUIVALENTS - End of year $ 13,064,101 $ 10,629,027 $ 12,186,572
============== ============== ==============
See Notes to Consolidated Financial Statements.
5
STURGIS BANCORP, INC. AND SUBSIDIARIES
================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION AND CONSOLIDATION - The consolidated financial
statements include the accounts of Sturgis Bancorp, Inc. (the
Corporation) and its wholly owned subsidiary, Sturgis Bank & Trust
Company (the Bank), which includes the Bank's wholly owned
subsidiaries, Oakleaf Financial Services, Inc., Ludington Service
Corporation, First Michiana Development Corporation of Sturgis and Oak
Mortgage, LLC. All significant intercompany transactions and balances
have been eliminated in consolidation.
The Bank formed Sturgis Bancorp, Inc., a holding company, on January
1, 2002 via an equal exchange of shares of Sturgis Bank & Trust Co.
common stock for Sturgis Bancorp, Inc. common stock. For comparative
financial statement purposes, the 2001 financial statements of Sturgis
Bank & Trust Co. and Subsidiaries is titled Sturgis Bancorp, Inc. and
Subsidiaries as the formation of the holding company had no impact on
the capital structure of the consolidated entity.
USE OF ESTIMATES - The accounting and reporting policies of the
Corporation conform to accounting principles generally accepted in the
United States of America. Management is required to make estimates and
assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from
these estimates and assumptions. Material estimates that are
particularly susceptible to significant change in the near term relate
to the determination of the allowance for loan losses, deferred tax
assets and evaluation of goodwill impairment.
NATURE OF OPERATIONS - The Corporation operates predominately in the
south-western portion of Michigan's lower peninsula. Its primary
services include accepting deposits, making commercial and mortgage
loans, engaging in mortgage banking activities, and providing
investment brokerage advisory services.
SIGNIFICANT GROUP CONCENTRATIONS OF CREDIT RISK - Most of the
Corporation's activities are with customers located within Michigan.
Note 2 discusses the types of securities the Corporation invests in.
Note 3 discusses the types of lending that the Corporation engages in.
The Corporation's loan portfolio is concentrated in residential
first-mortgage loans. The Corporation does not have any significant
concentrations to any one industry or customer.
CASH AND CASH EQUIVALENTS - For the purpose of the consolidated
statements of cash flows, cash and cash equivalents include cash and
amounts due from banks.
INTEREST-BEARING DEPOSITS IN BANKS - Interest-bearing deposits in
banks mature within two years and are carried at cost.
6
STURGIS BANCORP, INC. AND SUBSIDIARIES
================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
SECURITIES - Debt securities that management has the positive intent
and ability to hold to maturity are classified as "held to maturity"
and recorded at amortized cost.
Purchase premiums and discounts are recognized in interest income
using the interest method over the terms of the securities. Declines
in the fair value of held to maturity securities below their cost that
are deemed to be other than temporary are reflected in earnings as
realized losses.
FEDERAL HOME LOAN BANK STOCK - The Corporation's minimum investment in
the stock of the Federal Home Loan Bank of Indianapolis (FHLB) is an
amount equal to at least one percent of the unpaid principal balances
of the Corporation's residential mortgage loans or 5.0 percent of FHLB
advances, whichever is greater. Purchases and sales of stock are made
directly with the FHLB at par value and are recorded at cost.
LOANS HELD FOR SALE - Loans originated and intended for sale in the
secondary market are carried at the lower of cost or estimated fair
value in the aggregate. Net unrealized losses, if any, are recognized
in a valuation allowance by charges to income.
LOANS - The Corporation grants mortgage, commercial and consumer loans
to customers. Loans are reported at their outstanding unpaid principal
balances adjusted for charge-offs, the allowance for loan losses, and
any deferred fees or costs on originated loans. Interest income is
accrued on the unpaid principal balance. Loan origination fees, net of
certain direct origination costs, are deferred and recognized as an
adjustment of the related loan yield using the interest method.
The accrual of interest on loans is discontinued at the time the loan
is 90 days delinquent unless the credit is well-secured and in process
of collection. In all cases, loans are placed on nonaccrual or
charged-off at an earlier date if collection of principal or interest
is considered doubtful.
All interest accrued but not collected for loans that are placed on
nonaccrual or charged off is reversed against interest income. The
interest on these loans is accounted for on the cash-basis or
cost-recovery method, until qualifying for return to accrual. Loans
are returned to accrual status when all the principal and interest
amounts contractually due are brought current and future payments are
reasonably assured.
7
STURGIS BANCORP, INC. AND SUBSIDIARIES
================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
ALLOWANCE FOR LOAN LOSSES - The allowance for loan losses is
established as losses are estimated to have occurred through a
provision for loan losses charged to earnings. Loan losses are charged
against the allowance when management believes the uncollectibility of
a loan balance is confirmed. Subsequent recoveries, if any, are
credited to the allowance.
The allowance for loan losses is evaluated on a regular basis by
management and is based upon management's periodic review of the
collectibility of the loans in light of historical experience, the
nature and volume of the loan portfolio, adverse situations that may
affect the borrower's ability to repay, estimated value of any
underlying collateral and prevailing economic conditions. This
evaluation is inherently subjective as it requires estimates that are
susceptible to significant revision as more information becomes
available.
