UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2004 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ________________ to ________________ Commission file number 0-6233 1st SOURCE CORPORATION (Exact name of registrant as specified in its charter) INDIANA 35-1068133 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 100 North Michigan Street, South Bend, Indiana 46601 (Address of principal executive offices) (Zip Code) (574)235-2702 (Registrant's telephone number, including area code) Not Applicable (Former name, former address and former fiscal year, if changed since last report.) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No______ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes X No ______ Number of shares of common stock outstanding as of July 22, 2004 - 20,644,326 shares 1
TABLE OF CONTENTS PART I. FINANCIAL INFORMATION Page Item 1. Financial Statements (Unaudited) Consolidated statements of financial condition -- June 30, 2004, and December 31, 2003 3 Consolidated statements of income -- three months and six months ended June 30, 2004 and 2003 4 Consolidated statements of cash flows -- three months and six months ended June 30, 2004 and 2003 5 Notes to the Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 8 Item 3. Quantitative and Qualitative Disclosures About Market Risk 16 Item 4. Controls and Procedures 17 PART II. OTHER INFORMATION Item 1. Legal Proceedings 17 Item 2. Changes in Securities and Use of Proceeds 17 Item 3. Defaults Upon Senior Securities 17 Item 4. Submission of Matters to a Vote of Security Holders 17 Item 5. Other Information 18 Item 6. Exhibits and Reports on Form 8-K 18 SIGNATURES 19 2
<TABLE> <CAPTION> 1ST SOURCE CORPORATION CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (Unaudited - Dollars in thousands) June 30, December 31, 2004 2003 ------------------------------ <S> <C> <C> ASSETS Cash and due from banks $ 82,131 $ 109,787 Federal funds sold and interest bearing deposits with other banks 1,169 1,355 Investment securities, available-for-sale (amortized cost of $791,019 and $759,945 at June 30, 2004 and December 31, 2003, respectively) 782,525 763,763 Trading account securities 4,516 - Mortgages held for sale 66,296 60,215 Loans, net of unearned discount: Commercial and agricultural loans 426,933 402,905 Auto, light truck and environmental equipment 269,583 269,490 Medium and heavy duty truck 229,867 221,562 Aircraft financing 445,340 489,155 Construction equipment financing 213,609 219,562 Loans secured by real estate 551,058 533,749 Consumer loans 94,039 94,577 ------------------------------ Total loans 2,230,429 2,231,000 Reserve for loan losses (70,045) (70,045) ------------------------------ Net loans 2,160,384 2,160,955 Equipment owned under operating leases (net of accumulated depreciation) 56,186 70,305 Net premises and equipment 37,490 38,431 Accrued income and other assets 124,552 125,342 ------------------------------ Total assets $3,315,249 $3,330,153 ============================== LIABILITIES Deposits: Noninterest bearing $ 384,302 $ 396,026 Interest bearing 2,000,561 2,091,189 ------------------------------ Total deposits 2,384,863 2,487,215 Federal funds purchased and securities sold under agreements to repurchase 411,812 276,040 Other short-term borrowings 71,760 114,814 Long-term debt and mandatorily redeemable securities 22,901 22,802 Subordinated notes 56,444 56,444 Accrued expenses and other liabilities 52,533 58,147 ------------------------------ Total liabilities 3,000,313 3,015,462 SHAREHOLDERS' EQUITY Preferred stock; no par value - - Common stock; no par value 7,578 7,578 Capital surplus 214,001 214,001 Retained earnings 110,199 100,534 Cost of common stock in treasury (11,603) (9,777) Accumulated other comprehensive (loss)/income (5,239) 2,355 ------------------------------ Total shareholders' equity 314,936 314,691 ------------------------------ Total liabilities and shareholders' equity $3,315,249 $3,330,153 ============================== </TABLE> The accompanying notes are a part of the consolidated financial statements. 3
<TABLE> <CAPTION> 1ST SOURCE CORPORATION CONSOLIDATED STATEMENTS OF INCOME (Unaudited - Dollars in thousands, except per share amounts) Three Months Ended Six Months Ended June 30, June 30, ----------------------------------- ---------------------------------- 2004 2003 2004 2003 ----------------------------------- ---------------------------------- <S> <C> <C> <C> <C> Interest income: Loans $ 31,904 $ 36,103 $ 64,358 $ 72,713 Investment securities, taxable 4,106 4,710 8,395 9,244 Investment securities, tax-exempt 1,258 1,445 2,575 2,880 Other 46 295 111 445 ----------------------------------- ---------------------------------- Total interest income 37,314 42,553 75,439 85,282 Interest expense: Deposits 9,597 13,187 19,420 26,958 Short-term borrowings 1,283 1,498 2,540 2,762 Subordinated notes 962 941 1,923 1,881 Long-term debt and mandatorily redeemable securities 138 187 460 385 ----------------------------------- ---------------------------------- Total interest expense 11,980 15,813 24,343 31,986 ----------------------------------- ---------------------------------- Net interest income 25,334 26,740 51,096 53,296 Provision for loan losses 482 4,901 583 10,451 ----------------------------------- ---------------------------------- Net interest income after provision for loan losses 24,852 21,839 50,513 42,845 Noninterest income: Trust fees 3,140 2,736 6,230 5,376 Service charges on deposit accounts 4,115 3,922 7,821 7,646 Mortgage banking income 6,187 5,176 5,345 9,342 Equipment rental income 4,927 6,455 10,751 13,226 Other income 1,890 3,904 4,383 6,922 Investment securities and other investment losses (38) (275) (290) (555) ----------------------------------- ---------------------------------- Total noninterest income 20,221 21,918 34,240 41,957 ----------------------------------- ---------------------------------- Noninterest expense: Salaries and employee benefits 15,866 18,290 31,620 35,537 Net occupancy expense 1,725 1,785 3,558 3,649 Furniture and equipment expense 2,697 2,677 5,281 5,318 Depreciation - leased equipment 3,883 5,050 8,419 10,408 Supplies and communication 1,451 1,558 2,883 3,069 Loan collection and repossession expense 821 3,695 1,876 5,566 Other expense 5,502 4,220 10,650 8,530 ----------------------------------- ---------------------------------- Total noninterest expense 31,945 37,275 64,287 72,077 ----------------------------------- ---------------------------------- Income before income taxes 13,128 6,482 20,466 12,725 Income taxes 4,410 1,792 6,669 3,575 ----------------------------------- ---------------------------------- Net