UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarter Ended June 30, 2004
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
Commission File Number: 0-12507
ARROW FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
New York
22-2448962
(State or other jurisdiction of
(IRS Employer Identification
incorporation or organization)
Number)
250 GLEN STREET, GLENS FALLS, NEW YORK 12801
(Address of principal executive offices) (Zip Code)
Registrant’s telephone number, including area code: (518) 745-1000
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes X No
Indicate by checkmark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Class
Outstanding as of July 30, 2004
Common Stock, par value $1.00 per share
9,806,947
#
June 30, 2004
INDEX
PART I
FINANCIAL INFORMATION
Page
Item 1.
Financial Statements:
Consolidated Balance Sheets
as of June 30, 2004 and December 31, 2003
3
Consolidated Statements of Income
for the Three Month and Six Month Periods Ended June 30, 2004 and 2003
4
Consolidated Statements of Changes in Shareholders’ Equity
for the Six Month Periods Ended June 30, 2004 and 2003
5
Consolidated Statements of Cash Flows
7
Notes to Unaudited Consolidated Interim Financial Statements
8
Independent Auditors’ Review Report
11
Item 2.
Management's Discussion and Analysis of
Financial Condition and Results of Operations
12
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
37
Item 4.
Controls and Procedures
38
PART II
OTHER INFORMATION
Item 1
Legal Proceedings
Item 2
Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
Item 3
Defaults Upon Senior Securities
Item 4
Submission of Matters to a Vote of Security Holders
39
Item 5
Other Information
Item 6
Exhibits and Reports on Form 8-K
SIGNATURES
ARROW FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in Thousands) (Unaudited)
June 30,
2004
December 31,
2003
ASSETS
Cash and Due from Banks
$ 28,641
$ 27,526
Federal Funds Sold
---
5,800
Cash and Cash Equivalents
28,641
33,326
Securities Available-for-Sale
343,374
349,831
Securities Held-to-Maturity (Approximate Fair
Value of $109,888 at June 30, 2004 and $110,341 at December 31, 2003)
108,047
105,776
Loans
866,127
855,178
Allowance for Loan Losses
(11,984)
(11,842)
Net Loans
854,143
843,336
Premises and Equipment, Net
14,561
14,174
Other Real Estate and Repossessed Assets, Net
207
180
Goodwill
9,297
Other Intangible Assets, Net
179
166
Other Assets
21,690
17,834
Total Assets
$1,380,139
$1,373,920
LIABILITIES
Deposits:
Demand
$ 167,768
$ 151,847
Regular Savings, N.O.W. & Money Market Deposit Accounts
634,195
646,544
Time Deposits of $100,000 or More
64,177
65,585
Other Time Deposits
171,527
182,640
Total Deposits
1,037,667
1,046,616
Short-Term Borrowings:
Federal Funds Purchased and Securities Sold Under Agreements to Repurchase
46,402
39,515
Other Short-Term Borrowings
1,065
1,421
Federal Home Loan Bank Advances
157,500
150,000
Junior Subordinated Obligations Issued to Unconsolidated Subsidiary Trusts
15,000
Other Liabilities
14,265
15,503
Total Liabilities
1,271,899
1,268,055
SHAREHOLDERS’ EQUITY
Preferred Stock, $5 Par Value; 1,000,000 Shares Authorized
Common Stock, $1 Par Value; 20,000,000 Shares Authorized
(13,086,119 Shares Issued at June 30, 2004 and December 31, 2003)
13,086
Surplus
114,088
113,335
Undivided Profits
29,454
24,303
Unallocated ESOP Shares (100,159 Shares at June 30, 2004
and 117,964 Shares at December 31, 2003)
(1,502)
(1,769)
Accumulated Other Comprehensive (Loss) Income
(2,026)
1,084
Treasury Stock, at Cost (3,161,074 Shares at June 30,
2004 and 3,189,550 Shares at December 31, 2003)
(44,860)
(44,174)
Total Shareholders’ Equity
108,240
105,865
Total Liabilities and Shareholders’ Equity
See Notes to Unaudited Consolidated Interim Financial Statements.
CONSOLIDATED STATEMENTS OF INCOME
(In Thousands, Except Per Share Amounts)(Unaudited)
Three Months
Six Months
Ended June 30,
INTEREST AND DIVIDEND INCOME
Interest and Fees on Loans
$12,523
$13,863
$25,278
$27,784
Interest on Federal Funds Sold
42
16
62
45
Interest and Dividends on Securities Available-for-Sale
3,491
2,973
7,038
6,285
Interest on Securities Held-to-Maturity
1,006
859
1,986
1,692
Total Interest and Dividend Income
17,062
17,711
34,364
35,806
INTEREST EXPENSE
Interest on Deposits:
345
501
699
922
Other Deposits
2,671
3,084
5,396
6,363
Interest on Short-Term Borrowings:
Federal Funds Purchased and Securities Sold
Under Agreements to Repurchase
69
91
124
191
2
1,580
1,715
3,158
3,421
Junior Subordinated Obligations Issued to Unconsolidated
Subsidiary Trusts
284
568
Guaranteed Preferred Beneficial Interests in
Corporation’s Junior Subordinated Debentures
119
238
Total Interest Expense
4,951
5,512
9,949
11,138
NET INTEREST INCOME
12,111
12,199
24,415
24,668
Provision for Loan Losses
254
405
539
810
NET INTEREST INCOME AFTER
PROVISION FOR LOAN LOSSES
11,857
11,794
23,876
23,858
OTHER INCOME
Income from Fiduciary Activities
1,060
927
2,116
1,794
Fees for Other Services to Customers
1,910
1,708
3,595
3,325
Net Gains on Securities Transactions
141
210
509
Other Operating Income
165
480
438
659
Total Other Income
3,135
3,256
6,359
6,287
OTHER EXPENSE
Salaries and Employee Benefits
4,778
4,676
9,583
9,426
Occupancy Expense of Premises, Net
628
1,394
1,267
Furniture and Equipment Expense
695
746
1,389
1,417
Other Operating Expense
2,001
2,013
3,933
3,968
Total Other Expense
8,173
8,063
16,299
16,078
INCOME BEFORE PROVISION FOR INCOME TAXES
6,819
6,987
13,936
14,067
Provision for Income Taxes
2,121
2,232
4,373
4,506
NET INCOME
$ 4,698
$ 4,755
$ 9,563
$ 9,561
Average Shares Outstanding:
Basic
9,828
9,881
9,825
9,888
Diluted
10,057
10,112
10,056
10,105
Per Common Share:
Basic Earnings
$ .48
$ .97
Diluted Earnings
.47
.95
Share and Per Share amounts have been restated for the September 2003 five-for-four stock split.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
(In Thousands, Except Share and Per Share Amounts) (Unaudited)
Shares
Issued
Common
Stock
Undivided
Profits
Unallo-
cated
ESOP
Accumulated
Other Com-
prehensive
(Loss)
Income
Treasury
Total
Balance at December 31, 2003
13,086,119
$13,086
$113,335
$24,303
$(1,769)
$ 1,084
$(44,174)
$105,865
Comprehensive Income, Net of Tax:
Net Income
9,563
Increase in Additional Pension
Liability Over Unrecognized
Prior Service Cost (Pre-tax $40)
(24)
Net Unrealized Securities Holding
Losses Arising During the Period,
Net of Tax (Pre-tax $4,923)
(2,960)
Reclassification Adjustment for
Net Securities Gains Included in
Net Income, Net of Tax
(Pre-tax $210)
(126)
Other Comprehensive Loss
(3,110)
Comprehensive Income
6,453
Cash Dividends Declared,
$.45 per Share
(4,412)
Stock Options Exercised
(58,386 Shares)
106
467
573
Shares Issued Under the Employee
Stock Purchase Plan (11,997
Shares)
206
97
303
Shares Issued Under the Directors’
Stock Plan (1,171 Shares)
26
10
36
Tax Benefit for Disposition of
Stock Options
158
Allocation of ESOP Stock
(17,805 Shares)
257
267
524
Purchase of Treasury Stock
(43,078 Shares)
(1,260)
Balance at June 30, 2004
$114,088
$29,454
$(1,502)
$(2,026)
$(44,860)
$108,240
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY, Continued
Balance at December 31, 2002
10,468,895
$10,469
$115,110
$13,611
$(1,822)
$ 3,253
$(39,219)
$101,402
9,561
Net of Tax (Pre-tax $900)
(541)
(Pre-tax $509)
(306)
(847)
8,714
$.41 per Share
(4,028)
(41,493 Shares)
260
294
554
Stock Plan (1,100 Shares)
21
29
Stock Purchase Plan (14,374
193
104
297
43
(97,760 Shares)
(2,322)
Balance at June 30, 2003
$115,627
$19,144
$ 2,406
$(41,135)
$104,689
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in Thousands)(Unaudited)
Operating Activities:
Adjustments to Reconcile Net Income to Net Cash
Provided by Operating Activities:
Depreciation and Amortization
1,618
2,793
Compensation Expense for Allocated ESOP Shares
Gains on the Sale of Securities Available-for-Sale
(210)
(550)
Losses on the Sale of Securities Available-for-Sale
41
Loans Originated and Held-for-Sale
(7,497)
(14,994)
Proceeds from the Sale of Loans Held-for-Sale
7,609
15,366
Net Gains on the Sale of Loans, Premises and Equipment,
Other Real Estate Owned and Repossessed Assets
(64)
(319)
Tax Benefit for Disposition of Stock Options
Decrease in Deferred Tax Assets
122
Decrease in Interest Receivable
87
184
Decrease in Interest Payable
(127)
(141)
Increase in Other Assets
(2,081)
(918)
(Decrease) Increase in Other Liabilities
(1,111)
4,406
Net Cash Provided By Operating Activities
8,786
16,404
Investing Activities:
Proceeds from the Sale of Securities Available-for-Sale
20,226
96,541
Proceeds from the Maturities and Calls of Securities Available-for-Sale
36,714
81,117
Purchases of Securities Available-for-Sale
(56,162)
(168,968)
Proceeds from the Maturities of Securities Held-to-Maturity
2,957
1,197
Purchases of Securities Held-to-Maturity
(5,335)
(21,754)
Net Increase in Loans
(11,839)
(38,487)
Proceeds from the Sales of Premises and Equipment,
431
470
Purchases of Premises and Equipment
(1,052)
(779)
Net Cash Used In Investing Activities
(14,060)
(50,663)
Financing Activities:
Net (Decrease) Increase in Deposits
(8,949)
34,483
Net Increase (Decrease) in Short-Term Borrowings
6,531
(1,297)
20,000
Federal Home Loan Bank Repayments
(12,500)
(15,000)
Purchases of Treasury Stock
Treasury Stock Issued for Stock-Based Plans
912
880
Allocation of ESOP Shares
Cash Dividends Paid
Net Cash Provided By Financing Activities
589
32,716
Net Decrease in Cash and Cash Equivalents
(4,685)
(1,543)
Cash and Cash Equivalents at Beginning of Period
32,141
Cash and Cash Equivalents at End of Period
$ 30,598
Supplemental Cash Flow Information:
Interest Paid
$10,076
$11,278
Income Taxes Paid
5,244
1,224
Transfer of Loans to Other Real Estate Owned and Repossessed Assets
493
516
NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS
1. Financial Statement Presentation
In the opinion of the management of Arrow Financial Corporation (the "Company"), the accompanying unaudited consolidated interim financial statements contain all of the adjustments necessary to present fairly the financial position as of June 30, 2004 and December 31, 2003; the results of operations for the three-month and six-month periods ended June 30, 2004 and 2003; the changes in shareholders’ equity for the six-month periods ended June 30, 2004 and 2003; and the cash flows for the six-month periods ended June 30, 2004 and 2003. All such adjustments are of a normal recurring nature. The unaudited consolidated interim financial statements should be read in conjunction with the annual consolidated financial statements of the Company for the year ended December 31, 2003, included in the Company’s 2003 Form 10-K.
