City Holding Company - 10-Q quarterly report FY

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

For The Quarterly Period Ended June 30, 2006

OR

For The Transition Period From ____________To_____________.

Indicate by check mark whether the registrant has (1) 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.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical date.

Common stock, $2.50 Par Value - 17,565,971 shares as of August 7, 2006.

All statements other than statements of historical fact included in this Quarterly Report on Form 10-Q, including statements in Management’s Discussion and Analysis of Financial Condition and Result of Operations are, or may be deemed to be, forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Such information involves risks and uncertainties that could result in the Company’s actual results differing from those projected in the forward-looking statements. Important factors that could cause actual results to differ materially from those discussed in such forward-looking statements include, but are not limited to: (1) the Company may incur additional provision for loan losses due to negative credit quality trends in the future that may lead to a deterioration of asset quality; (2) the Company may incur increased charge-offs in the future; (3) the Company may experience increases in the default rates on previously securitized loans that would result in impairment losses or lower the yield on such loans; (4) the Company may continue to benefit from strong recovery efforts on previously securitized loans resulting in improved yields on this asset; (5) the Company could have adverse legal actions of a material nature; (6) the Company may face competitive loss of customers; (7) the Company may be unable to manage its expense levels; (8) the Company may have difficulty retaining key employees; (9) changes in the interest rate environment may have results on the Company’s operations materially different from those anticipated by the Company’s market risk management functions; (10) changes in general economic conditions and increased competition could adversely affect the Company’s operating results; (11) changes in other regulations and government policies affecting bank holding companies and their subsidiaries, including changes in monetary policies, could negatively impact the Company’s operating results; and (12) the Company may experience difficulties growing loan and deposit balances. Forward-looking statements made herein reflect management’s expectations as of the date such statements are made. Such information is provided to assist stockholders and potential investors in understanding current and anticipated financial operations of the Company and is included pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances that arise after the date such statements are made.

 

 

 

 

 

 

The accompanying consolidated financial statements, which are unaudited, include all of the accounts of City Holding Company (“the Parent Company”) and its wholly-owned subsidiaries (collectively, “the Company”). All material intercompany transactions have been eliminated. The consolidated financial statements include all adjustments that, in the opinion of management, are necessary for a fair presentation of the results of operations and financial condition for each of the periods presented. Such adjustments are of a normal recurring nature. The results of operations for the six months ended June 30, 2006 are not necessarily indicative of the results of operations that can be expected for the year ending December 31, 2006. The Company’s accounting and reporting policies conform with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Such policies require management to make estimates and develop assumptions that affect the amounts reported in the consolidated financial statements and related footnotes. Actual results could differ from management’s estimates.

The consolidated balance sheet as of December 31, 2005 has been extracted from audited financial statements included in the Company’s 2005 Annual Report to Stockholders. Certain information and footnote disclosures normally included in the annual financial statements prepared in accordance with U.S. generally accepted accounting principles have been omitted. These financial statements should be read in conjunction with the financial statements and notes thereto included in the 2005 Annual Report of the Company.

Certain amounts in the 2005 financial statements have been reclassified to conform to the 2006 presentation. Such reclassifications had no impact on net income or shareholders’ equity.

 

Between 1997 and 1999, the Company completed six securitization transactions involving approximately $760 million in 125% of fixed rate, junior-lien underlying mortgages. The Company retained a financial interest in each of the securitizations. Principal amounts owed to investors were evidenced by securities (“Notes”). The Notes were subject to redemption, in whole but not in part, at the option of the Company, as owner of the retained interests in the securitization transactions, or at the option of the Note insurer, on or after the date on which the related Note balance declined to 5% or less of the original Note balance. Once the Notes were redeemed, the Company became the beneficial owner of the mortgage loans and recorded the loans as assets of the Company within the loan portfolio. During 2003 and 2004, the outstanding Note balances of the six securitizations declined below this 5% threshold and the Company exercised its redemption options on each of those securitizations. The table below summarizes information regarding delinquencies, net credit recoveries, and outstanding collateral balances of previously securitized loans for the dates presented:

 

 

As the Company redeemed the outstanding Notes from its securitizations, no gain or loss was recognized in the Company’s financial statements and the remaining mortgage loans were recorded in the Company’s loan portfolio at carrying value. Because the book value of the mortgage loans incorporates assumptions for expected prepayment and default rates, the book value of the loans is generally less than the contractual outstanding balance of the mortgage loans. As of June 30, 2006, the Company reported a book value of previously securitized loans of $22.3 million whereas the actual contractual outstanding balance of previously securitized loans at June 30, 2006, was $40.0 million. The difference (“the discount”) between the book value and the expected total cash flows from previously securitized loans is accreted into interest income over the life of the loans.