income $ 8,718 $ 4,690 $ 13,797 $ 9,150 =================================== ================================== Other comprehensive (loss)/income, net of tax: Change in unrealized appreciation (depreciation) of available-for-sale securities (9,503) 881 (7,594) 685 ----------------------------------- ---------------------------------- Total comprehensive (loss)/income $ (785) $ 5,571 $ 6,203 $ 9,835 =================================== ================================== Per common share: Basic net income per common share $ 0.42 $ 0.22 $ 0.67 $ 0.43 =================================== ================================== Diluted net income per common share $ 0.42 $ 0.22 $ 0.66 $ 0.43 =================================== ================================== Dividends $ 0.100 $ 0.090 $ 0.200 $ 0.180 =================================== ================================== Basic weighted average common shares outstanding 20,700,516 21,071,946 20,713,775 21,036,329 =================================== ================================== Diluted weighted average common shares outstanding 20,969,669 21,407,824 20,993,471 21,368,940 =================================== ================================== </TABLE> The accompanying notes are a part of the consolidated financial statements. 4
<TABLE> <CAPTION> 1ST SOURCE CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited - Dollars in thousands) Six Months Ended June 30, ------------------------ 2004 2003 ------------------------ <S> <C> <C> Operating activities: Net income $ 13,797 $ 9,150 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 583 10,451 Depreciation of premises and equipment 10,912 13,053 Amortization of investment security premiums and accretion of discounts, net 2,965 2,696 Amortization of mortgage servicing rights 3,832 3,846 Mortgage servicing asset impairment charges (553) 5,415 Deferred income taxes 513 (1,677) Realized investment securities losses 290 555 Change in mortgages held for sale (6,081) 20,916 Change in trading account securities (4,516) 43 Decrease in interest receivable 1,034 1,333 Decrease in interest payable (64) (376) Change in other assets (3,523) (173) Change in other liabilities (1,346) 2,068 Other 294 2,245 ----------- --------- Net cash from operating activities 18,137 69,545 Investing activities: Proceeds from sales and maturities of investment securities 126,466 70,119 Purchases of investment securities (160,794) (109,886) Net change in short-term investments 186 20,530 Loans sold or participated to others 0 49,403 Net change in loans (12) 24,785 Net change in equipment owned under operating leases 5,700 3,350 Purchases of premises and equipment (1,562) (994) ----------- --------- Net cash used/from investing activities (30,016) 57,307 Financing activities: Net change in demand deposits, NOW accounts and savings accounts (110,530) (33,292) Net change in certificates of deposit 8,178 (35,869) Net change in short-term borrowings 92,720 (52,385) Proceeds from issuance of long-term debt 415 694 Payments on long-term debt (166) (319) Acquisition of treasury stock (2,207) (370) Cash dividends (4,187) (3,783) ----------- --------- Net cash used in financing activities (15,777) (125,324) Net change in cash and cash equivalents (27,656) 1,528 Cash and cash equivalents, beginning of year 109,787 120,894 ----------- --------- Cash and cash equivalents, end of period $ 82,131 $ 122,422 =========== ========= </TABLE> The accompanying notes are a part of the consolidated financial statements. 5
1ST SOURCE CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Note 1. Basis of Presentation The accompanying unaudited consolidated financial statements reflect all adjustments (all of which are normal and recurring in nature) which are, in the opinion of management, necessary for a fair presentation of the consolidated financial position, the results of operations, and cash flows for the periods presented. These unaudited consolidated financial statements have been prepared according to the rules and regulations of the Securities and Exchange Commission (SEC) and, therefore, certain information and footnote disclosures normally included in financial statements prepared in accordance with U. S. generally accepted accounting principles have been omitted. The Notes to the Consolidated Financial Statements appearing in 1st Source Corporation's (1st Source) Annual Report on Form 10-K (2003 Annual Report), which include descriptions of significant accounting policies, should be read in conjunction with these interim financial statements. The balance sheet at December 31, 2003, has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by U. S. generally accepted accounting principles for complete financial statements. Certain amounts in the prior period consolidated financial statements have been reclassified to conform with the current year presentation. 1st Source accounts for its stock-based compensation plans under the recognition and measurement principles provided in Accounting Principles Board Opinion (APB) No. 25, "Accounting for Stock Issued to Employees," and related Interpretations. Stock-based employee compensation expense for the Executive Incentive Plan and the Restricted Stock Award Plan is recognized in net income. For the stock option plans, the stock option agreement, and the Employee Stock Purchase Plan, no compensation expense is recognized in net income as all options granted under these plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation," as amended by SFAS No.148, requires pro forma disclosures of net income and earnings per share for companies not adopting its fair value accounting method for stock-based employee compensation. The pro forma disclosures presented in Note 5 - Stock-Based Compensation use the fair value method of SFAS No. 123 to measure compensation expense for stock-based employee compensation plans. Note 2. Recent Accounting Pronouncements APPLICATION OF ACCOUNTING PRINCIPLES TO LOAN COMMITMENTS: SEC Staff Accounting Bulletin (SAB) No. 105, "Application of Accounting Principles to Loan Commitments," summarizes the views of the staff of the SEC regarding the application of generally accepted accounting principles to loan commitments accounted for as derivative instruments. SAB No. 105 provides that the fair value of recorded loan commitments that are accounted for as derivatives under Financial Accounting Standards Board (FASB)Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities," should not incorporate the expected future cash flows related to the associated servicing of the future loan. In addition, SAB No. 105 requires registrants to disclose their accounting policy for loan commitments. The provisions of SAB No. 105 must be applied to loan commitments accounted for as derivatives that are entered into after March 31, 2004. The adoption of this accounting standard did not have a material impact on 1st Source's financial statements. ACCOUNTING FOR STOCK-BASED COMPENSATION: On March 31, 2004, FASB issued the Exposure Draft, Share-Based Payment, which is a proposed amendment to FASB Statement No. 123, "Accounting for Stock-Based Compensation." In this draft, the 6