A loan is considered impaired when, based on current information and
events, it is probable that the Corporation will be unable to collect
the scheduled payments of principal or interest when due according to
the contractual terms of the loan agreement. Factors considered by
management in determining impairment include payment status,
collateral value, and the probability of collecting scheduled
principal and interest payments when due. Loans that experience
insignificant payment delays and payment shortfalls generally are not
classified as impaired. Management determines the significance of
payment delays and payment shortfalls on a case-by-case basis, taking
into consideration all of the circumstances surrounding the loan and
the borrower, including length of the delay, the reasons for the
delay, the borrower's prior payment record, and the amount of the
shortfall in relation to the principal and interest owed. Impairment
is measured on a loan by loan basis for commercial and construction
loans by either the present value of expected future cash flows
discounted at the loan's effective interest rate, the loan's
obtainable market price, or the fair value of the collateral if the
loan is collateral dependent.
Large groups of homogeneous loans are collectively evaluated for
impairment. Accordingly, the Corporation does not separately identify
individual consumer and residential loans for impairment disclosures.
CREDIT RELATED FINANCIAL INSTRUMENTS - In the ordinary course of
business, the Corporation has entered into commitments to extend
credit, including commitments under commercial letters of credit and
standby letters of credit. Such financial instruments are recorded
when they are funded.
8
STURGIS BANCORP, INC. AND SUBSIDIARIES
================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
REAL ESTATE OWNED - Assets acquired through, or in lieu of, loan
foreclosure are held for sale and are initially recorded at fair value
at the date of the foreclosure, establishing a new cost basis.
Subsequent to foreclosure, valuations are periodically performed by
management and the assets are carried at the lower of carrying amount
or fair value less cost to sell. Revenue and expenses from operations
and changes in the valuation allowance are included in net expenses
from foreclosed assets.
INVESTMENT IN LIMITED PARTNERSHIP - The Corporation has an investment
in a Michigan limited partnership that is structured to generate low
income housing tax credits and an investment in a Michigan partnership
structured to generate commissions from the sale of title insurance.
Both of these investments are accounted for using the equity method
whereby the Corporation annually records its proportionate share of
partnership profits and losses as an adjustment to the carrying value
of the investment.
PREMISES AND EQUIPMENT - Land is carried at cost. Premises and
equipment are carried at cost, less accumulated depreciation computed
on the straight-line method over the estimated useful lives of the
assets.
ADOPTION OF FAS 142 - On January 1, 2002, the Corporation adopted
Statement of Financial Accounting Standards No. 142 (FAS 142),
accounting for "Goodwill and Other Intangible Assets". Under FAS 142,
identifiable intangible assets that meet certain criteria are
amortized over their estimated useful lives. However, goodwill and
non-identifiable intangible assets are no longer amortized. Instead,
these assets are evaluated for impairment on an annual basis. If an
asset is deemed to be impaired, the asset is written down through an
adjustment to current earnings. As a result of adopting FAS 142, the
Corporation recorded no amortization expense for goodwill in 2002.
Goodwill amortization amounted to $574,864 and $587,979 in 2001 and
2000, respectively. No impairment loss was recorded upon adoption of
FAS 142. For comparison purposes, had FAS 142 been adopted in 2001 and
2000, net income would have been approximately $3,167,347 and
$2,204,932 for 2001 and 2000 respectively. Basic earnings per share
equaled diluted earnings per share in 2001 and 2000 and would have
been $1.02 and $.71, respectively.
GOODWILL - On an ongoing basis, management assesses the recoverability
of the goodwill. If an assessment of the goodwill indicates that its
recoverability is impaired, a charge to expense is recorded for the
amount of the impairment. No impairment loss has been recorded.
9
STURGIS BANCORP, INC. AND SUBSIDIARIES
================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
SERVICING - Servicing assets are recognized as separate assets when
rights are acquired through purchase or through sale of financial
assets. Capitalized servicing rights are reported on the balance sheet
and are amortized into noninterest income in proportion to, and over
the period of, the estimated future net servicing income of the
underlying financial assets. Servicing assets are evaluated for
impairment based upon the fair value of the rights as compared to
amortized cost. Impairment is determined by stratifying rights by
predominant characteristics, such as interest rates and terms. Fair
value is determined using prices for similar assets with similar
characteristics, when available, or based upon discounted cash flows
using market-based assumptions. Impairment is recognized through a
valuation allowance for an individual stratum, to the extent that fair
value is less than the capitalized amount for the stratum. (See Note
4.)
INCOME TAXES - Deferred income tax assets and liabilities are
determined using the liability (or balance sheet) method. Under this
method, the net deferred tax asset or liability is determined based on
the tax effects of the various temporary differences between the book
and the tax bases of the various balance sheet assets and liabilities
and gives current recognition to changes in tax rates and laws.
Valuation allowances are established, when necessary, to reduce
deferred tax assets to the amount expected to be realized.
The Corporation has qualified under provisions of the Internal Revenue
Code which permit it to deduct from taxable income a provision for bad
debts in excess of such provision charged to income in the
consolidated financial statements. Accordingly, retained earnings at
December 31, 2002 and 2001 includes approximately $918,000 for which
no provision for federal income taxes has been made. Unrecognized
deferred taxes on this amount are approximately $312,000. If, in the
10
STURGIS BANCORP, INC. AND SUBSIDIARIES
================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
future, this portion of retained earnings is used for any purpose
other than to absorb bad debt losses, federal income taxes would be
imposed at the then applicable rates.