During the first six months of 2006 and 2005, the Company recognized $5.2 million and $5.9 million, respectively, of interest income from its previously securitized loans.

 

The Company utilizes interest rate floors to mitigate exposure to interest rate risk.  As of June 30, 2006, the Company has entered into seven interest rate floor contracts with a total notional amount of $500 million at a cost of $5.8 million that are designated as cash flow hedges. The objective of these interest rate floors is to protect the overall cash flows from the Company’s monthly interest receipts on a rolling portfolio of $500 million of variable-rate loans outstanding from the risk of a decrease in those cash flows to a level such that the yield on the underlying loans would be less than a range of 6.00% to 8.00%.

The notional amounts and estimated fair values of interest rate floor derivative positions outstanding at period end are presented in the following table. The estimated fair values of the interest rate floors on variable-rate loans are based on quoted market prices.

 

  Interest rate contracts involve the risk of dealing with counterparties and their ability to meet contractual terms. These counterparties must have an investment grade credit rating and be approved by the Company’s Asset and Liability Committee.

For cash flow hedges, the effective portion of the gain or loss on the derivative hedging instrument is reported in other comprehensive income, while the ineffective portion (indicated by the excess of the cumulative change in the fair value of the derivative over that which is necessary to offset the cumulative change in expected future cash flows on the hedge transaction) is recorded in current earnings as other income or other expense. The Company recognized a charge for the decrease in fair value of $1.0 million, net of taxes, in Other Comprehensive Income for the six months ending June 30, 2006 on these derivative instruments.

During the second quarter of 2006, the Company redesignated an interest rate floor contract with a total notional amount of $100 million that had previously been accounted for as a cash flow hedge as a freestanding derivative. As a result of this redesignation, the Company recorded a $0.1 million charge to expense to reflect changes in fair value of this instrument. This interest rate floor has no fair value reflected in the Company’s Consolidated Balance Sheet at June 30, 2006, matures in 23 months and has strike rate of 6.00%.

 

The components of short-term borrowings are summarized below:

 

The Company formed a statutory business trust, City Holding Capital Trust (“the Capital Trust”), under the laws of Delaware. The Capital Trust was created for the exclusive purpose of (i) issuing trust-preferred capital securities (“Capital Securities”), which represent preferred undivided beneficial interests in the assets of the trust, (ii) using the proceeds from the sale of the Capital Securities to acquire junior subordinated debentures (“Debentures”) issued by the Company, and (iii) engaging in only those activities necessary or incidental thereto. The trust is considered a variable interest entity for which the Company is not the primary beneficiary. Accordingly, the accounts of the trusts are not included in the Company’s consolidated financial statements.

The Capital Securities issued by the statutory business trust qualify as Tier 1 capital for the Company under the Federal Reserve Board guidelines. In March 2005, the Federal Reserve Board issued a final rule that allows the inclusion of trust preferred securities issued by unconsolidated subsidiary trusts in Tier 1 capital, but with stricter limits. Under this ruling, after a five-year transition period, the aggregate amount of trust preferred securities and certain other capital elements would be limited to 25% of Tier 1 capital elements, net of goodwill. The amount of trust preferred securities and certain other elements in excess of the limit could be included in Tier 2 capital, subject to restrictions. The Company expects to include all of its $25.5 million in trust preferred securities in Tier 1 capital. The trust preferred securities could be redeemed without penalty if they were no longer permitted to be included in Tier 1 capital.

 

On January 1, 2006, the Company adopted SFAS No. 123R, “Share-Based Payment,” which is a revision of SFAS No. 123, “Accounting for Stock Issued for Employees.” SFAS No. 123R establishes accounting requirements for share-based compensation to employees and carries forward prior guidance on accounting for awards to non-employees. Prior to the adoption of SFAS No. 123R, the Company reported employee compensation expense under stock option plans only if options were granted below market prices at grant date in accordance with the intrinsic value method of Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. In accordance with APB No. 25, the Company reported no compensation expense on options granted as the exercise price of the options granted always equaled the market price of the underlying stock on the date of grant. SFAS No. 123R eliminated the ability to account for stock-based compensation using APB No. 25 and requires that such transactions be recognized as compensation cost in the income statement based on their fair values on the measurement date, which is generally the date of the grant.