2. Accumulated Other Comprehensive (Loss) Income (In Thousands)
The following table presents the components, net of tax, of accumulated other comprehensive (loss) income as of June 30, 2004 and December 31, 2003:
Excess of Additional Pension Liability Over Unrecognized Prior Service Cost
$ (294)
$ (271)
Net Unrealized Holding (Losses) Gains on Securities Available-for-Sale
(1,732)
1,355
Total Accumulated Other Comprehensive (Loss) Income
$1,084
3. Earnings Per Common Share (In Thousands, Except Per Share Amounts)
The following table presents a reconciliation of the numerator and denominator used in the calculation of basic and diluted earnings per common share (EPS) for the three-month and six-month periods ended June 30, 2004 and 2003:
Per Share
(Numerator)
(Denominator)
Amount
For the Three Months Ended June 30, 2004:
Basic EPS
$4,698
$.48
Dilutive Effect of Stock Options
229
Diluted EPS
$.47
For the Three Months Ended June 30, 2003:
$4,755
231
For the Six Months Ended June 30, 2004:
$9,563
$.97
$.95
For the Six Months Ended June 30, 2003:
$9,561
217
4. Stock-Based Compensation Plans
The Company accounts for its stock-based compensation plans under the recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. No stock-based employee compensation cost has been reflected in net income for stock awards granted under these plans (other than for certain stock appreciation rights attached to options granted in 1992 and earlier, all of which have been exercised as of January 2002), as all awards granted under these plans have been options having an exercise price equal to the market value of the underlying common stock on the date of grant. However, options granted do generally impact diluted earnings per share by increasing the weighted average diluted shares outstanding and thereby decreasing diluted earnings per share as compared to basic earnings per share.
There were no options granted in the first six months of 2004. The weighted-average fair value of options granted during 2003 was $6.49 per option. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 2003: dividend yield of 3.28%; expected volatility of 27.2%; risk free interest rate of 3.76%; and expected lives of 7.0 years. The Company also sponsors an Employee Stock Purchase Plan (ESPP) under which employees purchase the Company’s common stock at a 15% discount below market price at the time of purchase. Under SFAS No. 123, the ESPP is considered a compensatory plan and the entire discount is considered to be a compensation expense in the pro forma disclosures set forth below. Under APB 25, a plan with a discount of 15% or less is not considered compensatory and expense is not recognized. The effects of applying SFAS No. 123 on the pro forma net income may not be representative of the effects on pro forma net income for future periods.
The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation plans.
Quarter Ended
Six Months Ended
Net Income, as Reported
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects
(137)
(107)
(271)
(209)
Pro Forma Net Income
$4,561
$4,648
$9,292
$9,352
Earnings per Share:
Basic - as Reported
Basic - Pro Forma
.46
Diluted - as Reported
Diluted - Pro Forma
.45
.92
.93
5. Guarantees
The Company does not issue any guarantees that would require liability-recognition or disclosure, other than its standby letters of credit. Standby and other letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including bond financing and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Typically, these instruments have terms of twelve months or less. Some expire unused, and therefore, the total amounts do not necessarily represent future cash requirements. Some have automatic renewal provisions.
For letters of credit, the amount of the collateral obtained, if any, is based on management’s credit evaluation of the counter-party. The Company had approximately $2.5 million of standby letters of credit on June 30, 2004, most of which will expire within one year and some of which were not collateralized. At that date, all the letters of credit were for private borrowing arrangements. The fair value of the Company’s standby letters of credit at June 30, 2004 was insignificant.
6. Retirement Plans (In Thousands)
The following table provides the components of net periodic benefit costs for the three months ended June 30:
Pension
Benefits
Postretirement
Service Cost
$246
$184
$ 44
$ 38
Interest Cost
346
336
96
Expected Return on Plan Assets
(527)
(346)
Amortization of Prior Service Cost (Credit)
32
89
(17)
Amortization of Transition Obligation
Amortization of Net Loss (Gain)
(30)
46
44
Net Periodic Benefit Cost
$113
$233
$180
$171
The following table provides the components of net periodic benefit costs for the six months ended June 30:
$ 492
$368
$ 88
$ 76
692
672
194
192
(1,054)
(692)
64
178
(34)
20
(60)
92
888
$ 226
$466
$360
$342
The Company previously disclosed in its financial statements for the year ended December 31, 2003 that it does not expect to make a contribution to the qualified defined benefit pension plan during 2004. The Company expected to contribute $375 to its postretirement benefit plans in 2004. There has been no change in the Company’s expectations as of June 30, 2004.
7. Recently Issued Accounting Pronouncements
In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities”. The objective of this interpretation is to provide guidance on how to identify a variable interest entity (“VIE”) and determine when the assets, liabilities, non-controlling interests, and results of operations of a VIE need to be included in a company’s consolidated financial statements. FIN 46 was effective for all VIE’s created after January 31, 2003. However, the FASB postponed that effective date to December 31, 2003. In December 2003, the FASB issued a revised FIN 46 (FIN 46 R), which further delayed this effective date until March 31, 2004 for VIE’s created prior to February 1, 2003, except for special purpose entities, which must adopt either FIN 46 or FIN 46 R as of December 31, 2003. The requirements of FIN 46 R resulted in the deconsolidation of the Com pany’s wholly-owned subsidiary trusts, formed to issue mandatorily redeemable preferred securities (“trust preferred securities”). The deconsolidation, as of December 31, 2003, results in the derecognition of the trust preferred securities and the recognition of junior subordinated debentures of $15,000 in the Company’s consolidated balance sheet. The assets of the trusts include cash held at the Company’s subsidiary banks, which aggregate approximately $465 at June 30, 2004 and December 31, 2003, offset by an identical amount representing the Company’s investment, which are included in deposits and other assets, respectively.
Currently, banking regulators allow trust preferred securities as a component of Tier 1 capital. The Company cannot predict whether trust preferred securities will continue to be allowed as a component of Tier 1 capital in future periods.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders
Arrow Financial Corporation:
We have reviewed the accompanying consolidated balance sheet of Arrow Financial Corporation and subsidiaries as of June 30, 2004, and the related consolidated statements of income for the three-month and six-month periods ended June 30, 2004 and 2003, and consolidated statements of changes in shareholders’ equity and cash flows for the six-month periods ended June 30, 2004 and 2003. These consolidated financial statements are the responsibility of the Company’s management.
We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the consolidated financial statements referred to above for them to be in conformity U.S. generally accepted accounting principles.
We have previously audited, in accordance with standards established by the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Arrow Financial Corporation and subsidiaries as of December 31, 2003, and the related consolidated statements of income, changes in shareholders’ equity and cash flows for the year then ended (not presented herein); and in our report dated January 21, 2004, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2003, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.
/s/ KPMG LLP
Albany, New York
July 15, 2004
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
JUNE 30, 2004
Cautionary Statement under Federal Securities Laws: The information contained in this Quarterly Report on Form 10-Q includes statements that are not historical in nature but rather are based on management’s beliefs, assumptions, expectations, estimates and projections about the future. These statements are “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and involve a degree of uncertainty and attendant risk. Words such as “expects,” “believes,” “anticipates,” “should,” “plans,” “likely,” “estimates” and variations of such words and similar expressions are intended to identify such forward-looking statements. Some of these statements are merely presentations of what future performance or changes in future performance would look like based on hypothetical assumptions and on simulati on models. Others are based on management’s general perceptions of market conditions and trends in activity, both locally and nationally, as well as current management strategies for future operations and development.
Examples of forward-looking statements in this Report are:
Topic
Location
Impact of changing rates on other time deposits
Last paragraph
Impact of changing rates on loans and deposits
22
Fifth paragraph
Inclusion of trust preferred securities in Tier 1 Capital
23
First paragraph
Impact of competition for indirect loans
Third to last paragraph
Loan yields in upcoming periods
24
27
Liquidity
28
Impact of changing interest rates
Forward-looking statements in this Report are not guarantees of future performance and involve certain risks and uncertainties that are difficult to quantify or, in some cases, to identify. In the case of all forward-looking statements, actual outcomes and results may differ materially from what the statements predict or forecast. Factors that could cause or contribute to such differences include, but are not limited to, unexpected changes in economic and market conditions, including unanticipated fluctuations in interest rates, new developments in state and federal regulation, enhanced competition from unforeseen sources, new emerging technologies, sharp fluctuations in capital markets and similar risks inherent in the business of banking. Significant geopolitical developments, whether or not anticipated, also may cause differences between expected future outcomes as expressed in forward-looking statements and actual outcomes. Re aders are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. Except as expressly required under applicable laws and regulations, the Company undertakes no obligation to revise or update forward-looking statements contained in this Report to reflect future occurrences, including unanticipated events. This Quarterly Report should be read in conjunction with the Company's Annual Report on Form 10-K for December 31, 2003.
Arrow Financial Corporation (the "Company") is a two-bank holding company headquartered in Glens Falls, New York. Its banking subsidiaries are Glens Falls National Bank and Trust Company (“GFNB”) whose main office is located in Glens Falls, New York, and Saratoga National Bank and Trust Company (“SNB”) whose main office is located in Saratoga Springs, New York. The Company’s principal banking operations are located in the eastern section of New York State, north of Albany.
Peer Group Comparisons: At certain points in the ensuing discussion and analysis, the Company's performance is compared with that of its peer group of financial institutions. Unless otherwise specifically stated, this peer group is the group of 207 domestic bank holding companies with $1 to $3 billion in total consolidated assets identified in the Federal Reserve Board's "Bank Holding Company Performance Report" dated March 31, 2004. Peer group data presented in this report was obtained from the Federal Reserve's Bank Holding Company Performance Report.