STOCK COMPENSATION PLANS - The Corporation has chosen to measure
compensation cost for employee stock compensation plans using the
intrinsic value based method of accounting, whereby compensation cost
is the excess, if any, of the quoted market price of the stock at the
grant date (or other measurement date) over the amount an employee
must pay to acquire the stock. Stock options issued under the
Corporation's stock option plan have no intrinsic value at the grant
date, and no compensation cost is recognized for them. The fair value
based method of accounting for employee stock compensation plans,
measures compensation cost at the grant date based on the value of the
award and is recognized over the service period, which is usually the
vesting period. The Corporation has provided pro forma disclosures of
net income and earnings per share and other disclosures, as if the
fair value based method of accounting has been applied. The pro forma
disclosures include the effects of all awards granted on or after
January 1, 1995. (See Note 10.)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
EARNINGS PER SHARE - Basic earnings per share represents income
available to common stockholders divided by the weighted-average
number of common shares outstanding during the period. Diluted
earnings per share reflects additional common shares that would have
been outstanding if dilutive potential common shares had been issued,
as well as any adjustment to income that would result from the assumed
issuance. Potential common shares that may be issued by the
Corporation relate solely to outstanding stock options, and are
determined using the treasury stock method.
11
STURGIS BANCORP, INC. AND SUBSIDIARIES
==========================================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
Earnings per share have been computed based on the following:
2002 2001 2000
---- ---- ----
Net Income $ 2,790,387 $ 2,787,937 $ 1,816,866
=============== =============== ==============
Weighted average number of common
shares outstanding 2,949,874 3,101,534 3,099,630
Effect of dilutive options 2,365 - -
--------------- --------------- --------------
Weighted average number of common
shares outstanding used to calculate
diluted earnings per share 2,952,239 3,101,534 3,099,630
=============== =============== ==============
SUPPLEMENTAL CASH FLOW INFORMATION
2002 2001 2000
---- ---- ----
Cash paid for:
Interest $ 8,471,931 $ 10,436,770 $ 10,449,594
Income taxes 1,374,118 1,730,136 386,000
Noncash investing and financing activities:
Loans transferred to real estate owned 1,552,740 847,550 352,274
Tax benefit of stock options exercised - - 4,010
RECLASSIFICATION - Certain amounts in the 2001 and 2000 financial
statements have been reclassified to conform to the 2002 presentation.
12
STURGIS BANCORP, INC. AND SUBSIDIARIES
=====================================================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 2 - SECURITIES
The amortized cost and estimated fair value of held-to-maturity securities are as follows at
December 31, 2002 and 2001:
2002
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED ESTIMATED FAIR
COST GAINS LOSSES VALUE
Obligations of states and
political subdivisions $ 3,177,986 $ 71,118 $ - $ 3,249,104
Mortgage-backed securities 8,912,723 136,491 (5,618) 9,043,596
Other Securities 500,000 - - 500,000
------------------ --------------- --------------- -----------------
Total investment securities $ 12,590,709 $ 207,609 $ (5,618) $ 12,792,700
================== =============== =============== =================
2001
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED ESTIMATED FAIR
COST GAINS LOSSES VALUE
U.S. Treasury and agency
securities $ 549,996 $ 5,707 $ - $ 555,703
Obligations of states and
political subdivisions 2,320,298 39,876 (680) 2,359,494
Mortgage-backed securities 1,034,119 9,748 (4,922) 1,038,945
------------------ --------------- --------------- -----------------
Total investment securities $ 3,904,413 $ 55,331 $ (5,602) $ 3,954,142
================== =============== =============== =================
The amortized cost and fair value of securities, by contractual maturity (except for mortgage-backed
securities), at December 31, 2002, are shown below. Expected maturities will differ from contractual
maturities because borrowers may have the right to call or prepay obligations with or without call or
prepayment penalties.
13
STURGIS BANCORP, INC. AND SUBSIDIARIES
=====================================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 2 - SECURITIES (CONTINUED)
AMORTIZED FAIR
COST VALUE
Held to maturity securities:
Due in one year or less $ 360,129 $ 363,182
Due in one through five years 755,169 776,547
Due after five years through ten years 648,674 688,515
Due after ten years 1,914,014 1,920,860
------------------ -----------------
Total 3,677,986 3,749,104
Mortgage-backed securities 8,912,723 9,043,596
------------------ -----------------
Total $ 12,590,709 $ 12,792,700
================== =================
Securities with a carrying value of $1,414,014 (market value of $1,420,860) were pledged at
December 31, 2002 to secure uninvested trust funds.
NOTE 3 - LOANS
A summary of the balances of loans follows:
2002 2001
---- ----
Mortgage loans on real estate:
Residential 1-4 family $ 127,770,040 $ 151,766,803
Commercial 50,440,340 34,872,863
Construction 11,844,367 8,371,916
------------------ -----------------
190,054,747 195,011,582
Commercial loans 15,072,501 12,906,602
Consumer installment loans:
Consumer and installment 11,354,651 15,299,376
Other 569,566 571,739
------------------ -----------------
11,924,217 15,871,115
------------------ -----------------
Subtotal 217,051,465 223,789,299
Less:
Allowance for loan losses 1,920,037 1,300,000
Unearned interest 16,925 26,013
Undisbursed portion of loans in process 3,167,369 3,257,555
Deferred loan origination and other fees (96,216) 91,791
------------------ -----------------
Loans, net $ 212,043,350 $ 219,113,940
================== =================
14
STURGIS BANCORP, INC. AND SUBSIDIARIES
==========================================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 3 - LOANS (CONTINUED)
An analysis of the allowance for loan losses follows:
2002 2001 2000
---- ---- ----
BALANCE - Beginning of year $ 1,300,000 $ 803,744 $ 730,000
Provision for loan losses 1,494,916 1,056,194 309,000
Loans charged off (950,106) (607,217) (330,683)
Recoveries of loans previously
charged off 75,227 47,279 95,427
--------------- --------------- --------------
BALANCE - End of year $ 1,920,037 $ 1,300,000 $ 803,744
=============== =============== ==============
The following is a summary of information pertaining to impaired loans:
2002 2001
---- ----
Impaired loans with a valuation
allowance $ 971,607 $ 1,071,876
Impaired loans without a valuation allowance - -
----------------- ----------------
Total impaired loans $ 971,607 $ 1,071,876
================= ================
Valuation allowance related to
impaired loans $ 265,663 $ 91,881
================= =================
2002 2001 2000
---- ---- ----
Average investment in
impaired loans $ 1,257,324 $ 965,274 $ 607,345
=============== =============== ==============
Interest income recognized
on impaired loans $ 49,937 $ 24,115 $ 45,228
=============== =============== ==============
Interest income recognized on a
cash basis on impaired loans $ 47,394 $ 24,115 $ 30,977
=============== =============== ==============
No additional funds are committed to be advanced in connection with impaired loans.