FASB formally proposed to require companies to recognize the fair value of stock options and other stock-based compensation to employees for future reporting periods in the income statement based on their fair values. The final standard is expected in late 2004 that would be effective for public companies (and certain nonpublic companies) that currently use the fair value method, rather than minimum value method, for recognition or disclosure purposes for fiscal years beginning after December 15, 2004. 1st Source is in the process of evaluating the impact of the exposure draft. Note 3. Reserve for Loan Losses The reserve for loan losses is maintained at a level believed to be adequate by management to absorb probable losses inherent in the loan portfolio. The determination of the reserve requires significant judgment reflecting management's best estimate of probable loan losses related to specifically identified loans as well as probable losses in the remainder of the various loan portfolios. The methodology for assessing the appropriateness of the reserve consists of several key elements, which include: specific reserves for identified special attention loans (substandard loans and leases and internal watch list credits), percentage allocations for special attention loans without specific reserves, formula reserves for each business lending division portfolio, including a higher percentage reserve allocation for special attention loans without a specific reserve, and reserves for pooled homogenous loans. Management's evaluation is based upon a continuing review of these portfolios, estimates of future customer performance, collateral values and dispositions and consideration of current economic trends, all of which are subject to judgment and will change. Note 4. Financial Instruments with Off-Balance-Sheet Risk To meet the financing needs of its customers, 1st Source and its subsidiaries are parties to financial instruments with off-balance-sheet risk in the normal course of business. These off-balance-sheet financial instruments include commitments to originate, purchase and sell loans and standby letters of credit. The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statements of financial condition. 1st Source's exposure to credit loss in the event of nonperformance by the other party to the financial instruments for loan commitments and standby letters of credit is represented by the dollar amount of those instruments. 1st Source uses the same credit policies and collateral requirements in making commitments and conditional obligations as it does for on-balance-sheet instruments. Trustcorp Mortgage Company and 1st Source Bank (Bank), subsidiaries of 1st Source, grant mortgage loan commitments to borrowers, subject to normal loan underwriting standards. The interest rate risk associated with these loan commitments is managed by entering into contracts for future deliveries of loans. Loan commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. The credit risk involved and collateral obtained in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers. As of June 30, 2004, and December 31, 2003, 1st Source had commitments outstanding to originate and purchase mortgage loans aggregating $179.11 million and $143.92 million, respectively. Outstanding commitments to sell mortgage 7
loans aggregated $106.28 million at June 30, 2004, and $99.53 million at December 31, 2003. Standby letters of credit totaled $98.39 million and $101.26 million at June 30, 2004, and December 31, 2003, respectively. Standby letters of credit have terms ranging from six months to one year. Note 5. Stock-Based Compensation The following pro forma information presents net income and earnings per share for the three and six month periods ended June 30, 2004, and 2003 as if the fair value method of SFAS No. 123, "Accounting for Stock-Based Compensation," as amended by SFAS No. 148, had been used to measure compensation cost for stock-based compensation plans. For the purposes of these pro forma disclosures, the estimated fair value of stock options and restricted stock awards is amortized to expense over the related vesting periods. <TABLE> <CAPTION> 3 Months ended 6 Months ended June 30 June 30 ------------------------------------------------------ 2004 2003 2004 2003 ---- ---- ---- ---- <S> <C> <C> <C> <C> Net income, as reported (000's) $ 8,718 $ 4,690 $13,797 $ 9,150 Add: Stock-based employee compensation expense included in reported net income, net of related tax effects 313 310 736 310 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (467) (442) (918) (479) -------- -------- -------- -------- Pro forma net income $ 8,564 $ 4,558 $13,615 $ 8,981 ========= ========= ======== ======== Earnings per share: Basic--as reported $0.42 $0.22 $0.67 $0.43 ===== ===== ===== ===== Basic--pro forma $0.42 $0.22 $0.66 $0.43 ===== ===== ===== ===== Diluted--as reported $0.42 $0.22 $0.66 $0.43 ===== ===== ===== ===== Diluted--pro forma $0.41 $0.21 $0.65 $0.42 ===== ===== ===== ===== </TABLE> ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Except for historical information contained herein, the matters discussed in this document express "forward-looking statements." Generally, the words "believe," "expect," "intend," "estimate," "anticipate," "project," "will" and similar expressions indicate forward-looking statements. Those statements, including statements, projections, estimates or assumptions concerning future events or performance, and other statements that are other than statements of historical fact, are subject to material risks and uncertainties. 1st Source cautions readers not to place undue reliance on any forward-looking statements, which speak only as of the date made. 1st Source may make other written or oral forward-looking statements from time to time. Readers are advised that various important factors could cause 1st Source's actual results or circumstances for future periods to differ materially from those anticipated or projected in such forward-looking statements. Such factors include, but are not limited to, changes in law, regulations or U. S. generally accepted accounting principles; 1st Source's competitive position within its markets served; increasing consolidation within the banking industry; unforeseen changes in interest rates; unforeseen changes in loan prepayment assumptions; unforeseen downturns in or major events affecting the local, regional or national economies or the industries in which 1st Source has credit concentrations; and other matters 8