Use of Non-GAAP Financial Measures: The Securities and Exchange Commission (SEC) recently adopted new rules that apply to all public disclosures, including SEC filings made by registered companies, that contain “non-GAAP financial measures.” GAAP is generally accepted accounting principles in the United States of America. Under Regulation G, companies including non-GAAP financial measures in their filings must also disclose, along with the non-GAAP financial measures, certain additional information, including a reconciliation of the non-GAAP financial measures to the closest comparable GAAP financial measures and a statement of management's reasons for utilizing the non-GAAP financial measures as part of the Company's financial disclosures. The SEC has exempted from the definition of “non-GAAP financial measures” certain specific types of commonly used financial measures that are not based on GAAP. When these exempted measures are included in public disclosures or SEC filings, supplemental information is not required. The following financial measures which are commonly used by banks in presenting their financial results are also used by the Company. However, management is unable to predict whether the SEC will regard these or certain other financial measures used by the Company in its normal presentation of financial information as "non-GAAP financial measures" within the meaning of the SEC's rules.
Tax-Equivalent Net Interest Income and Net Interest Margin: Net interest income, as a component of the tabular presentation by financial institutions of Selected Financial Information regarding their recently completed operations, is commonly presented on a tax-equivalent basis. That is, to the extent that some component of the institution's net interest income will be exempt from taxation (e.g., was received by the institution as a result of its holdings of state or municipal obligations), an amount equal to the tax benefit derived from that component is added back to the net interest income total. This adjustment is considered helpful in comparing one financial institution's net interest income (pre-tax) to that of another institution, as each will have a different proportion of tax-exempt items in their portfolios. Moreover, net interest income is itself a component of a second financial measure commonly use d by financial institutions, net interest margin, which is the ratio of net interest income to average earning assets. For purposes of this measure as well, tax-equivalent net interest income is generally used by financial institutions, again to provide a better basis of comparison from institution to institution. The Company follows these practices.
The Efficiency Ratio: Financial institutions often use an "efficiency ratio" as a measure of expense control. The efficiency ratio typically is defined as the ratio of noninterest expense to net interest income and noninterest income. As in the case of net interest income generally, net interest income as utilized in calculating the efficiency ratio is typically expressed on a tax-equivalent basis. Moreover, most financial institutions, in calculating the efficiency ratio, also adjust both noninterest expense and noninterest income to exclude from these items (as calculated under GAAP) certain component elements, such as intangible asset amortization (deducted from noninterest expense) and securities gains or losses (excluded from noninterest income). The Company follows these practices.
OVERVIEW
Selected Quarterly Information:
(Dollars In Thousands, Except Per Share Amounts)
Per share amounts have been restated for the September 2003 five-for-four stock split.
Jun 2004
Mar 2004
Dec 2003
Sep 2003
Jun 2003
$4,865
$4,787
$4,569
Transactions Recorded in Net Income (Net of Tax):
Net Securities Gains
126
1
147
85
Net Gains on Sales of Loans
52
70
Recovery Related to Former Vermont Operations
Period End Shares Outstanding
9,829
9,779
9,808
9,874
Basic Average Shares Outstanding
9,822
9,811
9,841
Diluted Average Shares Outstanding
10,080
Basic Earnings Per Share
.48
.50
.49
Diluted Earnings Per Share
Cash Dividends
.23
.22
.21
Stock Dividends/Splits
5 for 4
Average Assets
$1,396,678
$1,378,752
$1,386,271
$1,344,090
$1,310,826
Average Equity
109,416
108,877
103,955
102,911
103,843
Return on Average Assets, annualized
1.35%
1.42%
1.37%
1.46%
Return on Average Equity, annualized
17.27
17.97
18.27
17.61
18.37
Average Earning Assets
$1,329,145
$1,310,769
$1,319,122
$1,279,118
$1,253,422
Average Paying Liabilities
1,111,544
1,100,543
1,109,907
1,069,431
1,054,745
Interest Income, Tax-Equivalent 1
17,717
17,938
18,402
17,793
18,288
Interest Expense
4,998
5,256
5,216
Net Interest Income, Tax-Equivalent 1
12,766
12,940
13,146
12,577
12,776
Tax-Equivalent Adjustment
655
636
641
629
577
Net Interest Margin 1
3.86%
3.97%
3.95%
3.90%
4.09%
Efficiency Ratio Calculation 1
Noninterest Expense
$ 8,173
$ 8,126
$ 8,207
$ 8,200
$ 8,063
Less: Intangible Asset Amortization
(9)
(10)
Net Noninterest Expense
8,164
8,117
8,197
8,191
8,054
Net Interest Income, Tax-Equivalent
Noninterest Income
3,224
2,853
3,207
Less: Net Securities Gains
(1)
(245)
Net Gross Income, Adjusted
15,901
15,954
15,998
15,539
15,891
Efficiency Ratio 1
51.34%
50.88%
51.24%
52.71%
50.68%
Tier 1 Leverage Ratio
8.40%
8.37%
8.14%
8.12%
7.52%
Total Shareholders’ Equity (i.e. Book Value)
$111,389
$104,097
Book Value per Share
11.02
11.33
10.83
10.61
10.60
Intangible Assets
9,476
9,479
9,463
9,799
9,697
Tangible Book Value per Share
10.05
10.37
9.86
9.61
9.62
Selected Quarterly Information, Continued:
Net Loans Charged-off as a
Percentage of Average Loans, Annualized
.09%
.10%
.08%
.07%
.13%
Provision for Loan Losses as a
.12
.13
.11
.19
Allowance for Loan Losses as a
Percentage of Period-end Loans
1.38
1.39
1.36
Percentage of Nonperforming Loans
471.22
550.72
427.37
544.24
578.50
Nonperforming Loans as a
.29
.25
Nonperforming Assets as a
Percentage of Period-end Total Assets
.20
.16
.17
1 See “Use of Non-GAAP Financial Measures” on page 13.
Selected Six Month Period Information:
Per share amounts have been restated for September 2003 5-for-4 stock split.
306
68
223
Net Gains on the Sale of Other Real Estate Owned
.97
.41
$1,387,715
$1,299,086
109,147
102,898
Return on Average Assets
1.39%
1.48%
Return on Average Equity
17.62
18.74
$1,319,958
$1,241,731
1,106,044
1,046,025
35,655
36,935
25,706
25,797
1,291
1,129
3.92%
4.19%
$ 16,299
$ 16,078
(18)
16,281
16,060
(509)
31,855
31,575
51.11%
50.86%
Selected Six Month Period Information, Continued:
.12%
Average Consolidated Balance Sheets and Net Interest Income Analysis
(see “Use of Non-GAAP Financial Measures” on page 13)
(Fully Taxable Basis using a marginal tax rate of 35%)
(Dollars In Thousands)
Quarter Ended June 30,
Interest
Rate
Average
Income/
Earned/
Balance
Expense
Paid
$ 18,516
$ 42
0.91%
$ 5,544
$ 16
1.16%
Securities Available-for-Sale:
Taxable
333,637
3,410
4.111
300,798
2,856
3.81
Non-Taxable
11,354
134
4.75
18,220
187
4.12
Securities Held-to-Maturity:
274
5.87
486
9
7.43
105,462
1,515
5.78
78,804
1,264
6.43
859,902
12,612
5.90
849,570
13,956
6.59
Total Earning Assets
1,329,145
5.36
1,253,422
5.85
Allowance For Loan Losses
(11,933)
(11,452)
Cash and Due From Banks
35,209
31,264
44,257
37,592
Interest-Bearing NOW Deposits
$ 372,472
1,119
1.21
$ 303,476
1,033
1.37
Regular and Money Market Savings
289,340
0.65
273,453
595
0.87
65,411
2.12
84,588
2.38
176,405
1,082
2.47
197,068
1,456
2.96
Total Interest-Bearing Deposits
903,628
3,016
1.34
858,585
3,585
1.67
Short-Term Borrowings
42,696
71
0.67
39,951
93
0.93
Long-Term Debt
165,220
1,864
4.54
156,209
1,834
4.71
Total Interest-Bearing Liabilities
1.79
2.10
Demand Deposits
160,184
136,487
15,534
15,751
1,287,262
1,206,983
Shareholders’ Equity
Net Interest Income (Fully Taxable Basis)
Net Interest Spread
3.57
3.75
Net Interest Margin
3.86
4.09
Reversal of Tax-Equivalent Adjustment
(655)
(.20)
(577)
(.18)
Net Interest Income, As Reported
$12,111
$12,199
Six Months Ended June 30,
$ 13,634
$ 62
$ 7,750
$ 45
1.17%
330,378
6,871
4.181
301,016
6,054
4.06
11,782
275
4.69
18,170
370
4.11
285
5.64
472
13
5.55
105,684
2,980
5.67
76,782
2,486
6.53
858,195
25,459
5.97
837,541
27,967
6.73
1,319,958
5.43
1,241,731
6.00
(11,898)
(11,382)
34,642
31,123
45,013
37,614
$ 371,154
2,242
$ 312,235
2,179
1.41
284,648
917
269,953
1,219
0.91
66,161
75,254
178,805
2,237
2.52
197,887
2,965
3.02
900,768
6,095
855,329
7,285
1.72
40,166
128
0.64
39,287
1.00
165,110
3,726
151,409
3,659
4.87
1.81
2.15
156,373
134,975
16,151
15,188
1,278,568
1,196,188
3.62
3.85
3.92
4.19
(1,291)
(1,129)
$24,415
$24,668
The Company reported earnings of $4.698 million for the second quarter of 2004, a decrease of $57 thousand, or 1.2%, as compared to $4.755 million for the second quarter of 2003. Diluted earnings per share were $.47 for both quarters. Average shares outstanding were virtually the same for the two periods, representing the offsetting effect of Company stock repurchases against stock issuances under compensatory stock-based plans. For the first six months of 2004 the Company reported earnings of $9.563 million, an increase of $2 thousand as compared to $9.561 million for the first six months of 2003. Diluted earnings per share were $.95 for both periods.
Although the Company’s net earnings and earnings per share for the quarter and six month periods just ended were virtually unchanged from last year’s results, total assets and total equity increased between the periods. Thus returns on average assets and returns on average equity decreased between the periods.
The returns on average assets were 1.35% and 1.46% for the second quarters of 2004 and 2003, respectively, a decrease of 11 basis points, or 7.5%. The returns on average equity were 17.27% and 18.37% for the second quarters of 2004 and 2003, respectively, a decrease of 110 basis points, or 6.0%. For the first six months of 2004 the returns on average assets were 1.39% and 1.48%, respectively, a decrease of 9 basis points, or 6.1%. The returns on average equity were 17.62% and 18.74% for the six months of 2004 and 2003, respectively, a decrease of 112 basis points, or 6.0%.
The principal reason for the declining earnings ratios between the two periods was the decrease in the net interest margin. For the second quarter of 2004, the net interest margin was 3.86%, down 23 basis points, or 5.6%, from the 4.09% margin for the second quarter of 2003, and down 11 basis points from the 3.97% margin for the first quarter of 2004.