15
STURGIS BANCORP, INC. AND SUBSIDIARIES
================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 4 - SERVICING
Loans serviced for others are not included in the accompanying
consolidated balance sheet. The unpaid principal balance of mortgages
and other loans serviced for others approximated $178,500,000 and
$134,800,000 at December 31, 2002 and 2001, respectively.
The fair values of these rights were $1,501,922 and $1,281,208 at
December 31, 2002 and 2001, respectively. The fair value of servicing
rights was determined using the discount rate of 8.0 percent and
prepayment speed ranging from 6.0 percent to 9.0 percent, depending
upon the stratification of the specific right.
The following summarizes mortgage servicing rights capitalized and
amortized, along with the aggregate activity in related valuation
allowances:
2002 2001 2000
---- ---- ----
Mortgage servicing rights capitalized $ 1,375,920 $ 966,128 $ 180,492
=============== =============== ==============
Mortgage servicing rights amortized $ (881,354) $ (526,036) $ (85,286)
=============== =============== ==============
Valuation allowances:
Balance at beginning of year $ - $ - $ -
Additions (273,852) - -
Reductions - - -
Write-downs - - -
--------------- --------------- --------------
Balance at end of year $ (273,852) $ - $ -
=============== =============== ==============
16
STURGIS BANCORP, INC. AND SUBSIDIARIES
===============================================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 5 - PREMISES AND EQUIPMENT
A summary of the cost and accumulated depreciation of premises and
equipment follows:
2002 2001
---- ----
Land $ 666,993 $ 666,993
Land improvements 40,489 40,489
Office buildings 5,652,030 5,633,932
Furniture, fixtures and equipment 4,607,664 4,185,924
Construction in progress 485,569 48,269
---------------- ---------------
Total bank premises and equipment 11,452,745 10,575,607
Less accumulated depreciation (4,810,765) (4,205,447)
---------------- ----------------
Net carrying amount $ 6,641,980 $ 6,370,160
================ ================
NOTE 6 - DEPOSITS
Interest bearing deposit balances at December 31 are summarized as
follows:
2002 2001
---- ----
Passbook and savings deposits $ 40,890,720 $ 38,075,301
NOW accounts 50,724,071 49,406,921
Time:
$100,000 and over 34,452,825 15,096,975
Under $100,000 63,749,059 65,687,736
---------------- ----------------
Total interest-bearing $ 189,816,675 $ 168,266,933
================ ================
17
STURGIS BANCORP, INC. AND SUBSIDIARIES
================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 6 - DEPOSITS (CONTINUED)
At December 31, 2002, scheduled annual maturities of certificates of
deposit were as follows:
UNDER $100,000 AND
$100,000 OVER
2003 $ 34,641,247 $ 15,835,613
2004 7,619,710 1,554,733
2005 10,948,670 2,303,659
2006 2,608,818 207,498
2007 6,229,850 7,370,782
2008 and thereafter 1,700,764 7,180,540
----------------- ----------------
Total $ 63,749,059 $ 34,452,825
================= ================
NOTE 7 - FEDERAL HOME LOAN BANK ADVANCES
Advances from the Federal Home Loan Bank of Indianapolis ("FHLB") are
collateralized by FHLB stock and all non-employee residential mortgage
loans. Total short-term advances, including advances under a separate
line of credit with the FHLB, consisted of $6,671,907 at December 31,
2002 at an interest rate of 1.33% with an average balance for the year
of approximately $3,400,000 and an average interest rate of 1.85%.
Total short-term advances, including advances under a separate line of
credit with the FHLB, consisted of $6,000,000 at December 31, 2001 at
an interest rate of 5.12% with an average balance for the year of
approximately $9,500,000 and an average interest rate of 5%. Maximum
amounts outstanding on the short-term advances for the years 2002 and
2001 were approximately $13,700,000 and $10,300,000, respectively.
In addition to advances received under a master "Advances, Pledge and
Security Agreement" with the FHLB, the Bank also has an available line
of credit with the FHLB which provides for additional funds of up to
$10,000,000 at December 31, 2002 and expires in March, 2003. Advances
outstanding under the line of credit bear interest at a rate of
approximately 42 basis points over the rate paid by the FHLB on their
time deposits (an effective rate of 1.33 % and 1.82% at December 31,
2002 and 2001, respectively). Included in the above total short-term
advances is an outstanding balance on the line of credit of $1,671,907
at December 31, 2002. No amounts were outstanding on the line of
credit at December 31, 2001.
18
STURGIS BANCORP, INC. AND SUBSIDIARIES
================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 7 - FEDERAL HOME LOAN BANK ADVANCES (CONTINUED)
The Bank had approximately $57,709,489 and $64,076,863 in long-term
advances from FHLB at December 31, 2002 and 2001, respectively.
Interest rates range from 1.33% to 7.34% with maturities ranging from
January 2003 to February 2012.