The Company transitioned to SFAS No. 123R using the modified prospective application method ("modified prospective application"). As permitted under modified prospective application, as it is applicable to the Company, SFAS No. 123R applies to new awards and to awards modified, repurchased, or cancelled after January 1, 2006. Additionally, compensation cost for non-vested awards that were outstanding as of January 1, 2006 will be recognized as the remaining requisite service is rendered during the period of and/or the periods after the adoption of SFAS No. 123R, adjusted for estimated forfeitures. The recognition of compensation cost for those earlier awards is based on the same method and on the same grant-date fair values previously determined for the pro forma disclosures reported by the Company for periods prior to January 1, 2006.

The fair value of the Company's employee stock options granted is estimated at the date of grant using the Black-Scholes option-pricing model. This model requires the input of highly subjective assumptions, changes to which can materially affect the fair value estimate. Additionally, there may be other factors that would otherwise have a significant effect on the value of employee stock options granted, but are not considered by the model. Because the Company’s employee stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options at the time of grant. The assumptions used in the Black-Scholes option-pricing model are as follows:

 

 

As the Company has not issued any options during the six months ended June 30, 2006, the factors for June 30, 2006 are consistent with amounts reported in the Company’s 2005 Annual Report.

There was no material impact on the Company’s income before income taxes and net income from the adoption of SFAS No. 123R. Prior to the adoption of SFAS No. 123R, the Company presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows in the Consolidated Statements of Cash Flows. SFAS No. 123R requires the cash flows from the tax benefits resulting from tax deductions in excess of the compensation expense recognized for those options to be classified as financing cash flows. An excess tax benefit totaling $0.2 million is classified as a financing cash inflow for the six months ended June 30, 2006.

Stock-based compensation expense is recognized ratably over the requisite service period for all awards. Unrecognized stock-based compensation expense related to stock options totaled $0.4 million at June 30, 2006. At June 30, 2006, this unrecognized expense is expected to be recognized over 1.5 years based on the weighted average-life of the option.

The following pro forma information presents net income, earnings per share, and diluted earnings per share for the three and six months ended June 30, 2005 as if the fair value method of SFAS No. 123R had been used to measure compensation cost for stock-based compensation plans. For purposes of these pro forma disclosures, the estimated fair value of options is amortized to expense over the options’ vesting periods.

 

A summary of the Company’s stock option activity and related information is presented below for the six months ended June 30:

 

 

 

The Company provides retirement benefits to its employees through the City Holding Company 401(k) Plan and Trust (“the 401(k) Plan”), which is intended to be compliant with Employee Retirement Income Security Act (ERISA) section 404(c). Any employee who has attained age 21 is eligible to participate beginning the first day of the month following employment. Unless specifically chosen otherwise, every employee is automatically enrolled in the 401(k) Plan and may make before-tax contributions of between 1% and 15% of eligible pay up to the dollar limit imposed by Internal Revenue Service regulations. The first 6% of an employee’s contribution is matched 50% by the Company. The employer matching contribution is invested according to the investment elections chosen by the employee. Employees are 100% vested in both employee and employer contributions and the earnings they generate. The Company’s total expense associated with the retirement benefit plan approximated $0.3 million for both of the six month periods ended June 30, 2006 and June 30, 2005 and approximated $0.1 million for both of the three month periods ended June 30, 2006 and June 30, 2005.

The following table presents the components of the net periodic pension cost of the Defined Benefit Plan:

 

 

The following table sets forth the computation of total comprehensive income:

 

 

The following table sets forth the computation of basic and diluted earnings per share:

 

 

    Options to purchase 43,750 shares of common stock at exercise prices between $36.25 and $36.90 and 90,000 shares of common stock at exercise prices between $32.89 and $33.90 per share were outstanding during the second quarter of 2006 and 2005, respectively, but were not included in the computation of diluted earnings per share because the options’ exercise price was greater than the average market price of the common shares and therefore, the effect would have been anti-dilutive.

 

On May 20, 2005, City completed the acquisition of Classic Bancshares (“Classic”) and the merger of Classic’s subsidiary, Classic Bank, into City National Bank. City and Classic had entered into a definitive agreement and plan of merger on December 29, 2004. Classic operated 10 full-service branches located in Eastern Kentucky and Southeastern Ohio. The primary reason for the merger with Classic was for City to expand its presence in the Huntington/Ashland WV-KY-OH Metropolitan Statistical Area (“MSA”). With the acquisition of Classic, City is now the largest commercial banking franchise in the Huntington/Ashland WV-KY-OH MSA. On May 20, 2005, Classic had total assets of $338 million, net loans of $254 million, deposits of $252 million, and $38 million of shareholders’ equity. The acquisition was accounted for using the purchase accounting method and the results of operations of Classic are included in City’s consolidated statement of income from the date of acquisition forward.