discussed in 1st Source's filings with the SEC, including its Annual Report on Form 10-K for 2003, which filings are available from the SEC. 1st Source undertakes no obligation to publicly update or revise any forward-looking statements. The following management's discussion and analysis is presented to provide information concerning the financial condition of 1st Source as of June 30, 2004, as compared to December 31, 2003, and the results of operations for the three and six months ended June 30, 2004, and 2003. This discussion and analysis should be read in conjunction with 1st Source's consolidated financial statements and the financial and statistical data appearing elsewhere in this report and 1st Source's 2003 Annual Report. FINANCIAL CONDITION 1st Source's assets at June 30, 2004, were $3.32 billion, down 0.45% from December 31, 2003. Total loans remained stable and total deposits decreased 4.12% over the comparable figures at the end of 2003. Nonperforming assets at June 30, 2004, were $27.90 million compared to $36.83 million at December 31, 2003, a decrease of 24.25%. Nonperforming assets decreased due to a decrease in construction equipment and aircraft non-accrual loans and repossessed assets. At June 30, 2004, nonperforming assets were 1.22% of net loans and leases compared to 1.59% at December 31, 2003. Accrued income and other assets were as follows: (Dollars in Thousands) June 30, December 31, 2004 2003 ------------ ------------ Accrued income and other assets: Bank owned life insurance cash surrender value $ 33,001 $ 27,376 Accrued interest receivable 12,507 13,541 Mortgage servicing assets 23,587 24,324 Other real estate 2,767 4,625 Repossessions 3,222 6,229 Intangible assets 24,903 25,740 All other assets 24,565 23,507 ------------ ------------ Total accrued income and other assets $ 124,552 $ 125,342 ============ ============ CAPITAL As of June 30, 2004, total shareholders' equity was $314.94 million, up 0.08% from the $314.69 million at December 31, 2003. In addition to net income of $13.80 million, other significant changes in shareholders' equity during the first six months of 2004 included $2.21 million in treasury stock purchases, and $4.19 million of dividends paid. The accumulated other comprehensive income component of shareholders' equity totaled ($5.24) million at June 30, 2004, compared to $2.36 million at December 31, 2003. The decrease in accumulated other comprehensive income was a result of changes in unrealized gain or loss on securities in the available-for-sale portfolio. The 1st Source equity-to-assets ratio was 9.50% as of June 30, 2004, compared to 9.45% at December 31, 2003. Book value per common share rose to $15.26 at June 30, 2004, up from $15.19 at December 31, 2003. 1st Source declared and paid dividends per common share of $0.10 during the second quarter of 2004. The trailing four quarter dividend payout ratio was 34.21%. The dividend payout is continually reviewed by management and the Board of Directors. 9
The banking regulators have established guidelines for leverage capital requirements, expressed in terms of Tier 1 or core capital as a percentage of average assets, to measure the soundness of a financial institution. These guidelines require all banks to maintain a minimum leverage capital ratio of 4.00% for adequately capitalized banks and 5.00% for well-capitalized banks. 1st Source's leverage capital ratio was 10.83% at June 30, 2004. The Federal Reserve Board has established risk-based capital guidelines for U.S. banking organizations. The guidelines establish a conceptual framework calling for risk weights to be assigned to on and off-balance sheet items in arriving at risk-adjusted total assets, with the resulting ratio compared to a minimum standard to determine whether a bank has adequate capital. The minimum standard risk-based capital ratios effective in 2004 are 4.00% for adequately capitalized banks and 6.00% for well-capitalized banks for Tier 1 risk-based capital and 8.00% and 10.00%, respectively, for total risk-based capital. 1st Source's Tier 1 risk-based capital ratio on June 30, 2004, was 13.07% and the total risk-based capital ratio was 14.35%. LIQUIDITY AND INTEREST RATE SENSITIVITY The Bank's liquidity is monitored and closely managed by the Asset/Liability Committee (ALCO), whose members are comprised of the Bank's senior management. Asset and liability management includes the management of interest rate sensitivity and the maintenance of an adequate liquidity position. The purpose of interest rate sensitivity management is to stabilize net interest income during periods of changing interest rates. Liquidity management is the process by which the Bank ensures that adequate liquid funds are available to meet financial commitments on a timely basis. Financial institutions must maintain liquidity to meet day-to-day requirements of depositors and borrowers, take advantage of market opportunities and provide a cushion against unforeseen needs. Liquidity of the Bank is derived primarily from core deposits, principal payments received on loans, the sale and maturity of investment securities, net cash provided by operating activities, and access to other funding sources. The most stable source of liability funded liquidity is deposit growth and retention of the core deposit base. The principal sources of asset funded liquidity are available-for-sale investment securities, cash and due from banks, federal funds sold, securities purchased under agreements to resell and loans and interest bearing deposits with other banks maturing within one year. Additionally, liquidity is provided by bank lines of credit, repurchase agreements and the ability to borrow from the Federal Reserve Bank and Federal Home Loan Bank. Close attention is given to various interest rate sensitivity gaps and interest rate spreads. Maturities of rate sensitive assets are relative to the maturities of rate sensitive liabilities and interest rate forecasts. At June 30, 2004, the consolidated statement of financial condition was rate sensitive by $83.2 million more liabilities than assets scheduled to reprice within one year or approximately 0.95%. RESULTS OF OPERATIONS Net income for the three and six month periods ended June 30, 2004, was $8.72 million and $13.80 million respectively, compared to $4.69 million and $9.15 million for the same periods in 2003. Diluted net income per common share was $0.42 and $0.66 respectively, for the three and six month periods ended June 30, 2004, compared to $0.22 and $0.43 for the same periods in 2003. Return on average common shareholders' equity was 8.73% for the six months ended June 30, 2004, compared to 5.88% in 2003. The return on total average assets was 0.85% for the six months ended June 30, 2004, compared to 0.56% in 2003. 10