Annual payments of FHLB long-term advances are as follows:
2003 $ 7,377,466
2004 3,428,740
2005 2,557,211
2006 3,346,072
2007 -
2008 and thereafter 41,000,000
----------------
Total $ 57,709,489
================
The advances are subject to prepayment penalties subject to the
provisions and conditions of the credit policy of the Federal Home
Loan Bank.
NOTE 8 - FEDERAL INCOME TAXES
Sturgis Bancorp, Inc. and Subsidiaries file a consolidated federal
income tax return. The following is a summary of the provision for
income taxes for the three years ended December 31:
2002 2001 2000
---- ---- ----
Current expense $ 1,059,595 $ 1,304,568 $ 765,468
Deferred (benefit) expense 58,334 (1,667) -
--------------- --------------- --------------
Total income tax expense $ 1,117,929 $ 1,302,901 $ 765,468
=============== =============== ==============
19
STURGIS BANCORP, INC. AND SUBSIDIARIES
===============================================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 8 - FEDERAL INCOME TAXES (CONTINUED)
A reconciliation of the difference between total federal income tax
expense and the amount computed by applying the statutory tax rates to
income before income taxes is as follows:
2002 2001 2000
---- ---- ----
Amount computed at statutory rates $ 1,328,827 $ 1,390,885 $ 877,994
Dividends received deduction (4,256) (9,351) (14,944)
Tax-exempt interest income (171,906) (37,903) (28,054)
Low income housing tax credits (75,000) (75,000) (75,000)
Other, net 40,264 34,270 5,472
--------------- --------------- --------------
Total $ 1,117,929 $ 1,302,901 $ 765,468
=============== =============== ==============
The details of the net deferred tax asset (liability) are as follows:
2002 2001
---- ----
Deferred tax assets:
Investments $ - $ 33,333
Allowance for loan losses 504,928 364,089
Amortization - 124,008
Other 4,009 39,467
--------------- --------------
Total deferred tax assets 508,937 560,897
Deferred tax liabilities:
Deferred loan fees (26,830) (248,490)
Mortgage servicing rights (473,885) (435,610)
Amortization (33,466) -
Depreciation (111,871) (94,368)
Other (169,552) (30,762)
--------------- --------------
Total deferred tax liabilities (815,604) (809,230)
Valuation allowance - -
Net deferred tax liability $ (306,667) $ (248,333)
=============== ==============
20
STURGIS BANCORP, INC. AND SUBSIDIARIES
================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 9 - RETIREMENT BENEFITS
The Corporation is a participant in the multi-employer Financial
Institutions Retirement Fund (FIRF or the Plan), which covers
substantially all of its officers and employees. The defined benefit
Plan, for all full-time employees with one year of service, provides
benefits based on basic compensation and years of service. The
Corporation's contributions are determined by FIRF and generally
represent the normal cost of the Plan. Specific Plan assets and
accumulated benefit information for the Bank's portion of the Fund are
not available. Under the Employee Retirement Income Security Act
(ERISA), a contributor to a multi-employer pension plan may be liable
in the event of complete or partial withdrawal for the benefit
payments guaranteed under ERISA. The Bank has no present intention to
withdraw from the Fund. The expense of the Plan allocated to the Bank
for the years ended December 31, 2002, 2001 and 2000 amounted to $
194,273, $177,753 and $185,326, respectively.
Effective January 1, 2002, the Corporation began sponsoring a
non-qualified defined benefit plan to provide supplemental retirement
benefits for certain executives. The following table sets forth the
plan activity and other information as of and for the year ended
December 31, 2002.
2002
----
Plan assets at fair value $ -
Benefit obligation 126,620
-------------
Overfunded (underfunded) status $ (126,620)
=============
Pension liability $ 126,620
=============
Intangible assets $ 105,601
=============
Net periodic pension cost $ 21,020
=============
Change in minimum liability $ 105,601
=============
Actuarial assumptions:
Weighted average discount rate 7.25%
Increase in future compensation levels 4.00%
To fund the supplemental retirement benefit obligation, the
Corporation has purchased insurance policies on the lives of the
participants with the Corporation as the owner and beneficiary of the
policies. At December 31, 2002, the cash value of all corporate owned
life insurance policies on the participants and other officers
available to fund future benefit obligations, amounted to $6,335,429.
There were no supplemental retirement benefits paid by the plan during
2002.
21
STURGIS BANCORP, INC. AND SUBSIDIARIES
================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 10 - COMMON STOCK AND OPTIONS
Effective May 1998, two of the Bank's three stock options plans,
formerly referred to as the "Director Plan" and the "Employee Plan",
expired. The remaining stock option plan, referred to as the "New
Director Plan", which expired on December 31, 1999, provided for the
granting of options to the Bank's directors. Options granted expire
ten years and one day following the date of grant unless an individual
ceases to be a director prior to that time for reasons other than
death or disability, in which case the options expire thirty days
after cessation of director status. If cessation of director status
results from death or disability, the options expire ninety days after
cessation of director status.
Options granted under the former Director Plan expire under the same
terms as the New Director Plan. Options granted under the former
Employee Plan expire five years after the date of grant, unless
employment is terminated prior to that time for reasons other than
death or disability, in which case the options expire 30 days after
termination or employment. If employment with the Bank is terminated
by reason of death or disability, the options expire ninety days after
termination of employment. One-third of the granted shares are
exercisable after one year, two-thirds after two years and one hundred
percent after three years.