 

In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes--an interpretation of FASB Statement No. 109 (FIN 48), which clarifies the accounting and disclosure for uncertain in tax positions, as defined. FIN 48 requires that a tax position meet a "probable recognition threshold" for the benefit of the uncertain tax position to be recognized in the financial statements. A tax position that fails to meet the probable recognition threshold will result in either reduction of a current or deferred tax asset or receivable, or recording a current or deferred tax liability. FIN 48 also provides guidance on measurement, derecognition of tax benefits, classification, interim period accounting disclosure, and transition requirements in accounting for uncertain tax positions. This interpretation is effective for fiscal years beginning after December 15, 2006. The Company is assessing the impact of adopting the new pronouncement and is currently unable to estimate its impact, if any, on the Company's consolidated financial statements.

 

On August 3, 2006, the Company entered into a definitive agreement to sell its credit card portfolio of approximately $11.5 million to Elan Financial Services (Elan), a wholly owned subsidiary of U.S. Bancorp. As part of this agreement, the Company and Elan have entered into an agent marketing agreement that will enable the Company’s customers to continue to receive credit card products, while allowing Elan the exclusive marketing rights to the Company’s current and prospective customer base. This transaction is expected to be completed by December 31, 2006, subject to closing conditions, and is expected to result in an estimated pre-tax gain in excess of $3.4 million for the Company.

 

 

    The accounting policies of the Company conform with U.S. generally accepted accounting principles and require management to make estimates and develop assumptions that affect the amounts reported in the financial statements and related footnotes. These estimates and assumptions are based on information available to management as of the date of the financial statements. Actual results could differ from management’s estimates. As this information changes, management’s estimates and assumptions used to prepare the Company’s financial statements and related disclosures may also change. The most significant accounting policies followed by the Company are presented in Note One to the audited financial statements included in the Company’s 2005 Annual Report to Stockholders. The information included in this Quarterly Report on Form 10-Q, including the Consolidated Financial Statements, Notes to Consolidated Financial Statements, and Management’s Discussion and Analysis of Financial Condition and Results of Operations, should be read in conjunction with the financial statements and notes thereto included in the 2005 Annual Report of the Company. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the determination of the allowance for loan losses, income taxes, and previously securitized loans to be the accounting areas that require the most subjective or complex judgments and, as such, could be most subject to revision as new information becomes available.

Pages 24-28 of this Quarterly Report on Form 10-Q provide management’s analysis of the Company’s allowance for loan losses and related provision. The allowance for loan losses is maintained at a level that represents management’s best estimate of probable losses in the loan portfolio. Management’s determination of the adequacy of the allowance for loan losses is based upon an evaluation of individual credits in the loan portfolio, historical loan loss experience, current economic conditions, and other relevant factors. This determination is inherently subjective as it requires material estimates including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. The allowance for loan losses related to loans considered to be impaired is generally evaluated based on the discounted cash flows using the impaired loan’s initial effective interest rate or the fair value of the collateral for certain collateral dependent loans.

Note B, beginning on page 9 of this Quarterly Report on Form 10-Q, and pages 28 and 29 provide management’s analysis of the Company’s previously securitized loans. Amounts reported in the Consolidated Balance Sheets as “previously securitized loans” represent the carrying value of loans beneficially owned by the Company as a result of having fully redeemed the obligations owed to investors (“Notes”) in certain of the Company’s securitization transactions. The carrying value of previously securitized loans is determined using assumptions with regard to loan prepayment and default rates. Using cash flow modeling techniques that incorporate these assumptions, the Company estimated total future cash collections expected to be received from these loans and determined the yield at which the resulting discount would be accreted into income. If, upon periodic evaluation, the estimate of the total probable collections is increased or decreased but is still greater than the sum of the original carrying amount less subsequent collections plus the discount accreted to date, and it is probable that collection will occur, the amount of the discount to be accreted is adjusted accordingly and the amount of periodic accretion is adjusted over the remaining lives of the loans. If, upon periodic evaluation, the discounted present value of estimated future cash flows declines below the recorded value of previously securitized loans, an impairment charge would be provided through the Company’s provision for loan losses. Please refer to Note B of Notes to Consolidated Financial Statements, on pages 9 - 10 for further discussion of SOP 03-3.