The increase in net income for the six months ended June 30, 2004, over the first six months of 2003, was primarily the result of a $9.87 million decrease in the provision for loan losses and a $7.79 million decrease in noninterest expense offset by a $2.20 million decrease in net interest income and a $7.72 million decrease in noninterest income. Details of the changes in the various components of net income are further discussed below. NET INTEREST INCOME The taxable equivalent net interest income for the three months ended June 30, 2004, was $26.02 million, a decrease of 5.41% over the same period in 2003. The net interest margin on a fully taxable equivalent basis was 3.45% for the three months ended June 30, 2004, compared to 3.66% for the three months ended June 30, 2003. The taxable equivalent net interest income for the six month period ended June 30, 2004, was $52.49 million, a decrease of 4.24% over 2003, resulting in a net yield of 3.49%, compared to 3.69% for the same period in 2003. The impact on net interest margin on a fully taxable equivalent basis due to the recognition of fees on loans over the life of the loans was a reduction of eleven basis points for the six months ended June 30, 2004. Total average earning assets increased 0.56% and 0.93%, respectively, for the three and six month periods ended June 30, 2004, over the comparative periods in 2003. Average loan outstandings increased 3.74% and 2.97% for the three and six month periods, compared to the same periods in 2003, due primarily to increased loan outstandings in commercial loans secured by aircraft as a result of the fourth quarter 2003 purchase of the securitized aircraft loan portfolio, which was offset by continued runoff in other areas of this loan category and in the construction equipment portfolio. Total average investment securities increased 10.11% and 11.48% for the three and six month periods over one year ago due to an increase in United States agency, municipal and mortgage-backed securities. For the six month period, average mortgages held for sale decreased 44.67%, as demand for mortgage loans was lower in 2004 due to the increased mortgage rate environment. Other investments, which include federal funds sold, time deposits with other banks and trading account securities, decreased for the three and six month periods over 2003 as excess funds were used to purchase loans from the securitization facility. The taxable equivalent yields on total average earning assets were 5.04% and 5.77% for the three month periods ended June 30, 2004 and 2003, respectively, and 5.11% and 5.84% for the six month periods ended June 30, 2004 and 2003, respectively. Average interest bearing deposits decreased 7.20% and 6.73% for the three and six month periods, respectively, over the same periods in 2003. The rate on average interest-bearing deposits was 1.89% and 2.41% for the three month periods ended June 30, 2004 and 2003, and 1.91% and 2.48% for the six month periods ended June 30, 2004 and 2003, respectively, due to a decrease in public funds and brokered deposits. These higher cost deposits were not pursued due to lower funding needs. The rates on average interest-bearing funds were 1.94% and 2.54% for the three months ended June 30, 2004 and 2003, respectively. For the six months ended June 30, 2004 and 2003, the rates on average interest bearing funds were 1.96% and 2.57%, respectively. The following table sets forth consolidated information regarding average balances and rates. 11
<TABLE> <CAPTION> DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY INTEREST RATES AND INTEREST DIFFERENTIAL (Dollars in thousands) Three months ended June 30, 2004 2003 -------------------------------------- ----------------------------------------- Interest Interest Average Income/ Yield/ Average Income/ Yield/ Balance Expense Rate Balance Expense Rate -------------------------------------- ----------------------------------------- <S> <C> <C> <C> <C> <C> <C> ASSETS: Investment securities: Taxable $ 569,776 $ 4,106 2.90% $ 504,209 $ 4,710 3.75% Tax exempt (1) 168,124 1,870 4.47% 165,963 2,136 5.16% Mortgages held for sale 77,051 1,072 5.60% 137,651 2,141 6.24% Net loans (2 & 3) 2,191,348 30,901 5.67% 2,112,247 34,035 6.46% Other investments 23,945 46 0.77% 93,379 295 1.27% -------------------------------------- ----------------------------------------- Total earning assets 3,030,244 37,995 5.04% 3,013,449 43,317 5.77% Cash and due from banks 78,131 91,161 Reserve for loan losses (70,077) (62,976) Other assets 219,497 257,936 ---------------- ---------------- Total $ 3,257,795 $ 3,299,570 ================ ================ LIABILITIES AND SHAREHOLDERS' EQUITY: Interest bearing deposits $ 2,038,843 $ 9,597 1.89% $ 2,196,936 $13,187 2.41% Short-term borrowings 371,522 1,283 1.39% 231,971 1,498 2.59% Subordinated notes 56,444 962 6.85% 54,750 941 6.89% Long-term debt and mandatorily redeemable securities 23,091 138 2.40% 17,305 187 4.33% -------------------------------------- ----------------------------------------- Total interest bearing liabilities 2,489,900 11,980 1.94% 2,500,962 15,813 2.54% Noninterest bearing deposits 393,282 428,384 Other liabilities 56,808 54,291 Shareholders' equity 317,805 315,933 ---------------- ---------------- Total $ 3,257,795 $ 3,299,570 ================ ================ ----------- ------------- Net interest income $26,015 $27,504 =========== ============= Net yield on earning assets on a taxable equivalent basis ----------- ------------ 3.45% 3.66% =========== ============ </TABLE> <TABLE> <CAPTION> DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY INTEREST RATES AND INTEREST DIFFERENTIAL (Dollars in thousands) Six months ended June 30, 2004 2003 ----------------------------------------- ------------------------------------ Interest Interest Average Income/ Yield/ Average Income/ Yield/ Balance Expense Rate Balance Expense Rate ---------------------------------------- ------------------------------------ <S> <C> <C> <C> <C> <C> <C> ASSETS: Investment securities: Taxable $ 569,705 $ 8,395 2.96% $ 