Total assets were $1.4 billion at June 30, 2004, which represented an increase of $6.2 million, or 0.5%, from December 31, 2003, and an increase of $63.0 million, or 4.8%, above the level at June 30, 2003.
During the first six months of 2004 shareholders' equity increased $2.4 million to $108.2 million. The Company's risk-based capital ratios and Tier 1 leverage ratio continued to exceed regulatory minimum requirements at period-end. At June 30, 2004 both Company banks qualified as "well-capitalized" under federal bank guidelines. Efficient utilization of capital remains a high priority of the Company.
CHANGE IN FINANCIAL CONDITION
Summary of Selected Consolidated Balance Sheet Data
(Dollars in Thousands)
At Period-End
$ Change
% Change
From Dec
From Jun
$ ---
$ 5,800
$ (5,800)
(100.0)%
---%
314,966
(6,457)
28,408
(1.8)
9.0
Securities Held-to-Maturity
95,048
2,271
12,999
2.1
13.7
Loans, Net of Unearned Income (1)
848,778
10,949
17,349
1.3
2.0
11,984
11,842
11,518
142
466
1.2
4.0
Earning Assets (1)
1,317,548
1,316,585
1,258,792
963
58,756
0.1
4.7
1,380,139
1,373,920
1,317,158
6,219
62,981
0.5
4.8
$142,421
$15,921
$ 25,347
10.5
17.8
NOW, Regular Savings & Money
Market Deposit Accounts
574,286
(12,349)
59,909
(1.9)
10.4
80,610
(1,408)
(16,433)
(2.1)
(20.4)
195,173
(11,113)
(23,646)
(6.1)
(12.1)
$1,037,667
$1,046,616
$992,490
$ (8,949)
$ 45,177
(0.9)
4.6
$ 47,467
$ 40,936
$ 47,201
$6,531
$ 266
16.0
0.6
7,500
5.0
Shareholders' Equity
104,689
2,375
3,551
2.2
3.4
(1) Includes Nonaccrual Loans
Increases in Sources of Funds: Decreases in deposit balances of $8.9 million over the first six months of 2004 were more than offset by a $6.5 million increase in short-term borrowings and a net increase of $7.5 million in Federal Home Loan Bank (FHLB) advances. The Company experienced decreases in all types of deposit accounts except for demand deposits, which increased by $15.9 million, or 10.5% since year-end 2003. The decrease in total deposits from year-end 2003 was primarily attributable to a $16.9 million decrease in municipal deposit balances, which was offset in part by increases in deposit balances from individuals and businesses. At June 30, 2004, municipal deposits balances represented 18.0% of total deposits, down from 19.4% at December 31, 2003. Compared to the totals at June 30, 2003, total deposits increased by $45.2 million, or 4.6%.
Deployment of Funds into Earning Assets: The Company’s primary use of the increase in the sources of funds from December 31, 2003, cited above, in combination with federal funds balances and cashflows from the investment and loan portfolios was to fund loan growth ($10.9 million, net) and for securities purchases ($61.5 million).
Total loans outstanding increased $10.9 million from December 31, 2003 to June 30, 2004. The Company’s largest loan segment, indirect automobile financing, continued a trend by decreasing $13.4 million during the period. This decrease was more than offset by a $14.9 million increase in commercial loan balances, a $4.7 million increase in residential real estate loan balances and by a $4.3 million increase in home equity loan balances.
Deposit Trends
The following two tables provide information on trends in the balance and mix of the Company’s deposit portfolio by presenting, for each of the last five quarters, the quarterly average balances by deposit type and the percentage of total deposits represented by each deposit type.
Quarterly Average Deposit Balances
Quarter Ending
$ 160,184
$ 152,562
$ 154,537
$ 153,856
$136,487
Interest-Bearing Demand Deposits
372,472
369,837
365,995
311,470
303,476
279,957
278,503
282,437
66,911
67,012
75,771
181,203
184,791
190,336
$1,063,812
$1,050,470
$1,050,838
$1,013,870
$995,072
Percentage of Average Quarterly Deposits
15.1%
14.5%
14.7%
15.2%
13.7%
35.0
35.2
34.8
30.7
30.5
27.2
26.7
26.5
27.8
27.5
6.1
6.4
7.5
8.5
16.6
17.2
17.6
18.8
19.8
100.0%
For a variety of reasons, including the seasonality of municipal deposits, the Company typically experiences little net deposit growth in the first quarter of the year, but more significant growth in the second quarter. Deposit balances followed this pattern for the first two quarters of 2004. The average balance on all categories of deposits changed little from the fourth quarter of 2003 to the first quarter of 2004, but all categories except time deposits experienced growth in the second quarter of 2004.
In the comparison of average balances between the second quarter of 2004 and the second quarter of 2003, the Company experienced significant growth in all categories of non-maturity deposits, including the following increases: demand deposits - $23.7 million, or 17.4%; interest-bearing demand deposits - $69.0 million, or 22.7%; and regular and money market savings accounts - $15.9 million, or 5.8%. The average balances of time deposits of $100,000 or more decreased by $19.2 million, or 22.7%, (primarily municipal balances) and the average balances of other time deposits decreased by $20.7 million, or 10.5%. The decreasing average balance of other time deposits for each progressive quarter from June 2003 to June 2004 continues a trend that the Company and other financial institutions have experienced in low-rate environments where depositors maintain maturing time deposits in non-maturity accounts, presumably until rates start to increase.
In June 2003, the Company opened a new branch in Queensbury, New York. Otherwise, the increase in deposits between the two periods was achieved through the Company's existing base of branches.
Quarterly Average Rate Paid on Deposits
1.22
1.11
0.69
0.72
2.13
2.31
2.32
2.56
2.72
2.82
1.14
1.18
1.23
1.25
1.46
Key Interest Rate Changes 1999 - 2004
Primary Rate
Federal
Date
Discount Window
Funds Rate
Prime Rate
2.25%
1.25%
4.25%
June 25, 2003
2.00
4.00
January 9, 2003 (a)
2.25
November 6, 2002
.75
4.25
December 11, 2001
1.75
November 6, 2001
1.50
5.00
October 2, 2001
2.50
5.50
September 17, 2001
3.00
August 21, 2001
3.50
6.50
June 27, 2001
3.25
6.75
May 15, 2001
7.00
April 18, 2001
4.50
7.50
March 20, 2001
8.00
January 31, 2001
8.50
January 3, 2001
9.00
May 16, 2000
9.50
March 21, 2000
February 2, 2000
5.25
5.75
8.75
November 16, 1999
August 25, 1999
8.25
June 30, 1999
(a) The discount window borrowing rate was discontinued in January 2003 and replaced with two rates, a primary credit rate and a secondary credit rate.
The Company’s net interest income has traditionally been sensitive to and impacted by changes in prevailing market interest rates. Generally, there has been a negative correlation between changes in interest rates and net interest income in immediately ensuing periods. As prevailing rates have declined, net interest income has increased, in ensuing periods, and vice versa. As indicated in the preceding table, prevailing interest rates economy-wide increased in the second half of 1999 and throughout 2000, following a long period of flat or slowly-declining prevailing interest rates. The 1999 rate hikes had a moderately negative impact on financial results for 1999, as the Company experienced decreases in net interest spread and net interest margin. However, the full negative impact of rising rates was felt more sharply in 2000, when the decrease in net interest margin due to rising rates was significant.
In the first quarter of 2001, after an extended period of stable interest rates and six months of moderate rate increases, the Federal Reserve Board began decreasing short-term interest rates rapidly and significantly in response to perceived weakening in the economy. By December 2001, the total decrease in prevailing short-term interest rates for the year was 425 basis points. After eleven months with no rate changes, the Federal Reserve Board decreased rates another 50 basis points in November 2002 and concluded with an additional 25 basis point decrease in June 2003. As a result, the Company experienced a decrease in the cost of deposits in all quarters of 2001, which continued throughout 2002, 2003 and into 2004. However, although decreases in deposit rates began to be experienced in the first quarter of 2001, the Company did not experience a decrease in the average yield in its loan portfolio until the second quarter of 2001. Yields on the loan portfolio continued to decrease through the remainder of 2001 and through all of 2002, 2003 and into 2004 as well. See the “Loan Trends” section in this Report beginning on page 23, for a more complete analysis of yield trends in the loan portfolio.
During 2003 and 2004, the effect of the Federal Reserve’s rate decreases on the Company’s deposit rates began to diminish, because rates on several of the Company’s deposit products, such as savings and NOW accounts, were already priced at such low levels that further decreases in the rates for such products was not practical or sustainable, although the Company did continue to lower rates slightly certain non-maturity deposit products. Yields on the loan portfolio, however, continued to fall significantly in 2003 and 2004, putting serious pressure on the net interest margin for the first time in years. Thus the decreasing rate environment had a positive impact on net interest income during 2001 and 2002, as net interest margins increased both years, but for 2003 and 2004 the low rate environment had a negative impact on both net interest income and net interest margin.
The net interest margin for the full year of 2003 was 4.05%, a decrease of 45 basis points, or 10.0%, from the prior year. During 2003 the yields on earning assets fell 91 basis points, while the cost of paying liabilities fell only 57 basis points.
The net interest margin for the first quarter of 2004 was 3.97%, an increase of 2 basis points from the net interest margin for the fourth quarter of 2003. However, both the yields on average earning assets and the cost of paying liabilities decreased from the fourth quarter of 2003 to the first quarter of 2004, although at a similar pace.
The net interest margin for the second quarter of 2004 was 3.86%, a decrease of 11 basis points from the net interest margin for the first quarter of 2004. Yields on average earning assets decreased 14 basis points from the first quarter, while the cost of paying liabilities only decreased 4 basis points. Management is not able to predict how long it will be before an increase in prevailing rates will result in an increase in the Company’s yield on its earning assets or the cost of its paying liabilities, or whether or for how long the Company’s net interest margin may continue to decrease, adversely affecting earnings.
In both rising and falling rate environments, the Company faces significant competitive pricing pressures in its marketplace for both deposits and loans, and thus ultimately both assets and liabilities may be expected to reprice proportionately in response to changes in market rates.
Non-Deposit Sources of Funds
The Company has borrowed funds from the Federal Home Loan Bank ("FHLB") under a variety of programs, including fixed and variable rate short-term borrowings and borrowings in the form of "convertible advances." These convertible advances have maturities of 2 - 10 years and are callable by the FHLB at certain dates beginning no earlier than one year from the issuance date. If the advances are called (typically in a rising rate environment), the Company may elect to receive replacement advances from the FHLB at the then prevailing FHLB rates of interest.