 

The Company reported consolidated net income of $26.6 million, or $1.49 per diluted common share, for the six months ended June 30, 2006, compared to $24.0 million, or $1.40 per diluted common share for the six months ended June 30, 2005. Return on average assets (“ROA”) was 2.12% and return on average equity (“ROE”) was 18.1% for the first six months of 2006, compared to 2.10% and 20.3%, respectively, for the first six months of 2005.

The Company reported consolidated net income of $13.8 million, or $0.77 per diluted common share, for the three months ended June 30, 2006, compared to $12.3 million, or $0.71 per diluted common share, for the second quarter of 2005. Return on average assets (“ROA”) was 2.17% and return on average equity (“ROE”) was 18.8% for the second quarter of 2006, compared to 2.09% and 19.8%, respectively, for the second quarter of 2005.

On a tax equivalent basis, net interest income increased $5.9 million, or 12.8%, from $46.4 million in the first six months of 2005 to $52.3 million in the first six months of 2006. This increase was primarily due to a widening of the Company’s net interest margin that increased net interest income by $4.4 million from the first six months of 2005. Interest income from the Company’s loan portfolio excluding Previously Securitized Loans increased $7.1 million from the second quarter of 2005 as the yield on these loans increased 88 basis points. In addition to benefiting from increased yields on loans, the Company has also been able to increase the average balances of its traditional loan portfolio (residential real estate, home equity, commercial and consumer loans) due to both internal growth and the acquisition of Classic during the second quarter of 2005. The increase in average balances of $236 million, or 17.3%, from the first six months of 2005 increased interest income associated with these loans by $6.9 million.

These increases were partially offset by increased interest expenses associated with higher rates paid on interest-bearing deposit accounts and increased balances of interest-bearing deposits. As a result of an increase of 67 basis points in the rate paid on interest-bearing deposits, interest expense increased $4.7 million from the first six months ended June 30, 2005. In addition, as a result of an increase in the average balances of interest-bearing deposits of $211 million, or 15.2%, interest expense increased $2.6 million from the first six months of 2005. The increase in the average balance of interest-bearing deposits from the six months ended June 30, 2005 is attributable to the Classic acquisition and internal growth.

The net interest margin for the first six months of 2006 of 4.64% represented a 20 basis point increase from the first six months of 2005’s net interest margin of 4.44%. In order to offset the decreasing balances of high yielding previously securitized loans and resultant lower levels of interest income from these assets, the Company positioned its balance sheet to benefit from rising interest rates by emphasizing variable rate loan products. Excluding the impact of previously securitized loans and the Classic acquisition, the Company’s net interest margin increased 33 basis points, or $3.2 million, for the six months ended June 30, 2005 when compared to the six months ended June 30, 2006.

The Company’s tax equivalent net interest income increased $2.3 million, or 9.7%, from $23.9 million during the second quarter of 2005 to $26.2 million during the second quarter of 2006. This increase was primarily attributable to a widening of the Company’s net interest margin, which increased net interest income by $2.1 million from the second quarter of 2005. The increase was due primarily to an increase of 89 basis points in the Company’s traditional loan portfolio (residential real estate, home equity, commercial, and installment loans). As a result, interest income from the Company’s traditional loan portfolio increased $3.7 million from the second quarter of 2005. Also contributing to increased interest income was growth in the Company’s traditional loan portfolio due to internal growth and the acquisition of Classic Bancshares, Inc. during the second quarter of 2005. As a result of this growth of $178 million, or 12.5%, in the average balances of traditional loan products, interest income from these loans increased $2.5 million.

These increases were partially offset by increased interest expense associated with higher rates paid on interest-bearing deposits and increased balances of interest-bearing deposits. Interest expense increased $2.7 million due to a 75 basis point increase in the rate paid on interest-bearing deposits from the second quarter of 2005. Meanwhile, increased average balances of deposits of $190 million, or 13.2%, from the second quarter of 2005 were due to internal growth and the acquisition of Classic during the second quarter of 2005. Growth in average balances of deposits increased interest expense by $1.2 million.

The net interest margin for the second quarter of 2006 of 4.58% represented a 16 basis point increase from the second quarter of 2005’s net interest margin of 4.42%. In order to offset the decreasing balances of high yielding previously securitized loans and resultant lower levels of interest income from these assets, the Company positioned its balance sheet to benefit from rising interest rates by emphasizing variable rate loan products. Excluding the impact of previously securitized loans, the Company’s net interest margin increased 27 basis points, or $1.6 million, when comparing the quarter ended June 30, 2006 to the quarter ended June 30, 2005.

(in thousands)