498,345 $ 9,244 3.74% Tax exempt (1) 169,647 3,827 4.54% 164,870 4,250 5.20% Mortgages held for sale 72,747 1,979 5.47% 131,480 3,844 5.90% Net loans (2 & 3) 2,195,194 62,521 5.73% 2,131,930 69,019 6.53% Other investments 15,894 111 1.40% 68,600 445 1.31% ------------------------------------- ---------------------------------------- Total earning assets 3,023,187 76,833 5.11% 2,995,225 86,802 5.84% Cash and due from banks 77,703 88,583 Reserve for loan losses (70,109) (62,038) Other assets 223,396 265,026 ---------------- ------------- Total $ 3,254,177 $ 3,286,796 ================ ============= LIABILITIES AND SHAREHOLDERS' EQUITY: Interest bearing deposits $ 2,046,342 $19,420 1.91% $ 2,194,050 $ 26,958 2.48% Short-term borrowings 376,108 2,540 1.36% 242,411 2,762 2.30% Subordinated notes 56,444 1,923 6.85% 54,750 1,881 6.93% Long-term debt and mandatorily redeemable securities 23,076 460 4.01% 17,400 385 4.46% ------------------------------------- ---------------------------------------- Total interest bearing liabilities 2,501,970 24,343 1.96% 2,508,611 31,986 2.57% Noninterest bearing deposits 376,617 410,223 Other liabilities 57,902 54,075 Shareholders' equity 317,688 313,887 ---------------- ------------- Total $ 3,254,177 $ 3,286,796 ================ ============= ------------ -------------- Net interest income $52,490 $ 54,816 ============ ============== Net yield on earning assets on a taxable equivalent basis --------- --------- 3.49% 3.69% ========= ========= </TABLE> (1) Interest income includes the effects of taxable equivalent adjustments, using a 35% rate. Tax equivalent adjustments for the three month period were $612 in 2004 and $691 in 2003 and for the six month period were $1,252 in 2004 and $1,370 in 2003. (2) Loan income includes fees on loans for the three month period of $503 in 2004 and $1,378 in 2003 and for the six month period of $1,329 in 2004 and $2,574 in 2003. Loan income also includes the effects of taxable equivalent adjustments, using 35% rate for 2004 and 2003. The tax equivalent adjustments for the three month period were $69 in 2004 and $73 in 2003 and for the six month period were $142 in 2004 and $150 in 2003. (3) For purposes of this computation, nonaccruing loans are included in the daily average loan amounts outstanding. 12
PROVISION AND RESERVE FOR LOAN LOSSES The provision for loan losses for the three month periods ended June 30, 2004 and 2003 was $0.48 million and $4.90 million, respectively, and $0.58 million and $10.45 million for the six month periods ended June 30, 2004 and 2003, respectively. Net charge-offs of $0.48 million were recorded for the second quarter 2004, compared to $3.55 million for the same quarter a year ago. Year-to-date net charge-offs of $0.58 million have been recorded in 2004, compared to net charge-offs of $6.48 million through June 2003. In the second quarter 2004, 1st Source continued to experience moderate improvement in credit quality. Loan delinquencies were 0.64% on June 30, 2004, as compared to 1.51% on June 30, 2003, and 1.04% at the end of 2003. Second quarter 2004 net charge-offs decreased as compared to second quarter 2003. The reserve for loan losses as a percentage of loans outstanding at the end of the period was 3.14% as compared to 3.01% one year ago and 3.14% at December 31, 2003. A summary of loan loss experience during the three and six month periods ended June 30, 2004 and 2003, is provided below. <TABLE> <CAPTION> Summary of Reserve for Loan Losses ------------------------------------------------------------------------- (Dollars in Thousands) Three Months Ended Six Months Ended June 30, June 30, ------------------------------------------------------------------------- 2004 2003 2004 2003 ----------------- ----------------- -------------- -------------- <S> <C> <C> <C> <C> Reserve for loan losses - beginning balance $ 70,045 $ 61,843 $ 70,045 $ 59,218 Charge-offs (2,854) (4,453) (4,427) (8,123) Recoveries 2,372 903 3,844 1,648 ----------------- ----------------- -------------- -------------- Net charge-offs (482) (3,550) (583) (6,475) Provision for loan losses 482 4,901 583 10,451 ----------------- ----------------- -------------- -------------- Reserve for loan losses - ending balance $ 70,045 $ 63,194 $ 70,045 $ 63,194 ================= ================= ============== ============== Loans outstanding at end of period $ 2,230,429 $ 2,098,788 $ 2,230,429 $ 2,098,788 Average loans outstanding during period 2,191,348 2,112,247 2,195,194 2,131,930 Reserve for loan losses as a percentage of loans outstanding at end of period 3.14% 3.01% 3.14% 3.01% Ratio of net charge-offs during period to average loans outstanding 0.09% 0.67% 0.05% 0.61% </TABLE> NONPERFORMING ASSETS Nonperforming assets were as follows: (Dollars in thousands) June 30, December 31, June 30, 2004 2003 2003 --------- ------------- --------- Loans past due 90 days or more $ 164 $ 212 $ 289 Nonaccrual and restructured loans 22,210 27,085 41,930 Other real estate 2,184 3,010 3,213 Repossessions 3,222 6,263 12,583 Equipment owned under operating leases 118 257 168 --------- ------------- --------- Total nonperforming assets $ 27,898 $ 36,827 $ 58,183 ========= ============= ========= 13
Nonperforming assets totaled $27.90 million at June 30, 2004, decreasing 24.25% from $36.83 million at December 31, 2003 and decreasing 52.05% from $58.18 million at June 30, 2003. The decrease during the second quarter 2004 was primarily related to a decrease in aircraft and construction equipment nonaccrual loans and liquidation of repossessions. Nonperforming assets as a percentage of total loans and leases improved to 1.22% at June 30, 2004, from 1.59% at December 31, 2003 and 2.65% at June 30, 2003. As of June 30, 2004, the Bank had a $4.00 million standby letter of credit outstanding which supported bond indebtedness of a customer. Due to the current financial condition of the customer, if this standby letter of credit is funded, the Bank likely will foreclose on the real estate securing the customer's reimbursement obligation. This likely will result in an increase in other real estate for approximately the same amount as the funding. Repossessions continue to consist primarily of aircraft and aircraft parts, $2.62 million of the $3.22 million as of June 30, 2004. These aircraft and related equipment have primarily come from defaulted loans to air cargo operators and aircraft dealers. There are also automobiles, light trucks, construction equipment and environmental equipment in repossessed assets at June 30, 2004. At the time of repossession, the recorded amount of the loan is written down, if necessary, to the estimated