22
STURGIS BANCORP, INC. AND SUBSIDIARIES
================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 10 - COMMON STOCK AND OPTIONS (CONTINUED)
The following is a summary of the activity with respect to the
Corporation's stock option plans for the years ended December 31,
2002, 2001, and 2000:
WEIGHTED-
AVERAGE
NUMBER OF EXERCISE PRICE
SHARES PER SHARE
Outstanding - January 1, 2000 137,450 $ 12.81
Granted - -
Cancelled (4,400) 11.69
Exercised (6,648) 4.35
-------------- --------------
Outstanding - December 31, 2000 126,402 13.28
Granted - -
Cancelled (2,551) 13.56
Exercised - -
-------------- --------------
Outstanding - December 31, 2001 123,851 13.28
Granted - -
Cancelled - -
Exercised - -
-------------- --------------
Outstanding - December 31, 2002 123,851 $ 13.28
============== ==============
At December 31, 2002, 2001, and 2000, options exercisable under the
Corporation's stock option plans totaled 123,851, 123,851, and 94,272
shares, respectively, and had weighted-average exercise prices per
share of $13.28, $13.28, and $12.93, respectively. For options
outstanding at December 31, 2002, the exercise price per share ranged
from $9.00 to $15.88 and the weighted-average remaining contractual
life of the options was approximately 63 months.
23
STURGIS BANCORP, INC. AND SUBSIDIARIES
================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 10 - COMMON STOCK AND OPTIONS (CONTINUED)
The Corporation applies APB Opinion 25 and related Interpretations in
accounting for the stock option plan. Accordingly, no compensation
cost has been recognized. Had compensation cost for the Corporation's
stock option plan been determined based on the fair value at the grant
dates for awards under the plan consistent with the method prescribed
by FASB Statement No. 123, the Corporation's net income and earnings
per share would have been adjusted to the pro forma amounts indicated
below:
Year ended December 31
----------------------
2002 2001 2000
---- ---- ----
Net Income As reported $ 2,790,387 $ 2,787,937 $ 1,816,866
Pro forma $ 2,696,500 $ 2,570,856 $ 1,577,212
Earnings Per Share As reported $ 0.95 $ 0.90 $ 0.59
Pro forma $ 0.92 $ 0.83 $ 0.51
Earnings Per Share As reported $ 0.95 $ 0.90 $ 0.59
Assuming Dilution Pro forma $ 0.92 $ 0.83 $ 0.51
NOTE 11 - MINIMUM REGULATORY CAPITAL REQUIREMENTS
The Corporation is subject to regulatory capital requirements
administered by federal banking agencies. Failure to meet minimum
capital requirements can initiate certain mandatory and possibly
additional discretionary actions by regulators that, if undertaken,
could have a direct material effect on the Corporation's financial
statements. Under capital adequacy guidelines and the regulatory
framework for prompt corrective action, the Corporation must meet
specific capital guidelines that involve quantitative measures of
their assets, liabilities, and certain off-balance sheet items as
calculated under regulatory accounting practices. The capital amounts
and classification are also subject to qualitative judgments by the
regulators about components, risk weightings, and other factors.
Prompt corrective action provisions are not applicable to bank holding
companies.
Quantitative measures established by regulation to ensure capital
adequacy require the Corporation to maintain minimum amounts and
ratios, which are shown in the table below. Management believes, as of
December 31, 2002 and 2001, that the Corporation met all capital
adequacy requirements to which it is subject.
24
STURGIS BANCORP, INC. AND SUBSIDIARIES
==========================================================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 11 - MINIMUM REGULATORY CAPITAL REQUIREMENTS (CONTINUED)
As of December 31, 2002, the most recent notification from the Federal
Deposit Insurance Corporation categorized the Corporation as
well-capitalized under the regulatory framework for prompt corrective
action. To be categorized as well-capitalized, minimum capital amounts
and ratios must be maintained as shown in the following table (000s
omitted). Management believes that no conditions or events since that
notification have changed the Corporation's capital category.
TO BE WELL-
CAPITALIZED UNDER
FOR CAPITAL PROMPT CORRECTIVE
ACTUAL ADEQUACY PURPOSES ACTION PROVISIONS
------ ----------------- -----------------
AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
------ ----- ------ ----- ------ -----
AS OF DECEMBER 31, 2002:
Total capital (to risk-
weighted assets)
Consolidated $ 24,007 12.0% $ 15,952 >= 8.0% N/A N/A
Bank $ 24,985 12.5% $ 16,006 >= 8.0% $ 20,007 >= 10.0%
Tier 1 capital (to risk-
weighted assets)
Consolidated $ 22,087 11.1% $ 7,976 >= 4.0% N/A N/A
Bank $ 23,065 11.5% $ 8,003 >= 4.0% $ 12,004 >= 6.0%
Tier 1 capital (to adjusted
assets)
Consolidated $ 22,087 7.5% $ 11,848 >= 4.0% N/A N/A
Bank $ 23,065 7.8% $ 11,848 >= 4.0% $ 14,810 >= 5.0%
Tangible capital (to tangible
assets)
Consolidated $ 22,087 7.6% $ 8,740 >= 3.0% N/A N/A
Bank $ 23,065 7.9% $ 8,760 >= 3.0% N/A N/A
AS OF DECEMBER 31, 2001 (BANK ONLY):
Total capital (to risk-
weighted assets) $ 24,559 13.3% $ 14,739 >= 8.0% $ 18,424 >= 10.0%
Tier I capital (to risk-
weighted assets) $ 23,259 12.6% $ 7,370 >= 4.0% $ 11,054 >= 6.0%
Tier 1 capital (to adjusted
assets) $ 23,259 8.6% $ 10,859 >= 4.0% $ 13,574 >= 5.0%
Tangible capital (to tangible
assets) $ 23,259 8.5% $ 8,237 >= 3.0% N/A N/A
25
STURGIS BANCORP, INC. AND SUBSIDIARIES
================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 12 - OFF-BALANCE SHEET ACTIVITIES
CREDIT RELATED FINANCIAL INSTRUMENTS - The Corporation is a party to
credit related financial instruments with off-balance sheet risk in
the normal course of business to meet the financing need of its
customer. These financial instruments include commitments to extend
credit, standby letters of credit and commercial letters of credit.