Management continues to explore and evaluate new non-deposit sources of funds. In 1999, the Company established a financing vehicle, Arrow Capital Trust I ("ACT I"). ACT I issued so-called trust preferred securities, that is, 30 year guaranteed preferred beneficial interests in ACT I’s assets ("capital securities") in the aggregate amount of $5.0 million at a fixed rate of 9.5%. ACT I then used the proceeds from the sale of the capital securities to acquire as its primary asset junior subordinated debentures issued by the Company, bearing the same interest rate as the capital securities (9.5%) and similar in aggregate amount ($5.0 million). The debentures and capital securities are redeemable (subject to any required regulatory approval) at the option of the Company beginning December 31, 2004. In July 2003, the Company established a second financing vehicle, Arrow Capital Statutory Trust II ("ACST II ") also for the purpose of issuing trust preferred securities. ACST II issued 30 year guaranteed preferred beneficial interests in junior subordinated debentures of the Company ("capital securities") in the aggregate amount of $10.0 million at a fixed rate of 6.53% until September 30, 2008 (afterwards the rate is variable, set at the three month LIBOR rate plus 3.15%). ACST II then used the proceeds from the sale of the capital securities to acquire as its primary asset junior subordinated debentures issued by the Company, bearing the same interest rate as the ACST II capital securities and similar in aggregate amount. These securities are redeemable (subject to any required regulatory approval) at the option of the Company beginning September 30, 2008.
Currently, the Company’s ACT I and ACST II capital securities, with associated expense that is tax deductible, qualify as Tier I capital of the Company under regulatory definitions. The Company cannot predict whether trust preferred securities will continue to be allowed as a component of Tier 1 capital in future periods.
Both the ACT I and ACST II capital securities are subject to early redemption by the Company if the proceeds cease to qualify as Tier 1 capital of the Company, which would only happen if bank regulatory authorities were to reverse their current position that trust preferred securities issued by subsidiaries of bank holding companies, up to certain threshold levels, qualify for such treatment.
Loan Trends
The following two tables present, for each of the last five quarters, the quarterly average balances by loan type and the percentage of total loans represented by each loan type.
Quarterly Average Loan Balances
Commercial and Commercial Real Estate
$200,235
$191,592
$187,447
$188,048
$189,167
Residential Real Estate
280,636
278,785
283,145
268,967
265,684
Home Equity
40,500
38,779
37,403
34,748
31,893
Indirect Consumer Loans
301,972
310,219
320,286
326,796
326,856
Other Consumer Loans 1
36,559
37,112
36,673
35,698
35,970
Total Loans
$859,902
$856,487
$864,954
$854,257
$849,570
Percentage of Quarterly Average Loans
23.3%
22.5%
21.7%
22.0%
22.3%
32.6
32.5
32.8
31.5
31.3
4.5
4.3
3.8
35.1
36.2
37.0
38.3
38.4
Other Consumer Loans
4.2
1 Other Consumer Loans includes certain home improvement loans, secured by mortgages, in this table of average loan balances.
Indirect Loans: Indirect loans consist principally of auto loans financed through local dealerships where the Company acquires the dealer paper. In the several years preceding the third quarter of 2001, the indirect consumer loan portfolio was the fastest growing segment of the Company's loan portfolio, both in terms of absolute dollar amount and as a percentage of the overall portfolio. Over the subsequent quarters, this segment of the portfolio ceased to grow in absolute terms and in the ensuing period has decreased as a percentage of the overall portfolio. This development was largely the result of aggressive campaigns of zero rate and other subsidized financing commenced by the auto manufacturers in the fall of 2001, which has continued down to the present. During the fourth quarter of 2002, and for the first two quarters of 2003, the indirect portfolio experienced a small amount of growth as the Company be came more rate competitive, but the average balance of indirect loans was flat for the third quarter of 2003, decreased by $6.5 million during the fourth quarter of 2003, by another $10.1 million during the first quarter of 2004 and decreased by another $8.2 million in the most recent quarter. However, indirect loans still represent the largest category of loans (35%) in the Company’s loan portfolio. If the trend continues with auto manufacturers subsidizing their affiliates by offering zero rate loans on sales of vehicles, the Company’s indirect loan portfolio is likely to continue to experience rate pressure and limited, if any, overall growth.
Residential Real Estate Loans: Residential real estate loans represented the second largest segment of the Company’s loan portfolio at June 30, 2004, at 33% of total loans at quarter-end. This was the fastest growing segment in the Company's loan portfolio for the third and fourth quarters of 2003 and the second fastest for the first two quarters of 2004. The period of strong demand for residential real estate loans, which began when rates started falling in 2001, started to weaken in the third and fourth quarters of 2003 and into 2004, as refinancing activity began to slow down in the face of flat or rising mortgage rates.
During the first six months of 2004, the Company sold (with servicing retained) $5.3 million of newly originated, low-yielding, fixed rate mortgages with servicing retained by the Company.
During 2003 the Company sold (with servicing retained) $15.8 million of low-rate residential real estate loans. The size of the portfolio in 2003 was also restricted by the securitization of $11.5 million of mortgage loans during the year. In effect, the securitized loans were not sold but merely transferred to the Company's securities available-for-sale portfolio.
Commercial and Commercial Real Estate Loans: The Company continued to experience strong to moderate demand for commercial loans throughout 2003 and into the first two quarters of 2004, continuing a trend that has persisted for several years. Commercial and commercial real estate loans have grown each year for the past five years, both in dollar amount and as a percentage of the overall loan portfolio. These loans represented the fastest growing segment in the Company’s loan portfolio for the first two quarters of 2004.
Quarterly Taxable Equivalent Yield on Loans
6.14%
6.09%
6.32%
6.49%
6.61%
6.08
6.18
6.22
6.41
6.68
4.20
4.40
4.56
5.02
5.57
5.76
5.95
6.16
6.47
7.51
7.55
7.90
8.23
8.29
6.03
6.12
6.33
In general, the yield (tax-equivalent interest income divided by average loans) on the Company's loan portfolio and other earning assets has been impacted by changes in prevailing interest rates, as discussed above under the heading "Key Interest Rate Changes 1999 - 2004." Management expects that such will continue to be the case; that is, that loan yields will continue to rise and fall with changes in prevailing market rates, although the timing and degree of responsiveness will continue to be influenced by a variety of other factors, including the makeup of the loan portfolio, consumer expectations and preferences and the rate at which the portfolio expands. Many of the loans in the commercial portfolio have variable rates tied to prime, FHLB or U.S. Treasury indices. Additionally, there is a significant amount of cash flow from normal amortization and prepayments in all loan categories, and this cash flow reprices at current rates as new loans are generated at the current yields. As noted in the earlier discussion, during the recent period of declining rates (mid-2001 through June 2004), the Company experienced a time lag between the impact of declining rates on the deposit portfolio (which occurred relatively quickly) and the impact on the loan portfolio, which positively affected the net interest margin during the beginning of this period and then negatively affected the margin in more recent periods.
The net interest margin expanded during 2001 and into the first quarter of 2002 as deposit rates decreased rapidly. The Company's deposit rates began to flatten out in mid-2002, however, while loan yields continued to decline. As a result, the net interest margin began to contract in the second quarter of 2002. Generally, this pattern persisted through the remainder of 2002, all of 2003 and the first two quarters of 2004. Thus the yield on the Company’s loan portfolio decreased by 13 basis points in the second quarter of 2004, while the cost of the Company’s interest-bearing deposits only decreased by 4 basis points for the same period.
On June 30, 2004, the Federal Reserve Board ended an uninterrupted four-year period of falling rates with a 25 basis point increase in prevailing rates. If rates continue to increase in forthcoming periods, as many analysts have forecasted, the Company expects that the yield on the loan portfolio will continue to decline for a time and then start to increase, but will lag behind increases in the cost of deposits. If so, further reductions in net interest margin may be experienced.
Asset Quality
The following table presents information related to the Company's allowance and provision for loan losses for the past five quarters.
Summary of the Allowance and Provision for Loan Losses
(Dollars in Thousands)(Loans Stated Net of Unearned Income)
Loan Balances:
Period-End Loans
$ 866,127
$ 854,958
$ 855,178
$ 867,338
$ 848,778
Average Loans, Year-to-Date
856,487
848,664
843,174
Average Loans, Quarter-to-Date
864,954
854,257
Period-End Assets
1,394,285
1,384,193
Allowance for Loan Losses, Year-to-Date:
Allowance for Loan Losses, Beginning of Period
$11,842
$11,193
Provision for Loan Losses, Y-T-D
1,460
1,215
Loans Charged-off
(531)
(259)
(1,153)
(874)
(656)
Recoveries of Loans Previously Charged-off
55
342
244
171
Net Charge-offs, Y-T-D
(397)
(204)
(811)
(630)
(485)
Allowance for Loan Losses, End of Period
$11,984
$11,923
$11,778
$11,518
Allowance for Loan Losses, Quarter-to-Date:
$11,388
Provision for Loan Losses, Q-T-D
245
(272)
(279)
(218)
(368)
79
98
73
Net Charge-offs, Q-T-D
(193)
(181)
(145)
(275)
Nonperforming Assets, at Period-End:
Nonaccrual Loans
$2,113
$2,096
$1,822
$1,832
$1,684
Loans Past due 90 Days or More
and Still Accruing Interest
430
685
332
307
Loans Restructured and in
Compliance with Modified Terms
Total Nonperforming Loans
2,543
2,165
2,507
2,164
1,991
Repossessed Assets
115
198
Other Real Estate Owned
Total Nonperforming Assets
$2,750
$2,280
$2,687
$2,371
$2,189
Asset Quality Ratios:
Allowance to Nonperforming Loans
471.22%
550.72%
472.37%
544.24%
578.50%
Allowance to Period-End Loans
Provision to Average Loans (Quarter)
0.12
0.13
0.11
0.19
Provision to Average Loans (YTD)
0.17
0.20
Net Charge-offs to Average Loans (Quarter)
0.09
0.10
0.08
0.07
Net Charge-offs to Average Loans (YTD)
Nonperforming Loans to Total Loans
0.29
0.25
0.23
Nonperforming Assets to Total Assets
0.16
The Company’s nonperforming assets at June 30, 2004 amounted to $2.8 million, an increase of $63 thousand, or 2.3%, from December 31, 2003. At period-end, nonperforming assets represented .20% of total assets, well below the March 31, 2004 ratio for the Company’s peer group of .60%.
The balance of other non-current loans as to which interest income was being accrued (i.e. loans 30-89 days past due as defined in bank regulatory agency guidance) totaled $5.0 million at June 30, 2004 and represented 0.58% of loans outstanding at that date, as compared to approximately $6.6 million of non-current loans at December 31, 2003, representing 0.78% of loans outstanding at that date. These non-current loans were composed of approximately $3.8 million of consumer loans, principally indirect automobile loans, $.9 million of residential real estate loans and $322 thousand of commercial loans.
The percentage of the Company's performing loans that demonstrate characteristics of potential weakness from time to time, typically a very small percentage, is for the most part dependent on economic conditions in the Company's geographic market area of northeastern New York State. In general, the economy in this area was relatively strong in the 1997-2000 period. The U.S. slid into a mild recession in 2001 which continued throughout 2002, but the economic downturn was not as severe in the Company’s principal geographic market area. In the "Capital District" in and around Albany and in the area north of the Capital District, including the Company's principal service areas, unemployment remained at or below the national average. However, since 2001 the unemployment rate in the Company's other service areas including Clinton and Essex Counties, near the Canadian border has been at or above the national average.