value of the equipment or vehicle by a charge to the reserve for loan losses, unless the equipment is in the process of immediate sale. Any subsequent write-downs are included in noninterest expense. Repossessed assets are valued by the loan and credit officers of the Bank or, in certain circumstances, an independent third party. The estimated value generally is determined on an orderly liquidation basis and is based on a variety of available sources. These sources typically include vehicle and equipment dealers, valuation guides and other third parties, including appraisers. A number of variables can lead to a decrease in value after the asset is repossessed. These include deterioration in the market value, discovery of new or additional information about the asset, and validity or invalidity of other liens against the asset. Valuation adjustments and net losses upon disposition of repossessions for the three month period ended June 30, 2004, totaled $0.24 million as compared to the valuation adjustments and net losses for the three month period ended June 30, 2003, of $2.50 million, respectively, and $0.38 million and $2.72 million for the six month periods ended June 30, 2004 and 2003, respectively. <TABLE> <CAPTION> Supplemental Loan Information as of June 30, 2004 (Dollars in thousands) Other real estate Year-to-date Loan and net credit losses/ outstandings Nonaccrual repossessions recoveries -------------- ------------- ----------------- ---------------- <S> <C> <C> <C> <C> Commercial and agricultural loans $ 426,933 $ 2,191 $ - $ (200) Auto, light truck, and environmental equipment 269,583 3,256 169 317 Medium & heavy duty truck 229,867 1,007 - 348 Aircraft financing 445,340 10,764 2,622 52 Construction equipment financing 213,609 3,278 381 4 Loans secured by real estate 551,058 1,422 2,184 114 Consumer loans 94,039 292 50 328 -------------- ------------- ----------------- ---------------- Total $2,230,429 $ 22,210 $ 5,406 $ 963 ============== ============= ================= ================ </TABLE> 14
For financial statements purposes, nonaccrual loans are included in loan outstandings, whereas repossessions and other real estate are included in other assets. Net credit losses include net charge-offs on loans and valuation adjustments and gains and losses on disposition of repossessions and defaulted operating leases. NONINTEREST INCOME Noninterest income for the three month periods ended June 30, 2004 and 2003 was $20.22 million and $21.92 million, respectively, and $34.24 million and $41.96 million for the six month periods ended June 30, 2004 and 2003, respectively. The predominant factor behind the decrease in 2004 was a reduction in mortgage banking income. <TABLE> <CAPTION> (Dollars in Thousands) Three Months Ended Six Months Ended June 30, June 30, ------------------------ ---------------------- 2004 2003 2004 2003 <S> <C> <C> <C> <C> Noninterest income: Trust fees $ 3,140 $ 2,736 $ 6,230 $ 5,376 Service charges on deposit accounts 4,115 3,922 7,821 7,646 Mortgage banking income 6,187 5,176 5,345 9,342 Insurance commissions 763 616 1,725 1,428 Equipment rental income 4,927 6,455 10,751 13,226 Securitization income - 922 - 1,597 Other income 1,127 2,366 2,658 3,897 Investment securities and other investment losses (38) (275) (290) (555) ----------- ----------- ---------- ----------- Total noninterest income $ 20,221 $ 21,918 $ 34,240 $ 41,957 =========== =========== ========== =========== </TABLE> Mortgage banking income fluctuations were due to changes in origination volumes, gains on sales of loans in the secondary market, and mortgage servicing rights valuation impairment/recoveries. For the three months ended June 30, 2004, mortgage banking income increased over the same period in 2003 due to mortgage servicing rights impairment recovery of $3.78 million in the second quarter of 2004 versus $3.64 million of mortgage servicing rights impairment for the same period in 2003. For the six months ended June 30, 2004, mortgage servicing rights impairment recovery was $0.55 million versus $5.42 million of impairment for the same period in 2003. Additionally, impairment of $0.50 was determined to be unrecoverable and was recorded as a direct write-down to the carrying value of the asset. For both the three and six month periods ending June 30, 2004, mortgage banking income was negatively impacted by reduced origination volumes and decreased gains on sales of loans into the secondary market versus the same periods in 2003. Trust fees, insurance commissions and service charges on deposit accounts increased in both the three and six month periods ended June 30, 2004 over the same periods in 2003. Trust fees increased due to growth in assets under management and improvement in the equity markets. Insurance commissions increased due to growth in commercial lines and higher premiums, while an increase in income from consumer overdraft fees caused service charges on deposit accounts to rise. Equipment rental income decreased for both the three and six month periods ended June 30, 2004, over the same periods in 2003 due to the decrease in the operating lease portfolio, while securitization income was eliminated in 2004 as 1st Source no longer has loans securitized. Other income decreased due to decreased trading security income. 15
NONINTEREST EXPENSE Noninterest expense for the three month periods ended June 30, 2004 and 2003 was $31.95 million and $37.28 million, respectively, and $64.29 million and $72.08 million for the six month periods ended June 30, 2004 and 2003, respectively. The decrease in noninterest expense in 2004 was primarily due to decreased salaries and employee benefits, decreased loan collection and repossession expense, offset by increased professional fees. <TABLE> <CAPTION> (Dollars in Thousands) Three Months Ended Six Months Ended June 30, June 30, ------------------------ ------------------------ 2004 2003 2004 2003 <S> <C> <C> <C> <C> Noninterest expense: Salaries and employee benefits $ 15,866 $ 18,290 $ 31,620 $ 35,537 Net occupancy expense 1,725 1,785 3,558 3,649 Furniture and equipment expense 2,697 2,677 5,281 5,318 Depreciation - leased equipment 3,883 5,050 8,419 10,408 Professional fees 2,405 669 3,966 1,289 Supplies and communication 1,451 1,558 2,883 3,069 Business development and marketing expense 1,023 854 1,655 1,563 Intangible asset amortization 657 647 1,315 1,441 Loan collection and repossession expense 821 3,695 1,876 5,566 Other 1,417 2,050 3,714 4,237 ----------- ----------- ---------- ----------- Total noninterest expense $ 31,945 $ 37,275 $ 64,287 $ 72,077 =========== =========== ========== =========== </TABLE> Salaries