Such commitments involve, to varying degrees, elements of credit and
interest rate risk in excess of the amount recognized in the
consolidated balance sheets.
The Corporation's exposure to credit loss is represented by the
contractual amount of these commitments. The Corporation follows the
same credit policies in making commitments as it does for on-balance
sheet instruments.
At December 31, 2002 and 2001, the following financial instruments
were outstanding whose contract amounts represent credit risk:
CONTRACT AMOUNT
2002 2001
---- ----
Commitments to grant loans $ 4,700,000 $ 5,575,000
Unfunded commitments under lines of credit 23,000,000 20,000,000
Commercial and standby letters of credit 300,000 135,000
Commitments to extend credit are agreements to lend to a customer as
long as there are no violations of any condition established in the
contract. Commitments generally have fixed expiration dates or other
termination clauses and may require payment of a fee. The commitments
for equity lines of credit may expire without being drawn upon.
Therefore, the total commitment amounts do not necessarily represent
future cash requirements. The amount of collateral obtained, if it is
deemed necessary by the Corporation, is based on management's credit
evaluation of the customer.
Unfunded commitments under commercial lines of credit, revolving
credit lines and overdraft protection agreements are commitments for
possible future extensions of credit to existing customers. These
lines of credit are collateralized and usually do not contain a
specified maturity date and may be drawn upon to the total extent to
which the Corporation is committed.
Commercial and standby letters of credit are conditional commitments
issued by the Corporation to guarantee the performance of a customer
to a third party. Those letters of credit are primarily used to
support public and private borrowing arrangements. Essentially all
letters of credit issued have expiration dates within one year.
26
STURGIS BANCORP, INC. AND SUBSIDIARIES
================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 12 - OFF-BALANCE SHEET ACTIVITIES (CONTINUED)
Collateral Requirements - To reduce credit risk related to the use of
credit-related financial instruments, the Corporation might deem it
necessary to obtain collateral. The amount and nature of the
collateral obtained are based on the Corporation's credit evaluation
of the customer. Collateral held varies but may include cash,
securities, accounts receivable, inventory, property, plant and
equipment and real estate.
If the counterparty does not have the right and ability to redeem the
collateral or the Corporation is permitted to sell or repledge the
collateral on short notice, the Corporation records the collateral in
its balance sheet at fair value with a corresponding obligation to
return it.
NOTE 13 - RELATED PARTY TRANSACTIONS
In the ordinary course of business, the Corporation has granted loans
to principal officers, directors and affiliates. A summary of the
related party loan transactions for the years ended December 31, 2002
and 2001 is as follows:
2002 2001
---- ----
Related party loans outstanding at the
beginning of the year $ 1,170,943 $ 878,827
Advances 834,538 1,344,656
Principal repayments (626,329) (1,052,540)
------------ ------------
Related party loans outstanding at the
end of the year $ 1,379,152 $ 1,170,943
============ ============
Deposits from related parties held by the Bank at December 31, 2002
and 2001 approximated $7,000,000 and $14,000,000, respectively.
27
STURGIS BANCORP, INC. AND SUBSIDIARIES
================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 14 - FAIR VALUE OF FINANCIAL INSTRUMENTS
The fair value of a financial instrument is the current amount that
would be exchanged between willing parties, other than in a forced
liquidation. Fair value is best determined based upon quoted market
prices. However, in many instances, there are no quoted market prices
for the Corporation's various financial instruments. In cases where
quoted market prices are not available, fair values are based on
estimates using present value or other valuation techniques. Those
techniques are significantly affected by the assumptions used,
including the discount rate and estimates of future cash flows.
Accordingly, the fair value estimates may not be realized in an
immediate settlement of the instrument. SFAS 107 excludes certain
financial instruments and all nonfinancial instruments from its
disclosure requirements. Accordingly, the aggregate fair value amounts
presented may not necessarily represent the underlying fair value of
the Corporation.
The following methods and assumptions were used by the Corporation in
estimating fair value disclosures for financial instruments:
CASH AND CASH EQUIVALENTS - The carrying amounts of cash and
short-term instruments approximate fair values.
INTEREST-BEARING DEPOSITS IN BANKS - The carrying amounts of
interest-bearing deposits maturing within ninety days approximate
their fair values. Fair values of other interest-bearing deposits are
estimated using discounted cash flow analyses based on current rates
for similar types of deposits.
SECURITIES - Fair values for securities, excluding Federal Home Loan
Bank stock, are based on quoted market prices. The carrying value of
Federal Home Loan Bank stock approximates fair value based on the
redemption provisions of the Federal Home Loan Bank. If quoted market
prices are not available, fair values are based on quoted market
prices of comparable investment.
MORTGAGE LOANS HELD FOR SALE - Fair values of mortgage loans held for
sale are based on quoted market prices.
LOANS RECEIVABLE - For variable-rate loans that reprice frequently and
with no significant change in credit risk, fair values are based on
carrying values, as adjusted for estimated credit losses. Fair values
for other loans (e.g., commercial real estate and investment property
mortgage loans, commercial and industrial loans) are estimated using
discounted cash flow analyses, using interest rates currently being
offered for loans with similar terms to borrowers of similar credit
quality. Fair values for non-performing loans are estimated using
discounted cash flow analyses or underlying collateral values, where
applicable.