The ratio of the 2004 second quarter net charge-offs to average loans (annualized) was .09%, nearly unchanged from the ratio for the first quarter of 2004 and for the full year 2003. The provision for loan losses was $254 thousand for the second quarter of 2004, compared to a provision of $405 thousand for the second quarter of 2003 and a provision of $285 thousand for the first quarter of 2004. The provision as a percentage of average loans (annualized) was .12% for the second quarter of 2004, a decrease of 7 basis points from the .19% ratio for the comparable 2003 period. The decrease in the provision is due primarily to the fact that nonperforming loans, as a percent of total loans outstanding of .29% at June 30, 2004, was unchanged from December 31, 2003. Also, total loans outstanding at June 30, 2004 had increased $10.9 million from December 31, 2003, whereas total loans outstanding grew at a faster pace in the prior year per iod, when, at June 30, 2003, loans totaled $848.8 million, an increase of $37.5 million from the balance at December 31, 2002.
The allowance for loan losses at June 30, 2004 amounted to $12.0 million. The ratio of the allowance to outstanding loans at June 30, 2004 was 1.38%, unchanged from December 31, 2003 and 2 basis points higher than this ratio at June 30, 2003. The allowance as a percent of nonperforming loans was 471.22% at June 30, 2004.
CAPITAL RESOURCES
Shareholders' equity increased $2.4 million during the first six months of 2004. During this period, net income of $9.6 million was offset, in part, by net unrealized losses on securities available-for-sale (net of tax) of approximately $2.3 million, stock repurchases (net of new stock issuances through compensatory stock-based plans) of $348 thousand and cash dividends of $4.4 million ($.45 per share). From June 30, 2003 to June 30, 2004, shareholders' equity increased by 3.4%. Current and prior period changes in shareholders' equity are presented in the Consolidated Statements of Changes in Shareholders' Equity, on pages 5 and 6 of this Report.
On April 28, 2004 the Board of Directors approved a stock repurchase program authorizing the repurchase, at the discretion of senior management, of up to $5 million ($4.5 million remaining) of the Company’s common stock over the next twelve months in open market or negotiated transactions. See the stock repurchase table on page 38 of this Report.
The following discussion of capital focuses on regulatory capital ratios, as defined and applied to financial institutions by federal bank regulatory authorities. Regulatory capital, although a financial measure that is not provided for or governed by GAAP, nevertheless has been exempted by the SEC from the definition of "non-GAAP financial measures" in the SEC's newly adopted rules governing disclosure of non-GAAP financial measures. Thus, certain information, which is required to be presented in connection with disclosure of non-GAAP financial measures, need not be provided, and has not been provided, for the regulatory capital measures discussed below.
The Company and its subsidiaries are currently subject to two sets of regulatory capital measures, a leverage ratio test and risk-based capital guidelines. The risk-based guidelines assign risk weightings to all assets and certain off-balance sheet items of financial institutions and establish an 8% minimum ratio of qualified total capital to risk-weighted assets. At least half of total capital must consist of "Tier 1" capital, which comprises common equity and common equity equivalents, retained earnings and a limited amount of permanent preferred stock and trust preferred securities, less intangible assets. Up to half of total capital may consist of so-called "Tier 2" capital, comprising a limited amount of subordinated debt, other preferred stock, certain other instruments and a limited amount of the allowance for loan losses. The second regulatory capital measure, the leverage ratio test, establishes minimu m limits on the ratio of Tier 1 capital to total tangible assets, without risk weighting. For top-rated companies, the minimum leverage ratio is 3%, but lower-rated or rapidly expanding companies may be required to meet substantially higher minimum leverage ratios. Federal banking law mandates that banking regulators must take certain remedial actions for financial institutions that are deemed undercapitalized as measured by these ratios. The law establishes five levels of capitalization for financial institutions ranging from "critically undercapitalized" to "well-capitalized." The Gramm-Leach-Bliley Financial Modernization Act also ties the ability of banking organizations to engage in certain types of non-banking financial activities to the organizations' subsidiaries continuing to qualify as "well-capitalized" under these standards.
During July 2003, the Company issued $10 million of trust preferred securities in a private placement, in addition to the $5 million of trust preferred securities issued in 1999. Currently, banking regulators allow these trust preferred securities to count as a component of Tier 1 capital. For more detailed information regarding the trust preferred securities, see “Non-Deposit Sources of Funds,” on page 22.
As of June 30, 2004, the Tier 1 leverage and risk-based capital ratios for the Company and its subsidiary banks were as follows:
Summary of Capital Ratios
Tier 1
Risk-Based
Leverage
Capital
Ratio
Arrow Financial Corporation
13.35%
14.60%
Glens Falls National Bank & Trust Co.
7.79
12.91
14.16
Saratoga National Bank & Trust Co.
11.28
14.22
Regulatory Minimum
FDICIA's "Well-Capitalized" Standard
10.00
All capital ratios of the Company and its subsidiary banks at June 30, 2004 were above minimum capital standards for financial institutions. Additionally, at such date the Company and its subsidiary banks qualified as “well-capitalized” under FDICIA, based on their capital ratios on that date.
The Company’s common stock is traded on The Nasdaq Stock MarketSM under the symbol AROW. The high and low prices listed below represent actual sales transactions, as reported by Nasdaq.
On July 21, 2004, the Company announced the 2004 third quarter cash dividend of $.23 payable on September 15, 2004.
Quarterly Per Share Stock Prices and Dividends
(Restated for the September 2003 five-for-four stock split)
Cash
Dividends
Declared
Sales Price
Low
High
First Quarter
$22.480
$24.920
$.200
Second Quarter
22.648
26.840
.208
Third Quarter
25.200
28.736
Fourth Quarter
25.950
29.750
.220
$27.610
$31.250
$.220
$28.250
$30.800
.230
Third Quarter (dividend payable September 15, 2004)
Dividends Per Share
$.23
$.21
Dividend Payout Ratio
48.94%
44.68%
Total Equity (in thousands)
Shares Issued and Outstanding (in thousands)
Book Value Per Share
$11.02
$10.60
Intangible Assets (in thousands)
$9,476
$9,696
Tangible Book Value Per Share
$10.05
$9.62
LIQUIDITY
Liquidity is measured by the ability of the Company to raise cash when it needs it at a reasonable cost. The Company must be capable of meeting expected and unexpected obligations to its customers at any time. Given the uncertain nature of customer demands, the Company must have available sources of funds, on- and off-balance sheet, that can be acquired in time of need. The Company measures and monitors its basic liquidity as a ratio of liquid assets to short-term liabilities, both with and without the availability of borrowing arrangements.
In addition to regular loan repayments, securities available-for-sale represent a primary source of balance sheet cash flows. Certain securities are designated by the Company, at the time of purchase, as available-for-sale. Selection of such securities is based on their ready marketability, ability to collateralize borrowed funds, as well as their yield and maturity.
In addition to liquidity arising from on-balance sheet cash flows, the Company has supplemented liquidity with additional off-balance sheet sources such as credit lines with the Federal Home Loan Bank ("FHLB"). The Company has established overnight and 30 day term lines of credit with the FHLB each in the amount of $58.4 million at June 30, 2004. If advanced, such lines of credit are collateralized by the Company’s pledge of mortgage-backed securities, loans and FHLB stock. In addition, the Company has in place borrowing facilities from correspondent banks and the Federal Reserve Bank of New York and also has identified repurchase agreements and brokered certificates of deposit as appropriate potential sources of funding.
The Company is not aware of any known trends, events or uncertainties that will have or are reasonably likely to have a material effect or make material demands on the Company's liquidity in upcoming periods.
RESULTS OF OPERATIONS:
Three Months Ended June 30, 2004 Compared With
Three Months Ended June 30, 2003
Summary of Earnings Performance
(Dollars in Thousands, Except Per Share Amounts)
Change
$(57)
(1.2)%
(.11)%
(7.5)
17.27%
18.37%
(1.10)%
(6.0)
The Company reported earnings of $4.7 million for the second quarter of 2004, a decrease of $57 thousand, or 1.2%, from the second quarter of 2003. Diluted earnings per share were $.47 for both quarters. Included in net income are net securities gains, net of tax, of $85 thousand for the 2003 quarter and net gains on the sale of loans to the secondary market of $16 thousand and $206 thousand, net of tax, for the respective 2004 and 2003 quarters. The principal cause of the period-to-period decrease was a 23 basis point decrease in the net interest margin.
The following narrative discusses the quarter-to-quarter changes in net interest income, other income, other expense and income taxes.
Net Interest Income
Summary of Net Interest Income
(Taxable Equivalent Basis)
Interest and Dividend Income
$17,717
$18,288
$(571)
(3.1)%
(561)
(10.2)
$12,766
$12,776
$ (10)
(0.1)
Taxable Equivalent Adjustment
78
13.5
Average Earning Assets (1)
$75,723
6.0
56,799
5.4
Yield on Earning Assets (1)
5.36%
5.85%
(0.49)%
(8.4)
Cost of Paying Liabilities
(0.31)
(14.8)
(0.18)
(4.8)
(0.23)
(5.6)
The Company’s net interest income for the second quarter of 2004, on a taxable equivalent basis, was down $10 thousand, or 0.1%, from the second quarter of 2003. This was due to a decrease in the net interest margin. The Company’s net interest margin (net interest income on a tax-equivalent basis divided by average earning assets, annualized) decreased significantly, from 4.09% to 3.86%, from the second quarter of 2003 to the second quarter of 2004. Net interest margin in the second quarter of 2004 was also down 11 basis points from the preceding quarter. (See the discussion under “Use of Non-GAAP Financial Measures,” on page 13, regarding net interest income and net interest margin, which are commonly used non-GAAP financial measures.) The $75.7 million increase in average earning assets from the second quarter of 2003 to the second quarter of 2004, although significant, was not enough to offset the nega tive impact of the decrease in net interest margin on net interest income. The decrease in both net interest income and net interest margin between the comparable periods was significantly influenced by the long-term downward trend in prevailing interest rates, and the fact that, as the trend continued in 2003 and 2004, it had a disproportionate impact on earning assets as opposed to interest-bearing liabilities. This development was discussed previously in this Report under the sections entitled “Deposit Trends,” “Key Interest Rate Changes 1999-2004" and “Loan Trends.”
The provisions for loan losses were $254 thousand and $405 thousand for the quarters ended June 30, 2004 and 2003, respectively. The provision for loan losses was discussed previously under the heading "Summary of the Allowance and Provision for Loan Losses."