and employee benefits decreased on a year-over-year basis caused primarily by the capitalization of $2.87 million in salaries and benefits in connection with the deferral of loan origination costs in 2004. Decreased mortgage commissions also contributed to the decrease in salaries and employee benefits. These decreases were partially offset by higher executive incentive accruals and increased group insurance costs. Second quarter and year-to-date net occupancy expense, furniture and equipment expense, supplies and communication, and business development and marketing expense and intangible asset amortization, all remained comparable to 2003 levels. Leased equipment depreciation decreased due to the decrease in the operating lease portfolio. Loan collection and repossession expense decreased as valuation adjustments and other expenses related to repossessed assets decreased. Professional fees increased due to increased legal fees relating, in part, to the lawsuit described in the 2003 Form 10-K Item 3, Legal Proceedings. Other expenses decreased primarily due to gains on the disposition of leased equipment. INCOME TAXES 1st Source recognized income tax expense for the three and six months ended June 30, 2004, of $4.41 million and $6.67 million, for effective rates of 33.59% and 32.59%, compared to $1.79 million and $3.58 million, for effective rates of 27.65% and 28.09%, for the three and six months ended June 30, 2003. The effective income tax rate rose as a result of the increase in pretax income. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK There have been no material changes in market risks faced by 1st Source since December 31, 2003. For information regarding 1st Source's market risk, refer to 1st Source's Annual Report on Form 10-K for the year ended December 31, 2003. 16
ITEM 4. CONTROLS AND PROCEDURES 1st Source carried out an evaluation, under the supervision and with the participation of 1st Source's management, including 1st Source's Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of 1st Source's disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, at June 30, 2004, 1st Source's disclosure controls and procedures are effective in accumulating and communicating to management (including such officers) the information relating to 1st Source (including its consolidated subsidiaries) required to be included in 1st Source's periodic SEC filings. PART II. OTHER INFORMATION ITEM 1. Legal Proceedings. 1st Source reported in its Form 10-K filed February 19, 2004, on an adversary proceeding filed against the Bank by Airmotive, Inc., by and through the Official Unsecured Creditor's Committee of Airmotive, Inc. Discovery remains ongoing in this proceeding and management expects that discovery will conclude later in 2004 and that a trial of the proceeding will be scheduled sometime during 2005. ITEM 2. Changes in Securities and Use of Proceeds <TABLE> <CAPTION> ISSUER PURCHASES OF EQUITY SECURITIES (a) (b) (c) (d) Total number of Maximum number (or approximate Total number Average shares purchased dollar value) of shares of shares price paid per as part of publicly announced that may yet be purchased under Period purchased share plans or programs (1) the plans or programs - ----------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> April 01 - 30, 2004 0 0 0 855,785 May 01 - 31, 2004 103,733 21.54 103,733 752,052 June 01 - 30, 2004 0 0 0 752,052 </TABLE> (1) 1st Source maintains a stock repurchase plan that was authorized by the Board of Directors on October 23, 2001. Under the terms of the plan, 1st Source may repurchase up to 1,038,990 shares of its common stock when favorable conditions exist on the open market or through private transactions at various prices from time to time. Since the inception of the plan, 1st Source has repurchased a total of 286,938 shares. ITEM 3. Defaults Upon Senior Securities. None ITEM 4. Submission of Matters to a Vote of Security Holders. The following actions were taken by the shareholders of 1st Source at the annual shareholders' meeting held April 28, 2004: 1. Election of Directors The directors named below were elected to the board of directors for terms expiring in April 2006, as follows: 17
Nominee Votes For Votes Withheld - ------- --------- -------------- Terry L. Gerber 20,143,683 184,824 Craig A. Kapson 20,142,927 186,256 John T. Phair 20,143,683 180,020 Mark D. Schwabero 20,140,108 160,057 The directors named below were re-elected to the board of directors for terms expiring in April 2007, as follows: Nominee Votes For Votes Withheld - ------- --------- -------------- David C. Bowers 20,140,108 186,047 Daniel B. Fitzpatrick 20,140,094 206,504 Wellington D. Jones III 20,143,377 163,035 Dane A. Miller 20,143,671 178,984 Toby S. Wilt 20,143,683 184,274 In addition, the following directors continued in office after the 2004 annual meeting: Terms Expiring in April 2005: Terms Expiring in April 2006: Lawrence E. Hiler William P. Johnson Rex Martin Christopher J. Murphy III Timothy K. Ozark 2. Reapproval of 1998 Performance Compensation Plan Material Terms Reapproval of material items of the 1998 Performance Compensation Plan in accordance with Section 162(m) of the Internal Revenue Code of 1986, as amended, was approved, as follows: Votes in Favor Votes Against Abstentions - -------------- ------------- ----------- 19,828,355 311,645 178,291 ITEM 5. Other Information. None ITEM 6. Exhibits and Reports on Form 8-K. (a) The following exhibits are filed with this report: 1. Exhibit 31.1 Certification of Chief Executive Officer required by Rule 13a-14(a). 2. Exhibit 31.2 Certification of Chief Financial Officer required by Rule 13a-14(a). 3. Exhibit 32.1 Certification pursuant to 18 U.S.C. Section 1350 of Chief Executive Officer. 4. Exhibit 32.2 Certification pursuant to 18 U.S.C. Section 1350 of Chief Financial Officer. 18
(b) Reports on Form 8-K. A report on Form 8-K, dated April 27, 2004, was filed under report item number 7 and 12, concerning 1st Source's results of operations for the first quarter ended March 31, 2004. A report on Form 8-K, dated April 28, 2004, was filed under report item number 5 and 7, concerning the election of new members to the 1st Source Board. SIGNATURES 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. 1st Source Corporation DATE July 29, 2004 /s/Christopher J. Murphy III ------------- ------------------------------------ Christopher J. Murphy III Chairman of the Board, President and CEO DATE July 29, 2004 /s/Larry E. Lentych ------------- ------------------------------------- Larry E. Lentych Treasurer and Chief Financial Officer Principal Accounting Officer 19