28
STURGIS BANCORP, INC. AND SUBSIDIARIES
================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 14 - FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)
DEPOSIT LIABILITIES - The fair values disclosed for demand deposits
(e.g., interest and non-interest checking, passbook savings, and
certain types of money market accounts) are, by definition, equal to
the amount payable on demand at the reporting date (i.e., their
carrying amounts). The carrying amounts of variable-rate, fixed term
money market accounts and certificates of deposit approximate their
fair values at the reporting date. Fair values for fixed-rate
certificates of deposit are estimated using a discounted cash flow
calculation that applies interest rates currently being offered on
certificates to a schedule of aggregated expected monthly maturities
on time deposits.
FEDERAL HOME LOAN BANK ADVANCES - The carrying amount of short-term
FHLB advances is a reasonable estimate of their fair value due to
their variable interest rates and short-term maturities. The estimated
fair value of long-term FHLB is determined by discounting the future
cash flows of outstanding advances using rates currently available on
advances from the FHLB with similar characteristics.
ACCRUED INTEREST - The carrying amounts of accrued interest
approximate fair value.
OFF-BALANCE SHEET INSTRUMENTS - The fair value of loan commitments and
standby letters of credit, valued on the basis of fees currently
charged for commitments for similar loan terms to new borrowers with
similar credit profiles, is not considered material.
29
STURGIS BANCORP, INC. AND SUBSIDIARIES
==================================================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 14 - FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)
The estimated fair values, and related carrying or notional amounts,
of the Corporation's financial instruments are as follows (000s
omitted):
2002 2001
---- ----
Carrying Estimated Carrying Estimated
Amount Fair Value Amount Fair Value
------ ---------- ------ ----------
Financial assets:
Cash and cash equivalents $ 13,064 $ 13,064 $ 12,961 $ 12,961
Interest-bearing deposits in banks 23,018 23,342 12,710 13,063
Other short-term investments 7 7 260 260
Held-to-maturity investment securities 12,591 12,792 3,904 3,912
FHLB stock 4,115 4,115 4,115 4,115
Loans held for sale 7,437 7,522 4,415 4,453
Loans in portfolio 212,043 221,003 219,214 226,385
Accrued interest receivable 1,732 1,732 1,725 1,725
Financial liabilities:
Deposits 202,564 198,121 179,130 179,871
Accrued interest payable 936 936 994 994
FHLB advances 64,381 63,254 70,077 69,721
30
STURGIS BANCORP, INC. AND SUBSIDIARIES
================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 15 - CONDENSED FINANCIAL STATEMENTS OF PARENT COMPANY
Sturgis Bancorp, Inc., the parent company, was formed January 1, 2002
(Note 1). The financial statements of the parent company as of
December 31, 2002 and for the year then ended are presented below:
BALANCE SHEET
Assets:
Cash and due from banks $ -
Other assets 270,474
Investment in Sturgis Bank & Trust Company 28,430,605
----------------
Total assets $ 28,701,079
================
Liabilities and stockholder's equity:
Deferred federal income taxes $ 306,667
Advances from Sturgis Bank & Trust Company 941,884
----------------
Total liabilities 1,248,551
Stockholder's equity 27,452,528
----------------
Total liabilities and stockholders' equity $ 28,701,079
================
31
STURGIS BANCORP, INC. AND SUBSIDIARIES
==========================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 15 - CONDENSED FINANCIAL STATEMENTS OF PARENT COMPANY (CONTINUED)
STATEMENT OF INCOME
Revenue
Dividend from Sturgis Bank & Trust Company $ 3,000,000
Operating expenses 217,097
----------------
Income before income taxes and equity in undistributed net
income of Sturgis Bank & Trust Company 2,782,903
Applicable income tax provision (benefit) (73,813)
----------------
2,856,716
Reduction in undistributed net income of Sturgis
Bank & Trust Company (66,329)
----------------
Net income $ 2,790,387
================
32
STURGIS BANCORP, INC. AND SUBSIDIARIES
=========================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 15 - CONDENSED FINANCIAL STATEMENTS OF PARENT COMPANY (CONTINUED)
STATEMENT OF CASH FLOWS
Cash flows from operating activities:
Net income $ 2,790,387
Adjustments to reconcile net income to net cash
from operating activities:
Equity in undistributed net income of
Sturgis Bank & Trust Company 66,329
Increase in other assets (270,474)
Increase in deferred federal income taxes 306,667
---------------
Net cash provided by operating activities 2,892,909
Cash flows from financing activities:
Stock redeemed (3,005,294)
Proceeds from advance from Sturgis Bank & Trust Company 941,884
Cash dividends paid on common stock (829,499)
---------------
Net cash used in financing activities (2,892,909)
---------------
Net increase (decrease) in cash and cash
equivalents -
Cash and cash equivalents at beginning of year -
---------------
Cash and cash equivalents at end of year $ -
===============
33
STURGIS BANCORP, INC. AND SUBSIDIARIES
================================================================================
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002 AND 2001
NOTE 16 - RESTRICTION ON DIVIDENDS
Banking regulations place certain restrictions on dividends paid and
loans or advances make by the Bank to the Corporation. The total
amount of dividends that may be paid at any date is generally limited
to the retained earnings of the Bank. However, dividends paid by the
Bank would be prohibited if the effect thereof would cause the Bank's
capital to be reduced below applicable minimum standards. At December
31, 2002, the Bank's retained earnings available for the payment of
dividends totaled $4,893,159. Accordingly, approximately $23,500,000
of the Corporation's investment in the Bank was restricted at December
31, 2002.
Loans or advances made by the Bank to the Corporation are generally
limited to 10 percent of the Bank's capital stock and surplus.
Accordingly, at December 31, 2002, Bank funds available for loans or
advances, net of current loans and advances to the Corporation,
amounted to approximately $1,400,000.
34