Other Income
Summary of Other Income
Income From Fiduciary Activities
$1,060
$ 927
$ 133
14.3%
202
11.8
(100.0)
(315)
(65.6)
$3,135
$3,256
$(121)
(3.7)
For the second quarter of 2003, total other income included securities gains of $141 thousand on the sale of $41.7 million of securities available-for-sale (primarily U.S. agency securities). In the 2004 quarter, by contrast, there were no significant securities sales. The following table presents sales and purchases in the available-for-sale investment portfolio for the second quarters of 2004 and 2003:
Investment Sales and Purchases: Available-for-Sale Portfolio
(In Thousands)
Investment Sales
Collateralized Mortgage Obligations
$12,832
Other Mortgage-Backed Securities
17,552
U.S. Agency Securities
9,992
State and Municipal Obligations
Other
145
1,325
Total Sales
$145
$41,701
Net Gains
$---
$141
Investment Purchases
30,302
37,840
19,892
31,933
400
5,785
1,534
Total Purchases
$55,979
$71,707
The purchases of U.S. agency securities in the second quarter of 2004 represented a reinvestment of proceeds from the sales of agency securities late in the first quarter of 2004. The purchases of other mortgage-backed securities in the second quarter of 2004 was funded by normal cashflows from collateralized mortgage obligations and other mortgage-backed securities.
The securities transactions in the 2003 period represented a significant restructuring of the portfolio implemented by management for various strategic reasons, including the ability to replace agency securities with relatively short remaining maturities with those bearing higher yields and longer duration.
During the second quarter of 2004, the Company sold $.6 million of newly originated low-rate residential real estate loans in the secondary market with net gains of $26 thousand. During the second quarter of 2003, the Company sold a much higher dollar amount, $12.5 million, of newly originated residential real estate loans in the secondary market, with net gains of $343 thousand. The gains were due, in small part, to the fact that market interest rates on residential real estate loans kept falling during the period, but primarily to the fact that the Company was able to write loans with yields slightly higher than those required by the secondary market. Net gains on the sales of loans are included in other operating income in the table above.
Income from fiduciary activities totaled $1.1 million for the second quarter of 2004, an increase of $133 thousand, or 14.3%, from the second quarter of 2003. A principal cause of the increase was the increase in value of trust assets under administration and investment management, which in itself reflected rising prices in the equity markets and significant new business. The market value of assets under trust administration and investment management at June 30, 2004, amounted to $783.2 million, an increase of $131.7 million, or 20.2%, from June 30, 2003.
Income from fiduciary activities includes income from funds under investment management in the Company-advised North Country Funds, which include the North Country Equity Growth Fund (NCEGX) and the North Country Intermediate Bond Fund (NCBDX). These funds have an aggregate market value of $135.4 million at June 30, 2004. The funds were introduced in March 2001, and are advised by the Company’s subsidiary, North Country Investment Advisers, Inc. Currently, the funds are held predominately by qualified employee benefit plans. The funds are also offered on a retail basis at most of the branch locations of the Company’s banking subsidiaries and retail customers held $7.9 million in fund balances at June 30, 2004.
Fees for other services to customers (primarily service charges on deposit accounts, credit card merchant fee income, commissions on the sale of mutual funds and servicing income on sold loans) was $1.9 million for the second quarter of 2004, an increase of $202 thousand, or 11.8%, from the 2003 second quarter. The increase was primarily attributable to: i) increased sales of mutual funds; ii) merchant credit card fee income; and, iii) service charge income on deposit accounts.
Other operating income includes data processing servicing fee income received from one unaffiliated upstate New York bank, and net gains or losses on the sale of loans, other real estate owned and other assets. Apart from loan sales, discussed above, the remaining components of other operating income for the second quarter of 2004 were virtually unchanged from the second quarter of 2003.
Other Expense
Summary of Other Expense
$4,778
$4,676
$ 102
2.2%
11.3
(51)
(6.8)
(12)
(0.6)
$8,173
$8,063
$110
1.4
Efficiency Ratio
.66%
Other expense for the second quarter of 2004 was $8.2 million, an increase of $110 thousand, or 1.4%, over the expense for the second quarter of 2003. For the second quarter of 2004, the Company's efficiency ratio was 51.34%. This ratio is a comparative measure of a financial institution's operating efficiency. The efficiency ratio (a ratio where lower is better) is the ratio of noninterest expense (excluding intangible asset amortization) to net interest income (on a tax-equivalent basis) and other income (excluding net securities gains or losses). See the discussion on page 13 of this report under the heading “Use of Non-GAAP Financial Measures.” The Company's efficiency ratio compares favorably to the March 31, 2004 peer group ratio of 62.03%, as set forth in the Federal Reserve Board's "Peer Holding Company Performance Reports." The Federal Reserve, in calculating banks’ efficiency ra tios, excludes net securities gains or losses, but does not exclude intangible asset amortization from this calculation.
Salaries and employee benefits expense increased $102 thousand, or 2.2%, from the second quarter of 2003 to the second quarter of 2004. The increase in salary expense for the second quarter of 2004 was 2.4% over the second quarter of 2003. A decrease in pension expense was offset by increases in other benefits. On an annualized basis, the ratio of total personnel expense (salaries and employee benefits) to average assets was 1.38% for the second quarter of 2004, 29 basis points less than the ratio for the Company’s peer group of 1.67% at March 31, 2004.
Occupancy expense was $699 thousand for the second quarter of 2004, a $71 thousand increase, or 11.3%, over the second quarter of 2003. The increase was primarily attributable to increases in rental expenses and utilities. Furniture and equipment expense was $695 thousand for the second quarter of 2004, a $51 thousand decrease, or 6.8%, below the second quarter of 2003. The decrease was primarily attributable to decreases in data processing expenses.
Other operating expense was $2.0 million for the second quarter of 2004, a decrease of $12 thousand, or 0.6%, from the second quarter of 2003. The decrease was the net effect of increases and decreases spread across a variety of areas of operating expense.
Income Taxes
Summary of Income Taxes
$2,121
$2,232
$(111)
(5.0)%
Effective Tax Rate
31.10%
31.95%
(0.85)%
(2.7)
The provisions for federal and state income taxes amounted to $2.1 million for the second quarter of 2004 and $2.2 million for the second quarter of 2003. The decrease in the effective tax rate was primarily attributable to an increase in the percentage holdings of tax exempt securities.
Six Months Ended June 30, 2004 Compared With
Six Months Ended June 30, 2003
Six Months Ending
$2
0.0%
(.09)%
17.62%
18.74%
(1.12)%
The Company reported earnings of $9.6 million for the first six months of 2004, an increase of $2 thousand from the first six months of 2003. Diluted earnings per share were $.95 for both six month periods. Included in net income are: (i) net securities gains, net of tax, of $126 thousand and $306 thousand for the respective 2004 and 2003 six month periods; (ii) net gains on the sale of loans to the secondary market of $67 thousand and $223 thousand, net of tax, for the respective 2004 and 2003 six month periods; (iii) a recovery related to the Company’s former Vermont operations of $46 thousand, net of tax, in the 2004 six month period; and, (iv) net gains on the sale of other real estate owned, net of tax, of $7 thousand in the 2003 six month period.
The following narrative discusses the six month to six month changes in net interest income, other income, other expense and income taxes.
$35,655
$36,935
$(1,280)
(3.5)%
(1,189)
(10.7)
$25,706
$25,797
$ (91)
(0.4)
162
14.3
$145,984
60,019
5.7
5.43%
6.00%
(0.57)%
(9.5)
(0.34)
(15.8)
(0.27)
(6.4)
The Company’s net interest income for the first six months of 2004, on a taxable equivalent basis, was $25.7 million, down $91 thousand, or 0.4%, from the first six months of 2003. Principally this was the result of a diministed net interest margin (net interest income on a tax-equivalent basis divided by average earning assets, annualized), which decreased significantly, from 4.19% to 3.92%, from the first six months of 2003 to the first six months of 2004. (See the discussion under “Use of Non-GAAP Financial Measures,” on page 13, regarding net interest income and net interest margin, which are commonly used non-GAAP financial measures.) The $146.0 million increase in average earning assets from the first six months of 2003 to the first six months of 2004, although significant, was not enough to offset the negative impact of the decrease in net interest margin on net interest income. The decrease in both net interest income and net interest margin between the comparable periods was significantly influenced by the long-term downward trend in prevailing interest rates, and the fact that, as the trend continued in 2003 and 2004, it had a disproportionate impact on earning assets as opposed to interest-bearing liabilities. This development was discussed previously in this Report under the sections entitled “Deposit Trends,” “Key Interest Rate Changes 1999-2004" and “Loan Trends.”
The provisions for loan losses were $539 thousand and $810 thousand for the six months ended June 30, 2004 and 2003, respectively. The provision for loan losses was discussed previously under the heading "Summary of the Allowance and Provision for Loan Losses."
$2,116
$ 1,794
$ 322
17.9%
270
8.1
(299)
(58.7)
(221)
(33.5)
$6,359
$6,287
$ 72
1.1
For the first six months of 2004, total other income included securities gains of $210 thousand on the sale of $20.0 million of securities available-for-sale (primarily U.S. agency securities). For the first six months of 2003, total other income included $509 thousand of net securities gains on the sale of $96.0 million of available-for-sale securities (again, primarily U.S. agency securities). The following table presents sales and purchases in the available-for-sale investment portfolio for the first six months of 2004 and 2003:
First Six Months
19,816
63,524
200
2,124
$20,016
$96,032
$210
$509
$ 40,712
88,936
36,925
111
818
5,857
1,577
$56,162
$168,968
The purchases of U.S. agency securities in the 2004 period represented a reinvestment of the proceeds from sales of agency securities late in the first quarter of 2004. The purchases of other mortgage-backed securities in 2004 were funded by normal cashflows from collateralized mortgage obligations and other mortgage-backed securities and a deployment of funds generated through resource growth.
During the first six months of 2004, the Company sold $5.3 million of newly originated low-rate residential real estate loans in the secondary market with net gains of $112 thousand. During the first six months of 2003, the Company sold $13.0 million of newly originated residential real estate loans in the secondary market, with net gains of $371 thousand. In each case, the gains were due, in part, to the fact that market interest rates on residential real estate loans kept falling during the period, but primarily to the fact that the Company was able to write loans with yields slightly higher than those required by the secondary market. Net gains on the sales of loans are included in other operating income in the table above.
Income from fiduciary activities totaled $2.1 million for the first six months of 2004, an increase of $322 thousand, or 17.9%, from the first six months of 2003. A principal cause of the increase was the increase in value of trust assets under administration and investment management, which itself reflected higher prices in the equity markets and significant new business. The market value of assets under trust administration and investment management at June 30, 2004, amounted to $783.2 million, an increase of $131.7 million, or 20.2%, from June 30, 2003.
In both periods, income from fiduciary activities includes income from funds under investment management in the Company-advised North Country Funds, which include the North Country Equity Growth Fund (NCEGX) and the North Country Intermediate Bond Fund (NCBDX). These funds had an aggregate market value of $135.4 million at June 30, 2004. The funds were introduced in March 2001, and are advised by the Company’s subsidiary, North Country Investment Advisers, Inc. Currently, the funds are held principally by qualified employee benefit plans, although the funds are also offered on a retail basis at most of the branch locations of the Company’s banking subsidiaries. Retail customers held $7.9 million in fund balances at June 30, 2004.
Fees for other services to customers (primarily service charges on deposit accounts, credit card merchant fee income, commissions on the sale of mutual funds and servicing income on sold loans) was $3.6 million for the first six months of 2004, an increase of $270 thousand, or 8.1%, from the 2003 first six months. The increase was primarily attributable to: i) increased sales of mutual funds; ii) merchant credit card fee income; and, iii) service charge income on deposit accounts.
Other operating income includes data processing servicing fee income received from one unaffiliated upstate New York bank, and net gains or losses on the sale of loans (discussed above), other real estate owned and other assets. In the 2004 period, other operating income also included a pre-tax $77 thousand recovery for the Company’s former Vermont operations. Apart from this gain and the net gain on the sale of loans, the remaining components of other operating income were down slightly from the first six months of 2004 compared to the first six months of 2003.
$ 9,583
$ 9,426
$ 157
1.7%
127
10.0
(28)
(2.0)
(35)
$16,299
$16,078
$221
0.25%
Other expense for the first six months of 2004 was $16.3 million, an increase of $221 thousand, or 1.4%, over the expense for the first six months of 2003. For the first six months of 2004, the Company's efficiency ratio was 51.11%. This ratio is a comparative measure of a financial institution's operating efficiency. The efficiency ratio (a ratio where lower is better) is the ratio of noninterest expense (excluding intangible asset amortization) to net interest income (on a tax-equivalent basis) and other income (excluding net securities gains or losses). See the discussion on page 13 of this report under the heading “Use of Non-GAAP Financial Measures.” The Company's efficiency ratio compares favorably to the March 31, 2004 peer group ratio of 62.03%, as set forth in the Federal Reserve Board's "Peer Holding Company Performance Reports." The Federal Reserve, in calculating banks’ effici ency ratios, excludes net securities gains or losses, but does not exclude intangible asset amortization from this calculation.
Salaries and employee benefits expense increased $157 thousand, or 1.7%, from the first six months of 2003 to the first six months of 2004. The increase in salary expense for the first six months of 2004 was 2.8% over the first six months of 2003. A decrease in pension expense was more than offset by increases in other benefits. On an annualized basis, the ratio of total personnel expense (salaries and employee benefits) to average assets was 1.39% for the first six months of 2004, 28 basis points less than the ratio for the Company’s peer group of 1.67% at March 31, 2004.
Occupancy expense was $1.4 million for the first six months of 2004, a $127 thousand increase, or 10.0%, over the first six months of 2003. The increase was primarily attributable to increases in rental expenses, depreciation and utilities. Furniture and equipment expense was $1.4 million for the first six months of 2004, a $28 thousand decrease, or 2.0%, below the first six months of 2003. The decrease was primarily attributable to decreases in data processing expenses.
Other operating expense was $3.9 million for the first six months of 2004, a decrease of $35 thousand, or 0.9%, from the first six months of 2003. The decrease was the net effect of increases and decreases spread across a variety of areas of operating expense.
$4,373
$4,506
$(133)
(3.0)%
31.38%
32.03%
(0.65)%
The provisions for federal and state income taxes amounted to $4.4 million for the first six months of 2004 and $4.5 million for the first six months of 2003. The decrease in the effective tax rate was primarily attributable to an increase in the percentage holdings of tax exempt securities.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
In addition to credit risk in the Company's loan portfolio and liquidity risk, discussed earlier, the Company's business activities also generate market risk. Market risk is the possibility that changes in the market for the Company's products and services, including changes in market rates or prices, will make the Company's position less valuable. The ongoing monitoring and management of market risk is an important component of the Company's asset/liability management process which is governed by policies that are reviewed and approved annually by the Board of Directors. The Board of Directors delegates responsibility for carrying out asset/liability oversight and control to management's Asset/Liability Committee ("ALCO"). In this capacity ALCO develops guidelines and strategies impacting the Company's asset/liability profile based upon estimated market risk sensitivity, policy limits and overall market interest rate le vels and trends. The Company has not made use of derivatives, such as interest rate swaps, in its risk management process.
Interest rate risk is the most significant market risk affecting the Company. Interest rate risk is the exposure of the Company's net interest income to changes in interest rates, assuming other variables affecting the Company's business are unchanged. Interest rate risk is directly related to the different maturities and repricing characteristics of interest-bearing assets and liabilities, as well as to prepayment risks (primarily for mortgage-related assets), early withdrawal of time deposits, and the fact that the speed and magnitude of responses to interest rate changes vary by product.
The ALCO utilizes the results of a detailed and dynamic simulation model to quantify the estimated exposure of net interest income to sustained interest rate changes. While ALCO routinely monitors simulated net interest income sensitivity over a rolling two-year horizon, it also utilizes additional tools to monitor potential longer-term interest rate risk.
The simulation model captures the impact of changing interest rates on the interest income received and interest expense paid on all interest-sensitive assets and liabilities reflected on the Company's consolidated balance sheet. This sensitivity analysis is compared to ALCO policy limits which specify a maximum tolerance level for net interest income exposure over a one year horizon, assuming no balance sheet growth and a 200 basis point upward and downward shift in interest rates, and assuming that interest-bearing assets and liabilities reprice at their earliest possible repricing date. Due to the low level of interest rates, the downward shift is currently calculated using only a 100 basis point decrease in interest rates. A parallel and pro rata shift in rates over a 12 month period is assumed.
The resulting sensitivity analyses reflects only a hypothetical circumstance involving modification of a single variable affecting our profitability and operations, that is, prevailing interest rates, and does not represent a forecast. As noted elsewhere in this report, the Federal Reserve Board took certain actions in recent years to bring about a decrease in prevailing short-term interest rates which initially had a positive effect on the Company's net interest income. One June 30, 2004 the Federal Reserve Board increased its primary credit rate by 25 basis points to 2.25%. Management believes there is some likelihood that rates will continue to rise later in 2004. A rising rate environment is, in the long-term, the most favorable interest rate scenario for the Company. However, at least in the immediately ensuing periods, rising rates may continue to have a negative impact on net interest margin due to the lag in earning asset repricing over interest-bearing liabilities.
The hypothetical estimates underlying the sensitivity analysis are based upon numerous assumptions including: the nature and timing of interest rate levels including yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment/replacement of asset and liability cash flows, and others. While assumptions are developed based upon current economic and local market conditions, management cannot make any assurance as to the predictive nature of these assumptions including how customer preferences or competitor influences might change. The inaccuracy of any of the assumptions use in the analysis may negatively affect the accuracy and validity of the analysis itself.
Also, as market conditions vary from those assumed in the sensitivity analysis, actual results will differ due to prepayment/refinancing levels likely deviating from those assumed, the varying impact of interest rate changes on caps or floors on adjustable rate assets, the potential effect of changing debt service levels on customers with adjustable rate loans, depositor early withdrawals and product preference changes, unanticipated shifts in the yield curve and other internal/external variables. Furthermore, the sensitivity analysis does not reflect actions that ALCO might take in responding to or anticipating changes in interest rates.
CONTROLS AND PROCEDURES
Senior management, including the Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of the Company's disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended) as of June 30, 2004. Based upon that evaluation, senior management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Company's disclosure controls and procedures were effective. Further, there were no changes made in the Company's internal control over financial reporting that occurred during the most recent fiscal quarter that materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.
PART II - OTHER INFORMATION
The Company is not involved in any material pending legal proceedings, other than ordinary routine litigation occurring in the normal course of its business.
Changes in Securities and Use of Proceeds
The following table presents information about purchases by the Company during the six months ended June 30, 2004 of equity securities that are registered by the Company pursuant to section 12 of the Securities Exchange Act of 1934 (i.e., the Company’s Common Stock):
Calendar Month
Total Number of
Shares Purchased3
Average Price
Per Share3
Shares Purchased as
Part of Publicly
Announced
Plans or Programs1
Maximum
Approximate Dollar
Value of Shares that
May Yet be
Purchased Under the
Plans or Programs2
January
10,279
$27.87
February
9,889
28.92
March
15,520
29.96
April
5,000,000
May
22,017
30.02
17,250
4,479,000
June
14,488
29.14
72,193
$29.37
1 All shares purchased during the period were market transactions. Prior to April 2004 (see Note 2) the last publicly announced plan or program to repurchase shares was a repurchase program authorized by the Board of Directors and announced in 1999. No shares remain for repurchase under that program.
2 At March 31, 2004, there were no shares remaining available for purchase by the Company under publicly announced plans or programs. On April 28, 2004, the Board of Directors approved a stock repurchase program authorizing the repurchase, at the discretion of senior management, of up to $5 million of the Company’s common stock over the ensuing twelve months in open market or negotiated transactions. This stock repurchase program (the “2004 Stock Repurchase Program”) was publicly announced in a press release on April 30, 2004.
3 The total number of shares purchased and the average price paid per share in the above table include shares purchased in open market transactions under the Arrow Financial Corporation Automatic Dividend Reinvestment Plan (the "Plan") by the administrator of the Plan. In accordance with the terms of the Plan, shares used to fund purchases under the Plan may either be acquired in the open market by the Plan administrator or issued directly by the Company. These shares totaled 14,627 in March and 14,488 in June.
Defaults Upon Senior Securities - None
At the Company's Annual Meeting of Shareholders held April 28, 2004, shareholders elected the following directors to the Class C of the Board of Directors. The voting results were as follows:
Director
Term
Expiring In
For
Withhold
Authority
Broker
Non-Votes
Jan-Eric O. Bergstedt
2007
8,193,825
110,730
Gary C. Dake
8,234,081
70,473
Mary-Elizabeth T. FitzGerald
8,198,615
105,940
Thomas L. Hoy
8,236,609
67,945
Item 5.
Other Information - None
Item 6.
(a) Exhibits:
Exhibit 31.1
Certification of Chief Executive Officer under SEC Rule 13a-14(a)/15d-14(a)
Exhibit 31.2
Certification of Chief Financial Officer under SEC Rule 13a-14(a)/15d-14(a)
Eshibit 32
Certification of Chief Executive Officer under 18 U.S.C. Section 1350 and
Certification of Chief Financial Officer under 18 U.S.C. Section 1350
(b) Reports on Form 8-K: The Current Report on Form 8-K dated July 20, 2004, which included information regarding the Company’s operating results for the second quarter ended June 30, 2004, is furnished herewith pursuant to Item 12.
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Registrant
Date: August 4, 2004
s/Thomas L. Hoy
Thomas L. Hoy, President and
Chief Executive Officer and Chairman of the Board
s/John J. Murphy
John J. Murphy, Executive Vice President,
Treasurer and Chief Financial Officer
(Principal Financial Officer and
Principal Accounting Officer)